Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 23

Cost of Capital of Family Holding Company Interests

William H. Frazier

Introduction

Family Holding Company

Relationships between Time to a Liquidity Event and Value

Family Holding Companies Are Typically Very Long-term Investments

Lack of Control

Asymmetrical Information and Lack of Control

Incremental Required Rate of Return for Asymmetrical Information and Lack of Control

Estimating the Cost of Illiquidity

Illiquidity Theory

Volatility and Illiquidity

Empirical Studies on Embedded Illiquidity

Measuring Illiquidity from Market Data

Illiquidity Premium for Equity Investments

Increasing Cost of Illiquidity over Time

Illiquidity Term Structures for Asset Classes

Summary

INTRODUCTION

Family holding companies (FHCs) are closely held investment entities such as family limited partnerships (FLPs) and limited liability companies (LLCs) that hold investment assets such as stocks, bonds, and real estate.¹ Occasionally, these entities may own an operating business.

In the traditional market approach to valuing equity interests in FHCs, the major objectives are to determine the appropriate discounts for lack of control and lack of marketability. These discounts, when applied to the net asset value (NAV) of the entity, provide estimates of fair market value.

The nonmarketable investment company evaluation (NICE) method is a valuation method under the income approach. It is designed especially to determine the fair market value of equity interests in family holding companies by ...