New Rule 144: Lower Illiquidity Discounts and Another Boost for the PIPE Market?
By Espen Robak, CFA

The impact on valuations from proposed changes to Rule 144 is uncertain, but reductions in illiquidity discounts are expected.  Our research on the LiquiStat™ database of restricted securities transactions can help us predict how the new rules will change valuations.

The article:

• Outlines the proposed changes to Rule 144, as well as changes to Rule 145, Regulation D, and the S-3 and shelf registration requirements for small issuers
  
• Analyzes what effect the changes will have on restricted securities valuations
  
• Predicts how the rules will affect capital market activity.

Excerpts:

• Proposed changes include:
  
  
  • 1. shortening the initial holding period
    
  • 2. shortening the holding period for 144(k) eligibility
    
  • 3. re-introducing tolling for hedged positions
    
  • 4. loosening information and filing requirements
    
    
• The Securities and Exchange Commission is considering reducing the holding period for restricted stock from one year to six months, which should improve liquidity and reduce illiquidity discounts.
  The new rules do not affect the liquidity of private companies, but it is important to analyze them to understand how restricted stock discounts need to be adjusted when discounting private equity.
  The SEC is also proposing changes to Rule 145, Regulation D, and the S-3 and shelf registration requirements for small issuers.  These rules may have wide-ranging effects on Private Investments in Public Equities (PIPEs).
  
  
• The proposals are designed to improve capital formation for small issuers.

The Pluris LiquiStat™ study:

• Pluris analyzed a database of private transactions in restricted stock to see how discounts vary with different holding periods.
  
  
• LiquiStat data confirms that the discount is a function of (1) the expected time to liquidity and (2) the investment risk inherent in owning the stock during the expected holding period.

• Warrant discounts are higher for riskier securities.  However, due to the asymmetric payoff of warrants, different risk measures must be analyzed for warrants than for stock.  In particular, warrants with a higher “time value” as a proportion of their full Black-Scholes values have higher discounts.

• PIPE market discounts will likely decline after the Rule 144 holding period is cut in half.  But by how much?  We would not expect a straight-line relationship between the days remaining and the discount.  The LiquiStat data analysis published previously showed a quadratic relationship between the discount and the holding period.

Conclusion:
Based on these conclusions, if all else stays the same, the new rules will lower private placement discounts, enhance deal flow and improve the availability of capital – for the smallest, riskiest, least liquid issuers.  The data analyzed herein indicates, however, that if the new rules lead to an overall reduction in PIPE discounts, the change will most likely be slight, almost certainly no more than a few percentage-points.  Conversely, for the lowest-quality paper, from issuers that are currently raising equity at effective equity discounts in the 40 percent range, our models indicate that the change could lead to anywhere from a 3 percent to 14 percent reduction in the discount and, most likely, in the bottom of the range.