Preserving Value: The Case for Voluntary Liquidation

January 18, 2010 · Leave a Comment

This week we discuss investments in companies undergoing voluntary liquidation.

One of our favorite topics at Valuehuntr, these have typically been among the best performing of the ValueHuntr Portfolio. Opportunities we have highlighted in the past such as SOAP (88% return),  FACT (100% return), and VNDA (1150% return….got lucky on this one), have all been sub-liquidation investments.

A voluntary liquidation is one conducted at shareholder or management discretion, not one forced by creditors or bankruptcy courts. Managers may choose to liquidate make it value-increasing for shareholders. When engaging in such investment strategy we tend to only look at the value of the company’s balance sheet. Our rationale is that if the level of cash that could be extracted from a business through the liquidation of its inventory, property, equipment, etc. is greater than the market value of the company plus its liabilities, then liquidation may create value for shareholders. Because uncertainty of liquidation timing is a major risk, we proceed with liquidation investments only if there is a significant margin of safety between the cash that could be extracted and the company’s commitments, as mentioned above.

However, a 1995 statistical study conducted by Michael Fleming (Federal Reserve Bank of New York) and John Moon (Goldman Sachs), points out that the likelihood of a company’s voluntary liquidation may in fact be a function of several variables not accounted for on a company’s balance sheet. Interestingly, several hypotheses are laid out:

Financial Performance: This hypothesis argues that firms with poor financial performance are more likely to liquidate. Supporting evidence from this hypothesis comes from literature on takeover targets, which have generally been found to have low sales growth and low asset productivity. Therefore, both are predicted to be negatively associated with the probability of liquidation.

Asset Liquidity: This hypothesis argues that firms with more liquid assets are more likely to liquidate. This makes sense, as liquid assets can be sold more easily to other buyers at higher and more competitive prices than illiquid assets. Therefore, liquidity is predicted to be positively correlated with the likelihood of liquidation.

Market-to-Book: Firms with low market-to-book ratios due to high tangibility are generally good liquidation candidates. This is because tangible assets always remain on the books after a purchase, while intangibles may not.

Capital Structure:

Costs of Equity: Several studies conducted by Jensen and Meckling (1976) have shown that as the percentage of insider ownership decreases, management has greater incentive to consume the cash available for shareholder distribution.

Costs of Debt: For firms with no debt, maximizing the value of a firm is equivalent to maximizing the value of a firm’s equity. For firms with debt, however, firm value maximization is no longer equivalent to shareholder value maximization.  If shareholders face a choice between a fixed payoff under liquidation and an uncertain payoff if the firm continues as a going concern, shareholder interests may be served by not liquidating.

Executive Age: Several studies have found that friendly bids are more common when firms are run by founding families, and at these firms, the top executive tends to be older than the average firm. Therefore, the age of a chief executive may be a factor in the likelihood of voluntary liquidation.

Surprisingly, the study concludes that out of all possible variables that could have an effect on voluntary liquidation, only three ratios are significant: cash/assets, debt/assets, and market-to-book. Notice that all variables are balance sheet items. This validates our general strategy of focusing on the company’s balance sheet when looking for opportunities in liquidating businesses.

Moreover, there are other interesting conclusions we can infer from the data:

1)    The number of opportunities in voluntary liquidations increases inversely proportional to general market levels. That is, there liquidations are more likely in bear markets. Although this makes sense, the implications on investment strategy are less intuitive. Because liquidations are more likely in bear markets, investors may be able to insulate their portfolios from bear markets by allocating portions of their portfolio to opportunities in the liquidation space. This is exactly what we observed on March 2009, when the probability of excess market returns through liquidation investments was greatest when market fear was at a peak level.

2)     There is typically more money to be made before a liquidation announcement than after. On average, most candidates for voluntary liquidation returned more than 30% prior to the announcement. After the announcement, investors received roughly 6%. On announcement day, companies announcing voluntary liquidation increased their stock price by 12.5%.

We will continue to look for opportunities within the liquidation space. However, it is unlikely that we will find as many in 2010. It is very likely that no opportunities will be found in the near term, as the market has returned to its normal state relative to the distressed levels of March 2009. However, it is clear that liquidations should be a portion of every investor’s portfolio. These have a low correlation with general market returns, which may allow investors to make money even in bear markets.

Tomorrow, we will highlight Seth Klarman’s views on voluntary liquidations and how he is able to make money on them.


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Categories: Liquidation · Special Situations · Value Investing
Tagged: Dissolve, Investing, Liquidation, portfolio, ValueHuntr, Voluntary Liquidation

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