How are illiquidity adjustments applied in fair value measurement?

Question

AcadiFi · Accepted Answer

An illiquidity discount reduces fair value to reflect the economic cost of inability to monetize a position quickly at quoted prices. It is applied when either (a) the instrument is contractually restricted from sale (lockup, Rule 144), or (b) the market is so thin that an exit would move the price materially, or (c) no exit market exists.

Common methods:
1. **Restricted stock studies** — empirical discounts observed between restricted and freely tradable shares, historically 20-40%, more recently 15-25%.
2. **Put option method** — cost of a protective put matching the restriction period approximates the illiquidity discount (Chaffe, Finnerty models).
3. **Pre-IPO studies** — comparing pre-IPO transactions to IPO prices to estimate private company illiquidity.
4. **Qualitative adjustments** — judgmental haircuts based on float, bid-ask spreads, time-to-exit.

Worked example: Ironpath Growth Partners holds 800,000 shares of Vanta Therapeutics acquired in a secondary PIPE with a 12-month lockup. Unrestricted shares trade at $41.20. Ironpath applies a 22% Finnerty-derived illiquidity discount: 800,000 × $41.20 × (1 − 0.22) = $25.7M fair value vs unrestricted $33.0M.

**Hierarchy classification**: This is typically Level 2 if the discount is derived from market-observable put option prices or recent restricted stock study data, Level 3 if the discount is judgment-based or relies on unobservable holding-period volatility.

**Key constraint**: Under ASC 820 Level 1, adjustments to quoted prices for blockage (selling the full position would move the market) are generally NOT permitted. Only discounts for actual legal restrictions on the instrument itself are allowed.

How are illiquidity adjustments applied in fair value measurement?

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