Promoting confidence in Non-Executive Directors’ ability to challenge and approve the valuation of privately held investments

During the past few months, there has been heightened press attention directed at privately held investment valuations, following a major board reshuffle in one of Europe’s largest listed investment companies. One of the drivers of this corporate governance shake-up was due to concerns raised by an ex-director over the robustness of the directors’ processes over approving private investment valuations. Private investments are illiquid investments, categorised as ‘Level 3’ under International Financial Reporting Standards and are particularly challenging to value owing to the high estimation uncertainty and subjectivity. The issues highlighted by the events bring into focus the question of whether Boards of Directors have sufficient training and experience, and whether governance processes are strong enough to monitor private investments.

Having a robust governance framework over the valuation of private investments and illiquid assets is fundamental. Incorrectly applied valuation judgements have a direct impact on a company’s value, financial statements, investor confidence, share price and strategic decision-making.

A governance framework that includes NEDs attending valuations committees, a comprehensive well-documented valuation policy, use of an independent expert and more technical valuation training for the Board of Directors is the way forward to give NEDs confidence in approving valuations and demonstrating strong governance.

Why is it important for NEDS to be comfortable with private valuations?

In recent years, an increased demand for growth without the spotlight of the public market and technological advance has meant that developing businesses have remained private for longer. It has been recognised that this shift in growth strategies during what was a low interest rate environment, left stock market investors excluded from prime opportunities. Asset management and private equity firms responded by increasing their share of holdings in private firms.

With increased exposure to the unquoted market, asset management companies are more reliant than ever on strong valuation policies and controls and the expertise of valuation professionals. However, within a company’s controls over the valuations process, the final line of defence rests with the Board and the challenge from directors as part of their oversight over the valuation methods used. This is driven by a number of regulatory requirements including Section 174 of Companies Act which requires directors to exercise reasonable care, skill and diligence and the UK Corporate Governance Code which sets out one of the duties of the audit committee as being to review significant accounting judgements. In fact, the Financial Reporting Council (FRC) has proposed a number of changes to the UK Corporate Governance Code. The reform is set to commence 1 January 2025 and will place additional responsibility on the Board. It emphasises in Principle J; the need for a Board to have a combination of skills, experience and knowledge to perform their duties and in Principal K; the importance of monitoring whether directors have assessed the time commitment necessary to discharge their responsibilities effectively.

What measures can be implemented to achieve this?

Here are several examples of best practices in control frameworks that companies can enact voluntarily:

I. Assessment of any upskilling requirements when performing the annual board evaluation

The annual evaluation of the board should consider the performance of the directors and any skill gaps in relation to technical matters the board has oversight of. This will identify the need to make new appointments, invest in training and seek the input of third-party experts. It will also identify whether more time commitment is needed from directors, due to reading and challenging complex board papers, and attending valuation committee meetings which can feed into directors' remuneration discussions and into planning the annual timetable for meetings.

II. Dedicated valuation committee

By setting up a dedicated valuation committee, a direct link between management and the directors is established. A strong valuation committee should be comprised of members of the valuation team, finance team and at least one member of the Board of Directors. The committee should review and approve the valuation with due care and skill on an on-going basis, and especially before the investment is signed off by Board of the Directors.

The output from the valuation committee must be sufficient to allow NEDs to be able to perform their governance activities by evaluating whether the design and implementation of valuations controls is appropriate, and operated effectively throughout the period. NEDs should be in a position to review enough information to effectively demonstrate their challenge of valuation methodology, and this challenge should be clearly minuted as an additional control in the governance framework. It is a common finding in audits of private investments that firstly, documentation of valuations controls need to be improved and secondly, that challenge from directors is not evident.

III. Formally written comprehensive valuation policy

Following the establishment of a valuation committee, the next step is a formally documented and comprehensive valuation policy. Such a policy would outline and discuss the benefits and drawbacks of applying different valuation methodologies to the assets, for example; whether it is more appropriate to use a Discounted Cash Flow or Earnings Multiple approach. It is also important to document how the approach taken complies with relevant valuation guidelines such as IPEV or AICPA. Best practice has shown the importance of applying a secondary valuation method to cross-check the results of the primary method selected.

The policy must also examine the valuation inputs methodically to ensure that they can be traced to suitable up-to-date sources or when assumptions are used, there is clear rationale for using the specific assumptions. For instance, one of the most significant assumptions in Level 3 valuations is often the multiples that are applied based on data from comparable listed companies. A robust valuation policy would lay out specific qualitative and quantitative comparability criteria for the selection of any applicable multiples, and traded peers' baskets.

IV. Independent expert

The valuation of private investments is highly subjective, and concerns may be raised over the independence of management and the board. Involving an independent expert will help in benchmarking management’s valuations and can alleviate these concerns. It can also offer more confidence to the Board approving the valuation as well as investors and other stakeholders using the portfolio valuation.

V. More valuation specific training for Board of Directors

In order to scrutinise the valuation presented to the Board of Directors, it is critical that there is strong understanding of the valuation methodologies and the requirements of the relevant valuation guidelines such as IPEV/ AICPA. Some of the aspects of valuation practices and industry landscape change routinely. The training calendar should take this into account and ensure that training covers the latest practices, guidelines, and standard requirements and that a training programme is maintained regularly.

Looking ahead

As the financial and regulatory landscape continues to evolve pushing boards to assume greater responsibility in demonstrating effective governance, and reporting, investor and audit expectations are intensifying. The Financial Conduct Authority’s recent review on high-risk investments is one example of this. It is now more important than ever to have a defined framework in place for governance reporting concerning the valuation of illiquid assets. Such a framework is pivotal in enabling NEDs and the board to effectively discharge their duties. By adhering to a clear and defined framework, NEDs and the board can navigate the complexities of valuing illiquid assets and demonstrate the appropriate level of challenge which will mitigate the risk of incorrect valuation.

Get in touch

If you would like to speak with a member of our Financial Services team, please contact us. Or to submit Request for Proposal documents, use the link below.

Submit RFP