Equipping NEDs to challenge private investment valuations

Mon 09 Oct 2023

A recent major board reshuffle in one of Europe’s largest listed investment companies has focused attention on private investment valuations. It follows concerns raised by an ex-director over the robustness of the directors’ processes for approving investment valuations. The issues primarily question whether the Board of Directors has sufficient training and experience and whether governance processes are strong enough to monitor private investments.

Private investments are illiquid assets categorised as Level 3 under International Financial Reporting Standards. They are particularly challenging to value owing to high estimation uncertainty and subjectivity in choosing the most appropriate assumptions in the absence of quoted market prices for the underlying investee companies.

Having a robust governance framework for the valuation of private investments and illiquid assets is fundamental, as incorrectly applied valuation judgements directly impact a company’s value, financial statements, investor confidence, share price, and strategic decision-making. An essential part of this framework is about giving non-executive directors (NEDs) the tools to challenge management’s estimates.

An evolving regulatory landscape

In recent years, an increased demand for growth and a low interest rate environment have seen asset management companies and private equity firms increase their holdings in private investments. With increased exposure to the unquoted market, there is more reliance than ever on solid valuation policies and controls, as well as the expertise of valuation professionals.

In terms of controls over the valuation 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 the Companies Act which requires directors to exercise reasonable care, skill, and diligence. Also, the UK Corporate Governance Code sets out one of the audit committee’s duties as reviewing significant accounting judgements.

In addition, the Financial Reporting Council has proposed several changes to the UK Corporate Governance Code which will place additional responsibilities on the Board. Planned for 1 January 2025, the changes emphasise the need for a Board to have a combination of skills, experience, and knowledge to perform their duties. There is also an emphasis on the importance of monitoring whether directors have assessed the time commitment necessary to discharge their responsibilities effectively.

Focus on best practice to oversee the valuation process

As well as regulatory requirements, there are several examples of best practices in control frameworks that companies can implement voluntarily to improve governance and oversight of the valuation process.

1. Assess any upskilling requirements at the annual board evaluation

The annual board evaluation should consider directors’ performance and any skill gaps related to technical matters the board oversees. This will identify the need to make new appointments, invest in training and seek the input of third-party experts. It will also determine whether directors need to commit more time to read and challenge complex board papers, as well as attend valuation committee meetings. This can also feed into directors’ remuneration discussions and annual meeting schedules.

2. Set up a dedicated valuation committee

By setting up a dedicated valuation committee, a direct link between management and the directors is established. A robust valuation committee should comprise members of the valuation team, finance team, and at least one member of the Board of Directors. The committee should review and approve valuations with skill and due care on an ongoing basis before investments are signed off by the Board of Directors. 

The output from the valuation committee must be sufficient to allow NEDs on the Board to perform their governance activities by evaluating whether the design and implementation of valuation controls are appropriate and operated effectively throughout the period. NEDs should be able to review enough information to effectively demonstrate challenges to the valuation methodology, which should be clearly minuted as an additional control in the governance framework. It is a common finding in private investment audits that valuation control documentation needs to be improved and that challenges from directors are not evident.

3. Establish a formally written and comprehensive valuation policy

Once a valuation committee is set up, the next step is to establish a formally documented and comprehensive valuation policy. The policy should outline and discuss the benefits and drawbacks of applying different valuation methodologies to the assets. For example, is it more appropriate to use a Discounted Cash Flow or Earnings Multiple approach? It’s important to document how the approach taken complies with relevant valuation guidelines such as those outlined by the International Private Equity and Venture Capital Valuation (IPEV) or the American Institute of CPAs (AICPA). Best practice has shown the importance of applying a secondary valuation method to cross-check the results of the primary approach selected.

The policy should examine the valuation inputs methodically to ensure that they can be traced to suitable up-to-date sources or when assumptions are used, the rationale for their use is clearly considered. For instance, one of the most significant assumptions in Level 3 valuations is often multiples 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.

4. Involve an independent expert

Private investment valuations are highly subjective and concerns may be raised over the independence of management and the Board. Involving an independent expert will help benchmark management’s valuations and alleviate concerns. It also offers more confidence to the Board approving the valuation as well as investors and other stakeholders using the portfolio valuation.

5. Introduce more valuation-specific training for the Board of Directors

In order to scrutinise valuations presented to the Board of Directors, there must be a strong understanding of the valuation methodologies and guidelines outlined by IPEV or AICPA. As some aspects of valuation practices and industry landscapes change routinely, the training calendar should take this into account. Training programmes should cover the latest practices, guidelines, standard requirements and be maintained regularly.

Helping NEDs to navigate complexities

As the financial and regulatory landscape evolves, Boards are being pushed to assume greater responsibility in demonstrating effective governance and reporting. As investor and audit expectations intensify, having a clear and defined governance framework also enables NEDs to navigate the complexities of valuing illiquid assets and demonstrate the appropriate level of challenge needed to mitigate the risk of incorrect valuation. A governance framework that includes NEDs attending valuations committees, a comprehensive and well-documented valuation policy, the use of an independent expert, and more technical valuation training for the Board of Directors is not only best practice; it can also equip NEDs to challenge private investment valuations with confidence.