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A focus on valuation governance

The determination of fair value of deployed Private Capital has always been subjective, requiring insight and significant judgment by the preparers in determining how much an asset is worth. It is a challenging determination which has only been heightened by the pandemic as well as the UK’s exit from the EU. This ever-changing, volatile environment results in a much greater focus on governance, whether that it is through regulatory pressure (e.g. audit reform), investor demand (due to being more sophisticated) or the emerging best practices. As a result, well governed businesses are expected to outperform those that aren’t, and well governed businesses are expected to attract more capital than those that aren’t.

The growing private equity market

Private Capital, as a sector, has shown substantial growth over the past decades and has broadly been relatively unimpacted by the recent global events. The reported amounts of dry powder are in excess of $ 2.5 trillion as of 2020. This is in comparison to approximately $1 trillion in 2010 indicative of a 150% growth in less than a decade, with future forecasts of more significant growth (see Deloitte industry report here) This record level of unutilised capital illustrates the attractiveness of the asset class, but also the levels of uncertainty, reservation and caution in completing deals. The allocation to private capital by investors has scaled, increasing the level of unutilised capital which has grown faster than the ability of PE houses to deploy the funding. There is more cash chasing quality assets.

This combination of a strong regulatory climate with a focus on restoring trust as well as the available capital in a volatile environment is highlighting a growing need for strong governance in the private capital sector, in particular over the valuations process.

The determination of fair value and the associated subjectivity has been topical for some time. The increase in private capital is resulting in a more sophisticated investor pool requiring more reliable and timely reporting.

How can investors and other stakeholders be confident that the judgments applied in the valuations process are reasonable in determining fair value?

An investor who is seeking to invest capital through PE houses will most certainly seek to obtain assurance that the fund can obtain required returns, or that the manager has done so previously. How do you get assurance that the valuations are appropriate and therefore representative of return? Many will refer to an audit report which is reasonable assurance at a specific point in time but does not provide any assurance over the remainder of the year and can rapidly become stale. More robust processes to value the portfolio facilitate accurate and reliable reporting at any point in time, not just period end.

Strong governance provides all stakeholders with some assurance that the internal controls operating within the valuations process are appropriate, and operational, and therefore are reliable in the decision-making process. It also reduces the reliance on an audit report, or a historical track record, as the sole basis of assurance of a fund’s performance.

Strong governance over the valuations process is essential and should be on the agenda of all Private Equity houses. Focus should be applied over the controls that are associated with the critical judgments and estimates which represent material drivers of valuations. Strong governance:

  • Holds management teams to account to provide accurate reflections of the portfolio company valuations
  • Reduces the risk that valuations are manipulated
  • Allows better decision making on strategic direction of a portfolio company either if values are increasing or decreasing
  • Allows for a more effective plan to exit.

There are a range of practices across the PE world when it comes to investment valuation governance. Some firms will have dedicated valuation committees which are responsible for approving valuations, some will have investment committees which approve deals and then sign off on valuations as well as a number of different structures that other firms implement.

Elements of a good control framework are:

  • Challenge – Appropriate processes to challenge the key assumptions at various stages of the valuation process, from methodology used, to the validity of the inputs, and the reasonableness of material judgements used to determine valuations. Providing appropriate challenge requires the right level of seniority and expertise.
  • Independence – this is key to achieving a good governance framework. This will mean that the challenge provided in the valuation process is performed independently and avoids issues with respect to conflict of interest. This independence can be achieved either by having individuals from outside the ‘front-office’ within the governance framework or bring in external independence (either through independent non-executives or a third party valuation specialist),
  • Valuation Policy- a thought out and detailed valuation approach approved by those charged with governance facilitates a consistent approach in determining fair value and defining processes and controls by for example eg

a. supporting establishing processes to ensure the accuracy and completeness of information and data used in the valuation;
b. ensuring consistency in approach
c. manages conflicts of interests through establishes processes

The nature of the risk surrounding the appropriate fair value of investments subjective and will not necessarily be covered by a standard service organisation controls assurance report. A tailored solution is required to obtain assurance that the governance over the valuations process is aligned with the industry associations, determined best practice, and published guidance to truly address the needs of all stakeholders. Strong governance is the way in which the sector restores trust in valuations and so continues to thrive. In addition, consideration should be made over the type of assurance that can be provided to stakeholders in addition to an audit report.

If you have any queries regarding the valuation governance of Private Capital, please do get in touch - contact details can be found below.

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