Investment trust boards have 'room for improvement' when it comes to private valuations, following concerns that they may not have the sufficient training and experience, or not have strong enough governance processes, to monitor private investments.
The ability of investment trust non-executive directors (NEDs) to effectively understand and challenge valuations of private companies has been called into question, as demand for private investments rises and regulatory scrutiny intensifies.
Appetite for private market opportunities has rapidly increased in recent years, with investment trusts traditionally one of the preferred vehicles to access this area, with Numis analyst Ash Nandi highlighting the steady presence of alternative asset investment trusts on retail platforms' ‘most bought lists' over the last year.
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As a result of this demand and launches of newer products targeting private market opportunities – including LTAFs in the UK and ELTIFs in Europe – processes and structures related to private companies and their valuations have come under fresh scrutiny.
The governance of investment trust boards has also fallen under this spotlight, after some former and current non-executive directors (NEDs) shared concerns over transparency and board practices, including recruitment and independence, with some relating to private markets in particular.
One of the main issues raised has been the treatment of private investments since the board of directors is responsible, at times, for accepting or challenging private valuations; an area the Financial Conduct Authority decided to launch a review into in October last year.
At the time, the watchdog said it was concerned about asset managers' disciplines and governance over valuations, especially in a high-interest rate environment, with an emphasis on responsibility of valuation outcomes and what supervision is in place for such processes.
Investment trusts under the spotlight
Investment trusts have not been exempt from this wider scrutiny, according to Nargis Yunis, head of asset management at Forvis Mazars, who argued their boards have "room for improvement" when it comes to private valuations, following concerns that they may not have the sufficient training and experience, or, not have strong enough governance processes, to monitor private investments.
This is important as investment trust boards are the "final line of defence" to challenge the valuation methods for private investments Yunis explained which, at times, will either be put forward by the asset manager or even by a third-party valuer, if required.
Relying only on the asset manager's valuations is "not ideal", argued Jock Glover, strategic relationship director at Square Mile Investment Consulting and Research, although he noted that managers should have the appropriate controls in place to carry out such valuations, which will also need to be evidenced to the FCA.
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Often there is at least one NED with investment experience on an investment trust board, as the FCA's disclosure and transparency rules require at least one sitting NED to have financial and/or accounting experience.
However, that is not always the case, highlighted James Carthew, head of investment companies at QuotedData.
As such, this can create a knowledge and skills vacuum within an investment trust board, making it even more difficult to review valuations of private companies or even be able to challenge any aspect of the methodology used by either the asset manager, the third-party valuer, or both.
Codes of conduct
The Association of Investment Companies' own corporate governance code sets out that NEDs must establish an audit committee "with relevant experience in the sector that the [trust] invests in", explained Annabel Brodie-Smith, communications director at the AIC.
Additionally, as far as the valuation of unquoted companies is concerned, the board's task is to oversee the accounting policies and assumptions underpinning the valuations, which are then subject to examination by both the auditor and board in order to provide "independent oversight, scrutiny and challenge", she noted.
With demand for private investment opportunities soaring lately, especially among the high-net-worth segment, it is therefore paramount to have robust structures in place when valuing unquoted companies, and the skillset and experience of investment trust NEDs plays a significant role in the oversight of such valuations.
A former NED, who wished to remain anonymous, told Investment Week part of the issue revolves around challenging current hiring practices of NEDs for investment trust boards.
During their time as an investment trust non-executive director, they said there was a "direct exclusion of anyone with investment experience" at the vehicle, highlighting a much closer relationship between the board and the investment manager than expected.
"I was surprised about how much of a say the investment manager had in the selection of new directors," the former NED said, something that cast a shadow over the independence of the investment trust board.
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In fact, the AIC sets out that a board of directors "must be independent of the fund manager. This means that a majority of directors must be independent, and the chair must be independent".
The former NED called for the introduction of a "set of qualifications" and tackling "overboarding" – where NEDs sit on several company boards at the same time - as they argued this practice could disincentivise and discourage them from taking a stance against the manager, if needed, in order to protect their seat at the table.
Amar Bhide, the former Scottish Mortgage non-executive director, lamented similar worries last year after leaving the trust and turned to the FCA to express his concerns over the director selection process.
At the time, SMT dismissed Bhide's claims, with chair Justin Dowley arguing the board was "in compliance with all [its governance] and disclosure obligations".
Recruitment and training
In his recent book Uncertainty and Enterprise: Venturing Beyond the Known, seen by IW, Bhide argued that, generally, public companies have widespread "governance problems".
This is because even though a board is supposed to be independent of managers and have a duty to champion the interests of shareholders, he argued in the book that "in practice, the independent direction is perfunctory" as "executives control board nominations".
Several industry players told Investment Week there is a need to reshape hiring practices for investment trust NEDs, as well as bolster training for directors who may not have financial or accounting skills.
A current investment trust NED, who also wished to remain anonymous, told IW that boards must establish "better relationships" with auditors and valuation experts to help them understand, accept and/or challenge valuations of private companies.
However, that should go hand in hand with targeted, regular training for the entire board, with the NED suggesting the use of the International Private Equity Valuation (IPEV) guidelines as a starting point.
On a similar note, Forvis Mazars' Yunis argued investment company boards should take their annual board evaluation as an opportunity to regularly evaluate NEDs' performance and any "skill gaps related to technical matters the board oversees".
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As far as unquoted investments are concerned, the creation of a valuation committee could bridge any knowledge and skill gaps among board members, she said, as it would comprise members of the valuation and finance teams and "at least one NED", creating a "direct link" between the investment trust's manager and board.
The committee would be tasked with reviewing and approving valuations on an ongoing basis "before investments are signed off by the board", she noted. Subsequently, NEDs should be able to review and evaluate "enough information to effectively demonstrate challenges to the valuation methodology, which should be clearly minuted as an additional control in the governance framework".
However, the formation of a valuation committee would not solve any of the aformentioned issues unless joined by the establishment of a comprehensive valuation policy, Yunis argued. The document should outline the benefits and drawbacks of applying different valuation methodologies or even set out a secondary valuation method to "cross-check results from the primary approach".
The involvement of a valuation expert is always available to investment trust boards if there is a lack of confidence in their skillsets or knowledge on the matter, although NEDs should be self-aware enough to understand when specific training should be attended in a bid to adequately fulfil their roles and responsibilities.
As such, Square Mile's Glover argued the investment trust board should "self-identify" where it has needs and make sure the appropriate training is put in place.
"If it does not, they are failing in their duties to shareholders."
