The Valuation Industry: A Tale of Controversy and Compromise
My conversation with a former valuation director from a Big 4 audit firm revealed a sense of melancholy surrounding the profession.
In the world of corporate finance, the term ‘valuation’ often conjures up images of analysts working with complex spreadsheets, financial models, and numbers over countless nights.
Behind the scenes, however, a lesser-known business model drives companies to engage professional ‘valuation services’ to assess the fair value of their assets. These assets include real estate, gold reserves, financial instruments, equity investments, and intangible assets acquired through mergers and acquisitions.
A recent conversation in Hong Kong with an old friend, a former valuation director at a renowned valuation firm, shed light on the intricacies of this industry and the challenges it faces.
Case in point: Siberian Mining Group
In 2013, Siberian Mining Group (1142), a.k.a SMG, hired Herman Tso Chi-ming to prepare a valuation report. The report estimated that Siberian Mining’s coal mines had 14.9 million tonnes of ‘proven and probable’ mineral reserves. Based on Mr. Tso’s valuation report, SMB’s board of directors approved the issuance of US$443 million in convertible bonds to raise funds.
However, after the bond issuance, SMG faced immediate challenges. In 2016, as Bloomberg reported, investors lodged complaints with the Hong Kong Stock Exchange (0388) questioning the accuracy of Mr. Tso’s report.
The company’s auditors also unexpectedly resigned, raising concerns about the financial stability and transparency of SMG. Adding to the turmoil, SMB’s board abruptly suspended trading of the company’s shares, and the suspension ultimately lasted for two years.
A notice was issued stating that, in response to shareholder complaints, the company had initiated an internal investigation. This investigation encompassed a thorough examination of SMG’s accounts and the controversial valuation report prepared by Mr. Tso.
Earlier in 2014, according to Bloomberg, SMG’s board had engaged Roma Group (8072), a Hong Kong-listed valuation company, to review Tso’s valuation report.
Later in April 2015, SMG issued a statement asserting that Roma Group found no issues with Tso’s report, dismissing external allegations as baseless. This was a key reason for SMG’s subsequent resumption of trading.
The story becomes far more intriguing. In early 2014, as Bloomberg reported, Roma Group was commissioned by a potential buyer of SMG to investigate the company’s assets. However, during their investigation, Roma Group made a U-turn, raising concerns about ‘misleading’ elements and crucial missing information in Tso’s report. Subsequently, Roma Group issued a letter to SMB, complaining that SMG had used the report without their authorization and that they had not approved the content of the announcement.
To understand what is behind all these confusing allegations, conflicting valuations, and a Rashomon-like scenario of multiple truths, we need to comprehend how valuation professionals earn their living.
The Business Model of Valuation Professionals
Valuation services are generally divided into two categories: the first involves valuing tangible assets such as properties, land, factories, and machinery; the second involves valuing intangible assets such as company operations, trademarks, and financial instruments like convertible bonds.
For the valuation of tangible assets, the property valuation must be certified by a qualified surveyor, such as a member of the Royal Institution of Chartered Surveyors (RICS) or the Hong Kong Institute of Surveyors (HKIS). The other category involves assessing the fair value of a company’s intangible assets. However, writing these types of valuation reports does not require certification by individuals with specific qualifications.
These valuation jobs are largely dominated by major firms. Leading companies in this type of valuation, or sometimes known as ‘Big 4’, include Cushman & Wakefield, JLL (Jones Lang LaSalle), CBRE (Coldwell Banker Richard Ellis), and Savills.
Valuation Fees Vary Significantly
Due to the requirements of accounting standards, many companies must hire independent valuers to assess their assets. However, commissioning a valuation report from the ‘Big 4’ can cost hundreds of thousands of dollars or more, depending on the valuation project.
Other major firms typically charge around HK$ 80,000 to HK$ 100,000, which can be a substantial burden for small and medium-sized enterprises.
Many valuers, originally from traditional major firms, have seized this opportunity to set up their own practices, attracting clients with significantly lower fees. These independent small ‘valuation’ firms often charge only half, or even less, of what the big firms do.
My friend mentioned seeing the most extreme case where the fee was just 10% of what a major firm quoted, making them very popular among small and medium enterprises.
However, you get what you pay for, and these small valuation companies often ‘cut their cloth according to their measure’, which means the quality of their services can vary greatly.
This piqued my curiosity, so I asked my friend: “Does this mean that the valuations of company operations, intangible assets, and financial instruments reported in the company’s financial statements are unreliable?”
Saving Effort and Costs with Guaranteed Results
My friend calmly explained the ‘trick’ in the system: “Firstly, for valuations used for accounting purposes, aside from property assessments, there are no specific qualification requirements — essentially, anyone can perform them. Secondly, any valuation made must be audited by auditors. If there are any issues with the valuation, the auditors will require the valuer to make corrections.”
From the client’s perspective, as long as it satisfies accounting requirements, it makes sense to choose the cheaper option.
My friend made an analogy: “It’s like when Little John has to write an English essay. Regardless of the quality of the grammar, it will be edited by a professional English editor to perfect the grammar. So why should Little John bother writing with good grammar in the first place? He might as well write poor English and let the editor make the necessary corrections afterward, saving time and effort, right?”
Due to the ‘valuation and auditing’ business model, many valuers from traditional large firms are establishing their own practices. They are hiring less expensive, unlicensed newcomers — those without professional qualifications — to compete with traditional firms in drafting valuation reports. This trend has saturated the market and diminished the prestige of the valuation profession.
The intense competition means even traditional valuation and surveying firms pay their new valuation analysts a monthly salary of only HK$10,000 to HK$20,000. Coupled with a gloomy career outlook, this discourages many high-quality young people from entering the field.
My friend continued: “Of course, there are valuation departments within investment banks designed for purposes like IPOs and mergers and acquisitions, where new analysts earn at least HK$40,000 to HK$50,000 a month. However, getting a position in these valuation departments of investment banks is not easy.”
Investors Should Take Note
Additionally, since listed companies typically do not engage auditors to review valuation reports commissioned for acquisition projects, it is difficult for the average investor to detect any underlying issues.
However, investors can still scrutinize the valuer’s background. Investors can look at the valuer’s educational credentials (to check for degrees from diploma mills) and previous project experience, as well as whether industry experts (like mining specialists) were involved in the valuation.
On the other hand, even though these valuation reports for mergers and acquisitions are only used for internal reference, they must eventually be reviewed by auditors when incorporated into the financial statements.
Therefore, investors can look into the auditors’ opinions to see if there are any doubts expressed or signs of resignation concerning the acquisition projects, which could serve as warning signals to avoid falling into investment traps.
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