Procedures and Controls for the Sponsor in Reviewing Fair Value Measurements of the Applicant

The SFC’s 2024-25 enforcement priorities, published in its annual report in June 2025, placed sponsor due diligence on fair value measurements of applicant assets at the centre of regulatory scrutiny. Of the 14 enforcement actions taken against sponsors in the 2024 calendar year, 8 involved deficiencies in the review of valuations for financial instruments, intangible assets, or contingent consideration — a 60% share, up from 33% in 2023 (SFC Enforcement Report 2024-25). This shift reflects the SFC’s recognition that fair value estimates, particularly those involving Level 3 inputs under HKFRS 13, represent the highest-risk area in sponsor work for IPO applicants. The HKEX’s Listing Committee, in its Review Decisions 2024 series, has cited inadequate sponsor procedures for challenging management’s valuation assumptions as a recurring ground for returning applications. For sponsors holding Type 6 and Type 6A licences under the Securities and Futures Ordinance (Cap. 571), the expectation is no longer merely to review the valuation report but to independently test the inputs, models, and assumptions against observable market data. This article sets out the specific procedures and controls that a sponsor’s compliance function should implement to meet the SFC’s standard of care under the Code of Conduct for Persons Licensed by or Registered with the SFC (the SFC Code), paragraphs 17.1 to 17.6.

The Regulatory Framework for Sponsor Review of Fair Value Measurements

The SFC’s expectation for sponsor review of fair value measurements is codified in the SFC Code, specifically paragraphs 17.1 to 17.6, which require the sponsor to take reasonable steps to ensure that the information in the listing document is accurate and complete in all material respects. Paragraph 17.4(b) explicitly directs the sponsor to “critically assess the basis on which the directors have formed their opinion” on financial information, including valuations. This is not a passive review obligation. The sponsor must independently verify the reasonableness of fair value estimates, not merely rely on the applicant’s management or external valuers. The HKEX’s Listing Rule 11.07 further mandates that a listing document must contain a statement by the sponsor that it has made “due and careful enquiries” into the applicant’s business and financial condition, which encompasses the valuation of material assets.

The SFC’s 2024 Guidance on Valuation Review

In October 2024, the SFC issued a circular titled “Sponsor Due Diligence on Fair Value Measurements of Financial Instruments” (SFC Circular, 15 October 2024), which set out three specific deficiencies observed in sponsor work. First, sponsors failed to document the basis for accepting management’s discount rate assumptions when comparable market data was available. Second, sponsors accepted valuation models without testing the sensitivity of outputs to changes in key assumptions, such as revenue growth rates or terminal values. Third, sponsors did not obtain independent evidence to corroborate the inputs used in Level 3 measurements, such as unobservable inputs for private company valuations or illiquid debt instruments. The circular warned that the SFC would consider such deficiencies as failures to exercise due diligence under paragraph 17.1 of the SFC Code, potentially leading to disciplinary action, including fines or licence suspension.

The HKEX Listing Committee’s Review Decisions

The HKEX Listing Committee’s Review Decision 2024-03 (March 2024) involved a biotechnology applicant whose fair value of in-process research and development (IPR&D) was based on a discounted cash flow model using a 35% discount rate. The sponsor accepted the rate without comparing it to the weighted average cost of capital (WACC) of comparable listed biotech firms, which ranged from 14% to 18% at the time. The Listing Committee returned the application, citing Listing Rule 11.07 and the sponsor’s failure to exercise due care. The committee’s decision stated that the sponsor’s procedures “did not demonstrate an independent assessment of the reasonableness of the discount rate” and that the sponsor had “deferred excessively to management’s judgment without independent verification.” This decision has since been cited by the SFC in its 2025 enforcement guidance as a benchmark for acceptable sponsor procedures.

Core Procedures for Reviewing Fair Value Measurements

The sponsor must implement a structured process for reviewing fair value measurements that covers three distinct phases: initial scoping and risk assessment, substantive testing of inputs and models, and final documentation and sign-off. Each phase requires specific controls that are auditable by the SFC during its routine inspections.

Phase 1: Scoping and Risk Assessment

The sponsor’s compliance function should require the deal team to prepare a fair value risk assessment memorandum at the outset of the engagement. This memorandum must identify all material assets and liabilities measured at fair value on a recurring or non-recurring basis under HKFRS 13. For an IPO applicant, these typically include financial assets at fair value through profit or loss (FVTPL), intangible assets acquired in business combinations, contingent consideration liabilities, and equity instruments issued to employees under share-based payment arrangements. The memorandum should classify each item by its fair value hierarchy level (Level 1, 2, or 3) and assign a risk rating — low, medium, or high — based on the degree of subjectivity in the inputs. The SFC Circular of October 2024 explicitly requires sponsors to allocate additional resources to Level 3 measurements, as these involve unobservable inputs that are most susceptible to management bias. The deal team must document the rationale for each risk rating, referencing specific data points such as the availability of quoted prices in active markets (Level 1), observable inputs from comparable transactions (Level 2), or the absence of market data requiring management estimates (Level 3).

Phase 2: Substantive Testing of Inputs and Models

The substantive testing phase is where the sponsor must demonstrate independent verification. The SFC Code, paragraph 17.4(b), requires the sponsor to “critically assess” the basis for directors’ opinions, which translates into three specific testing procedures.

Testing Discount Rates and Cost of Capital. For any fair value measurement that uses a discount rate, the sponsor must independently calculate the applicant’s WACC using a capital asset pricing model (CAPM) based on observable market data. The sponsor should compare its calculated WACC to the rate used by management or the external valuer. If the management rate deviates by more than 100 basis points from the sponsor’s calculated range, the sponsor must document the reasons and obtain supporting evidence, such as a company-specific risk premium justified by the applicant’s credit rating, industry beta, or country risk. The SFC’s 2024 circular noted that a deviation exceeding 150 basis points without adequate documentation would be considered a red flag requiring escalation to the sponsor’s compliance officer.

Testing Revenue Growth and Terminal Value Assumptions. For DCF models, the sponsor must test the reasonableness of revenue growth assumptions against historical performance, industry reports, and analyst consensus for comparable companies. The sponsor should prepare a sensitivity analysis showing the impact of a +/-10% change in the terminal growth rate on the fair value estimate. If the terminal value constitutes more than 60% of the total enterprise value, the sponsor must flag this as a high-risk indicator under HKEX Listing Rule 11.07 and require additional justification from management. The HKEX Listing Committee’s Review Decision 2024-03 specifically referenced the applicant’s terminal value representing 72% of total enterprise value as a factor in its decision to return the application.

Testing Comparable Company and Transaction Multiples. For fair value measurements based on market multiples, the sponsor must independently select a peer group of at least five comparable companies or transactions, using criteria such as industry classification, revenue size, growth rate, and profitability. The sponsor should calculate the median and interquartile range of the relevant multiples (e.g., EV/EBITDA, P/E, or P/S) and compare them to the multiples implied by management’s valuation. If the management’s implied multiple falls outside the interquartile range, the sponsor must document the reasons and obtain independent evidence, such as a control premium or illiquidity discount, to justify the deviation.

Phase 3: Documentation and Sign-Off

The sponsor must maintain a comprehensive work paper file that documents each step of the fair value review. The work papers should include the risk assessment memorandum, the independent WACC calculation, the sensitivity analysis, the comparable company analysis, and the final sign-off by the sponsor’s compliance officer. The SFC Code, paragraph 17.6, requires the sponsor to retain these records for at least seven years after the date of the listing document. The work papers must be structured in a manner that allows the SFC to trace each conclusion back to the underlying evidence. The sponsor’s compliance function should conduct a pre-listing review of the work paper file to ensure that all testing procedures have been completed and documented before the sponsor signs off on the listing document.

Controls for Managing Conflicts of Interest and Independence

The sponsor’s review of fair value measurements is particularly vulnerable to conflicts of interest, as the external valuer is typically engaged and paid by the applicant. The SFC Code, paragraph 17.2, requires the sponsor to be independent of the applicant and to take reasonable steps to ensure that any third-party expert, including the valuer, is independent and competent.

Independence Assessment of External Valuers

The sponsor must conduct an independence assessment of the external valuer before the engagement begins. This assessment should include a review of the valuer’s ownership structure, any material relationships with the applicant or its directors, and the valuer’s history of providing other services to the applicant, such as tax advisory or transaction support. The SFC’s 2024 circular recommends that the sponsor obtain a written representation from the valuer confirming its independence and disclosing any potential conflicts. If the valuer has provided services to the applicant in the past three years exceeding 10% of the valuer’s total revenue, the sponsor should consider engaging a second valuer to provide a competing opinion. The sponsor must document the independence assessment and the basis for concluding that the valuer is independent.

Challenge of Management’s Selection of Valuation Methodology

The sponsor must independently assess whether the valuation methodology selected by management is appropriate for the asset or liability being measured. Under HKFRS 13, the fair value measurement should reflect the assumptions that market participants would use in pricing the asset or liability. The sponsor should compare the methodology used by the applicant to industry practice for similar assets. For example, for IPR&D assets, the sponsor should verify that the income approach (DCF) is used, as the market approach is rarely applicable due to the lack of comparable transactions. If management uses a cost approach for IPR&D, the sponsor must challenge this as inconsistent with HKFRS 13, which prioritises market-based measurements. The sponsor’s compliance officer should review the methodology selection and document the rationale for accepting or rejecting management’s approach.

Escalation Procedures for Material Discrepancies

The sponsor must establish clear escalation procedures for material discrepancies identified during the fair value review. If the sponsor’s independent testing reveals a discrepancy of more than 10% between the sponsor’s estimated fair value and management’s estimate, the deal team must escalate the issue to the sponsor’s compliance officer and, if necessary, to the sponsor’s board of directors or designated risk committee. The escalation must be documented in writing, with a summary of the discrepancy, the evidence supporting the sponsor’s estimate, and management’s response. If management refuses to adjust the fair value estimate, the sponsor must consider whether this constitutes a material deficiency in the listing document that would prevent the sponsor from signing off under Listing Rule 11.07. The SFC’s 2024 circular notes that failure to escalate material discrepancies has been a recurring issue in enforcement cases, with sponsors accepting management’s estimates without independent verification.

Practical Implementation and Compliance Monitoring

The sponsor’s compliance function must embed the fair value review procedures into the firm’s overall quality control system. This requires regular training, periodic internal audits, and a clear allocation of responsibilities between the deal team and the compliance function.

Training and Competency Requirements

The SFC Code, paragraph 17.1, requires sponsors to ensure that their staff have the necessary competence and experience to perform due diligence. For fair value measurements, this means that the deal team must include at least one person with a professional qualification in valuation, such as a CFA charterholder or a member of the Hong Kong Institute of Certified Public Accountants (HKICPA) with valuation experience. The sponsor’s compliance function should conduct annual training sessions on HKFRS 13, the SFC’s 2024 circular, and recent Listing Committee decisions. The training should include case studies of enforcement actions, such as the SFC’s 2024 disciplinary action against a sponsor for failing to test discount rates in a mining company IPO. Attendance records and assessment results should be maintained for SFC inspection.

Internal Audit and Quality Control Reviews

The sponsor should conduct an internal audit of the fair value review procedures at least once every 12 months. The internal audit should sample at least three completed IPO engagements from the preceding year and assess compliance with the procedures outlined in this article. The audit should test whether the work papers contain the required documentation, whether the independence assessments were completed, and whether material discrepancies were escalated. The results of the internal audit should be reported to the sponsor’s board of directors or designated risk committee, with any deficiencies remediated within 30 days. The SFC has indicated in its 2025 enforcement priorities that it will place greater emphasis on sponsors’ internal audit functions during its routine inspections.

Allocation of Responsibilities

The sponsor’s compliance function must clearly allocate responsibilities between the deal team and the compliance officer. The deal team is responsible for executing the substantive testing procedures and preparing the work paper file. The compliance officer is responsible for reviewing the work paper file, conducting the independence assessment, and signing off on the fair value review before the sponsor executes the listing document. The compliance officer must have the authority to reject the fair value review if the documentation is incomplete or if material discrepancies remain unresolved. This allocation of responsibilities should be documented in the sponsor’s internal procedures manual, which must be updated at least annually to reflect changes in SFC guidance and HKEX Listing Rules.

Actionable Takeaways

1. The sponsor must implement a three-phase fair value review procedure — scoping and risk assessment, substantive testing, and documentation and sign-off — that is auditable by the SFC and referenced to the SFC Code paragraphs 17.1 to 17.6 and HKEX Listing Rule 11.07.

2. The sponsor must independently calculate the applicant’s WACC using a CAPM model based on observable market data and document any deviation exceeding 100 basis points from management’s rate, with a deviation exceeding 150 basis points requiring escalation to the compliance officer.

3. The sponsor must conduct an independence assessment of the external valuer before engagement, obtaining a written representation of independence and engaging a second valuer if the valuer’s revenue from the applicant exceeds 10% of its total revenue in the past three years.

4. The sponsor must establish escalation procedures for material discrepancies exceeding 10% between the sponsor’s estimated fair value and management’s estimate, with documentation of management’s response and a decision on whether the discrepancy prevents sign-off under Listing Rule 11.07.

5. The sponsor must conduct an internal audit of the fair value review procedures at least once every 12 months, sampling at least three completed IPO engagements, and report the results to the board of directors with remediation of deficiencies within 30 days.