In March, the Financial Conduct Authority (FCA) published its review of private market valuations. Thirty-six FCA-regulated firms were sent an initial questionnaire, followed by face-to-face interviews, focusing on the process and governance side of valuations.
While the findings were generally positive, there are some important points to note. Firms will need to digest these findings in full, benchmarking their own practices against these points and developing action plans to address any gaps. Pension schemes with direct investments in private assets should also perform a benchmarking and gap analysis. Meanwhile those who rely on asset managers should take a keen interest in how their asset managers measure up, and what actions they’re proposing to take in response to the FCA’s findings.
The report’s findings divide, in order of significance, into action points, good practice and wider observations.
Below we take a closer look at the four main action points. The FCA expects firms to take action on these, even if that action may, in some cases, only involve documenting appropriate consideration of the points, eg, if a firm’s business model enables it to justify why it isn’t addressing a requirement.
The FCA identified a lack of clarity in who is ultimately responsible within the valuation governance structure for having the final say on valuations. A valuation committee that might ostensibly be responsible for valuation decisions may in practice act more like an advisory function to a decision-maker elsewhere in the valuation governance structure.
An associated concern was a lack of clear audit trails showing how a valuation conclusion had been reached and who had made that decision.
Weaknesses in documentation and record-keeping are a recurring theme of the FCA’s review – driving the concern that it is harder for stakeholders to understand and assess a firm’s approach to valuation when key judgements or decisions, which can be quite subtle, are not recorded. Opaque processes make effective oversight hard. This could lead to an actual valuation impact due to a risk of inconsistency in the application of valuation approaches.
Key actions
Firms should make sure that:
The primary conflict of interest – the linking of employee remuneration to the fair values of the investments – turned out not to be a significant concern. The vast majority of firms had addressed this obvious conflict some time ago.
However, the FCA noted that many firms had not fully identified all other relevant valuation-related conflicts in their business models. An example would be the use of unrealised valuation gains in marketing materials. Even where conflicts had been identified, they hadn’t been sufficiently considered and recorded. This left firms struggling to explain the mitigating actions taken to address conflicts, or to evidence that they'd been escalated and discussed at the appropriate senior levels.
Key actions
Firms should make sure that:
Independence is key to a sound valuation process. The FCA noted several features that support achieving a truly independent function, including:
While recognising the practical constraints, especially for smaller firms, the FCA would prefer valuation committees to be separate, dedicated functions to lead on, debate and challenge valuation decisions. Although valuation committees are not barred from including investment professionals, this is clearly sub-optimal from the FCA’s perspective, through its potential to undermine independence. There’s acknowledgment that the experience of portfolio team members is hugely important, but in the context of the valuation committee’s decision-making process, those views need to be separately documented, and appropriately considered and challenged. Firms will also need to document how potential conflicts arising from that involvement are addressed.
Key actions
Firms should make sure that:
The last action point reflects one of the original drivers for regulators to look at private market valuations in the first place: an observed lack of response in valuations to significant market movements. The FCA’s worry is that ‘stale’ valuations could potentially mean inaccurate stakeholder information influencing decisions, and for open-ended funds or listed funds, potentially inaccurate subscription, redemption or net asset value (NAV)-influenced trading.
Many of the firms in the FCA’s sample were regular (e.g., quarterly) valuation reporters, but did not have clear processes for updating asset valuations outside that reporting cycle in response to material events. The FCA therefore expects firms to consider implementing specific processes for ad hoc valuations, which should include defined triggers for when such valuations are required.
This is an area which requires careful consideration given the potential for creating significant resource demands associated with running such out-of-cycle valuations. How an ad hoc process might work is something I’ve explored in this article. It’s likely that ad hoc valuation processes will require trialling over time to achieve the appropriate balance between practical implementation and the avoidance of stale valuations.
Key actions
Firms should make sure that:
In practice, the need to update valuations on an ad hoc basis will differ between funds, with this having the greatest impact on funds with daily trading. For many private capital funds, requirements for interim valuations will be driven more by the needs and expectations of limited partners.
The private market valuations review also included a number of other areas for firms to consider as good practice, including:
Firms should now take the time to properly digest the FCA’s findings, benchmark their own practices against the points noted, and develop an action plan to address any gaps identified.
For insight and guidance, contact Adam Sutton or Euan Hamilton.
