The FCA isn't alone in being concerned about the current potential for wider market turmoil as a result of sudden material value declines in private assets. Financial regulators around the world share similar concerns. The International Organization of Securities Commission issued a recent warning to the USD 13 trillion global private capital sector about complacency, highlighting 'valuations' as one of a number of risk areas where vulnerabilities could emerge. US regulators recently asked private funds to make more disclosures about their performance and expenses in an attempt to increase transparency and accountability, while in July the European Central Bank published the results of a review of banks’ exposures to rapidly rising interest rates and how that risk could spread to other sectors.
The scope of the review is yet to be confirmed, but it has been described as "sweeping". Fund managers, and their clients who hold material private or illiquid investments would be wise to take advantage of this heads up and spend some time over the next few months reviewing the robustness of their valuation processes, with a focus on 'discipline and governance'.
Triggers for a review of private market valuations
In the context of regulators’ broader market concerns, we think the following factors are likely drivers of the FCA’s review.
Rising levels of private assets invested through managers and funds
The FCA is very aware that an increasing number of managers are launching forays into these asset classes for the first time. Prior issues the FCA has had to investigate have involved managers who may not have built the capability necessary to manage and value these assets robustly and effectively.
Liability-driven investment strategies exposing liquidity issues
Last September, a sudden jump in British bond yields triggered calls for cash from defined benefit pension funds, forcing them to sell positions and prompting the Bank of England to mount an emergency bond buying programme. Significant changes in the valuations of private investments also have the potential to cause sudden liquidity issues.
Low interest debts requiring refinancing at higher rates
Public and private valuations have broadly held up in the face of higher interest rates, but this may change, especially for more highly leveraged investments. As more low interest rate debts approach maturity and need to be refinanced at today’s much higher rates, so called zombie companies who have survived with access to previously cheap debt may suddenly be exposed.
Potential delay of private valuations write-downs
A common criticism of private valuations is that some funds may be delaying write-downs in the value of their investments when public markets fall. DCF-based methods and long holding periods can be used to justify sticky valuations at odds with what might be being observed in the market. While this can be explained in part by the quarterly reporting cycle, our experience is that there can be a longer lag and the FCA’s review may aim to address this disconnect.
Funds may face additional risk from vulnerable sectors, such as commercial property, if the valuations aren't updated on a timely basis in response to interest rate rises.
Who might the review focus on?
The FCA’s primary focus is likely to be on managers and funds which are holding asset classes that are risky enough for material valuation write-downs to potentially cause wider market ripples. This could include the larger pension funds, asset managers, and public sector funds, especially those which may be subject to redemptions in times of stress and may be unable to liquidate unlisted investments quickly enough.
Traditionally, when the FCA conducts work on a thematic area, they aim to review a spectrum of organisations so they can understand how practices might differ between larger players, and mid-size and smaller managers, so there should be interest across the board in their review. We can also expect that some organisations in the sample will be relatively new to private asset investment, reflecting the FCA’s interest in the rising number of market participants.
What should a good valuation and governance process look like?
Although the exact scope of the review is unknown at this point, it's a good opportunity for fund managers, trustees, and other stakeholders to review internal processes and reflect ahead of December valuation rounds.
The International Private Equity and Venture Capital (IPEV)’s 2022 guidelines (p.8) contains a helpful, if high-level, example of what constitutes best practice in terms of valuation processes, methodologies, and governance. In terms of the application of valuation methods it notes the following points:
- "Consistency of valuation methodology at each measurement date and for similar investments"
- "Appropriateness of valuation judgments consistent with market-participant assumptions"
- "Calibrating valuation inputs"
- "Rigour and thoughtfulness of valuation approach"
The guide also notes that a robust valuation process will incorporate industry best practice regarding processes and documentation, highlighting the following for consideration:
- "A robust written valuation policy, incorporating the IPEV guidelines, that requires documentation of the procedures and methodologies to be used to determine the fair value of each individual Investment in the fund’s portfolio"
- "Documentation of the inputs and assumptions included in the valuation analysis and the rationale supporting the conclusion of value"
- "Use of an independent internal valuation committee and/or external advisers to review methodologies, significant inputs, and Fair Value estimates for reasonableness"
- "Incorporation of back-testing as a component of the valuation process."
Although the IPEV guidance is not designed to be all-inclusive, it's still a helpful reference.
Potential outcome of the review
When the FCA reports on thematic findings they typically set out examples of where they've seen practices that they consider to be good, while also calling out specific examples that they consider to be bad practice. They will typically also request that all regulated firms review their practices in the light of the feedback they're providing. The longest lasting consequences will be where they consider that poor practices justify changes in their rules, and it's therefore plausible that the upcoming thematic work will begin the process of changing the regulatory regime for private asset valuations.
An immediate consequence of the FCA’s review might also be that they elect to take further Supervisory (or even Enforcement) action against the firms they have reviewed – if they feel the examples of poor practices they have seen are serious enough.