Private market valuations come under the microscope of the UK financial regulator

A recent Financial Conduct Authority (FCA) multi-firm review has found strong practices across the industry but highlighted areas for improvement in private market valuations – and heralds more in-depth regulatory scrutiny for which private fund managers will need to prepare.

Private markets have experienced substantial growth in recent years. The UK has maintained its position amid this expansion as the largest hub for private market asset management in Europe. These markets have become a crucial avenue for investors to diversify their portfolios and pursue new sources of returns, while also providing corporates with long-term capital to support growth.

Due to the absence of frequent trading and regular price discovery found in more liquid public markets, firms must rely on judgement-based approaches to estimate the values of private assets. This introduces a risk of inappropriate valuations, which can stem from factors such as insufficient expertise, lack of focus or poorly managed conflicts of interest. Ensuring accuracy and reliability in valuations of private markets is crucial for both investor confidence and regulatory compliance.

Review findings

The FCA reviewed the robustness of selected firms' valuation processes and governance concerning private equity, venture capital, private debt and infrastructure assets. It assessed what checks and balances firms had in place to address the risk of poor conduct and investor harm. This was on the basis of a questionnaire sample of 36 firms, of which a dozen are understood to have been selected for an in-depth review through document requests and on-site visits, including data on asset-level valuations to select case studies.

The regulator did not, however, seek to verify independently the fair value assessments of specific assets.

Evidence of good practices

The FCA found several examples of good practice among firms.

• Quality of reporting to investors. It found that most firms reported quantitative and qualitative information on performance, at both fund and asset-level, as well as holding regular conference calls with investors.
• Documenting valuations. The FCA reported that most firms used valuation templates to ensure a consistent and clear approach and demonstrated good practice by clearly highlighting changes in inputs, assumptions and value, as well as providing qualitative information on the context and performance of the asset.
• Using third-party valuation advisors. Firms demonstrating good practice had used third-party valuation services after identifying material conflicts of interest such as calculating fees, pricing redemptions and subscriptions or asset transfers using valuations. The FCA also found that some firms had introduced an automated third-party valuation software to improve consistency and reduce the risk of human error.

More work to be done

Although "many examples" of good practice were found, improvements were pinpointed.

• Identifying, documenting and assessing potential valuation-related conflicts. Although firms recognised conflicts related to fees and remuneration, other potential conflicts were only partially identified and documented (for example, conflicts associated with investor marketing, secured borrowing, asset transfers, redemptions and subscriptions, as well as uplifts and volatility).
• Ensuring sufficient independence in valuation functions and the voting membership of valuation committees. There were varying levels of independence within firms' valuation processes.
• Incorporating defined processes for ad hoc valuations. Many firms lacked a defined and consistent approach for ad hoc valuations to reassess asset values during market fluctuations or asset-specific events. Firms were advised to identify the events and quantitative thresholds that may necessitate ad hoc valuations and to document the procedures for conducting these valuations.

The FCA expects firms to review the findings and identify gaps, as well as consider examples of good practice. It is expecting firms to identify, document and assess "all potential and relevant valuation-related conflicts, their materiality and actions they may need to take to mitigate or manage them". However, only a few of the reviewed firms "demonstrated strong awareness and control over all potential valuation-related conflicts".

Reform and a further review

The FCA will consider how to take account of these findings in its work reforming the UK's future asset-management regime. It will share the findings to support the Bank of England's work on non-bank financial institutions. It will also incorporate them into international workstreams addressing the principles for the valuation of investment funds. The regulator will launch another multi-firm review in the sector later this year, as outlined in its "dear CEO" letter to asset managers in February.

Osborne Clarke comment

Fund managers should review their current valuation policies and practices against the outcomes of the review – particularly whether they adequately manage conflicts of interests, meet the independence criteria and address potential ad hoc valuations. A manager's current identification and governance processes – and their approach to documentation of these – should be the core areas of focus.

The announcement of an additional multi-firm review means that it is imperative to ensure private fund-manager practices are up to standard, as firms that fail to address issues after they have been raised by the regulator are unlikely to be let off lightly in relation to any shortcomings.

The rules governing fund managers require robust valuation standards and proper management of conflicts of interest, without providing much detail on which valuation standards to apply or how conflicts may arise in practice and, where they do, how to manage them in a compliant way. Therefore, managers may fall back on established industry guidance and standards and processes (such as those published by the Alternative Investment Management Association, Institutional Limited Partners Association and others) rather than forging their own path.

In announcing the additional review, the FCA is signalling scrutiny of specific areas where conflicts might arise, mentioning "asset managers operating multiple intersecting business lines, continuation funds, co-investment opportunities or [those] partnering with other financial institutions".

Aside from co-investment allocation, these focal points are more the domain of the larger fund managers. Those operating in the mid-market may find themselves offering co-investment and in fewer cases contemplating a continuation fund, so this announcement should be placed in context by those managers without raising too much alarm. For the larger managers, the review of policies recommended above should be forward-looking and take these areas into account.