By Grace Tshiota, Investment Analyst
The UK Financial Conduct Authority (FCA) has initiated a review of private market valuation practices due to concerns that current governance and methodologies are not sufficiently robust. This article outlines the rationale and scope for this review, current valuation best practice, the potential implications of this initiative, and next steps for stakeholders in private asset management.
Announced last year and confirmed in the FCA’s March 2024 Asset Management and Alternatives portfolio letter, the review aims to assess the integrity and quality of valuation processes used by asset managers. Firms identified for the review will have received an online questionnaire, with responses due three weeks later, followed by a detailed examination of their practices.
The initiative follows a report from the International Organization of Securities Commissions (IOSCO) published in September 2023 that identified valuation as “a significant risk in private finance”. Globally, public and private asset valuations have remained relatively stable amid rising interest rates; however, this stability may be deceptive where valuation methods are currently too opaque. The FCA’s review will specifically evaluate accountability, governance and reporting practices, alongside board oversight related to asset valuations.
What has triggered this review?
Beyond the IOSCO report, the initiative has been triggered by several broader changes:
The macroeconomic environment and the cost of debt
Many funds historically took cheaper debt at lower interest rates via loans that are now approaching maturity; these may require refinancing at higher rates, and previously stable investments could become exposed. Funds may struggle to meet their debt obligations, raising the risk of valuation declines and insolvency of their underlying assets.
Increased sector and liquidity risk
Funds may face heightened risk from sectors particularly sensitive to interest rate fluctuations; namely, commercial real estate, private debt and private credit could face significant challenges if valuations do not quickly and accurately account for rising borrowing costs in investor communications. Meanwhile, the sharp rise in gilts in H2 2022 triggered a liquidity crisis for some defined benefit pension funds, forcing loss-making asset sales. The FCA has since recognised a similar liquidity risk in private markets, necessitating a thorough review.
Subjectivity and conflicts of interest
Valuations of privately held investments are subjective due to their illiquid nature, leading to non-homogenous valuation techniques across the industry. Meanwhile, throughout the fund lifecycle, various conflicts of interest may arise that incentivise fund managers, valuation teams, investment teams and other market participants to endorse inflated valuations that jeopardise market integrity. A common criticism of private valuations is a tendency to delay write-down recognition when public markets decline, misrepresenting market realities and affecting investor trust. Ashley Alder (Chair of the FCA) has emphasised the risks posed by conflicts of interest and the importance of transparent valuation practices in previous communications.
Consumer Duty
The FCA is observing an increasing number of retail, professional and institutional investors entering private markets, some of which lack the necessary expertise and systems to manage and value these assets effectively. The FCA is chiefly concerned with the harm that poor valuations can impart on end investors, whether via misleading perceptions of performance, missed investment opportunities or poor liquidity management – themes parallel with their recent regulatory overhaul as part of the Consumer Duty regime.
What will the private markets review look like?
The rational and scope of the private markets review
The FCA will concentrate on managers and funds holding high-risk private products, where significant valuation write-downs could have a ripple effect on the broader market. This includes, but is not limited to:
- Larger pension funds
- Asset managers
- Public sector funds
- Venture capital funds
- Private equity houses
Emphasis is on those facing potential redemptions during stressful periods.
The aim will be to assess a diverse range of organisations, reviewing and consolidating the varying practices among large, mid-sized and smaller managers. This review will also include firms new to private asset investment, reflecting the FCA’s acknowledgment of the growing market, and the effect of these workstreams on other financial sectors, collaborating with regulatory bodies across this domain (including the FSB). Thematically, the focus will remain on:
- Valuation governance, ownership and accountability
- Information dissemination and cross-functional communication
- Risk management and conflict of interest mitigation
The structure of the private markets review
Approximately 20 firms were involved in Phase 1 (July 2024), with a reduction in the number for Phase 2 (September 2024), focusing on understanding current valuation practices.
Firms must justify their valuation approaches, considering conflicts, oversight and independence. The FCA’s findings may lead to clarifications, guidance or potential rule amendments, with results and the communication of feedback likely to occur by year-end 2024 by way of a “Dear CEO” letter and individual correspondence with assessed firms.
Current best practice for valuation methodologies
The current requirements
In the UK and EU, the FCA allows alternative investment fund managers (AIFMs) to conduct valuations themselves. Under FUND 3.9.7, there are no independent asset valuation requirements for alternative investment funds (AIFs) provided that:
- Portfolio management and valuation processes are functionally and strategically independent
- Mitigants exist for internal conflicts of interest such as through remuneration incentives
The valuation ‘gold-standard’: exemplars from IPEV and AIMA
The International Private Equity and Venture Capital Valuation (IPEV) and Alternative Investment Management Association (AIMA) publications are two examples of practical outlines for valuation accepted across the UK and EU domiciles.
Actions firms should take
This is an opportune moment for fund managers, trustees and stakeholders to proactively review and assess their internal processes ahead of the December valuation rounds, attempting to reduce valuation risks and FCA scrutiny while enhancing governance and control processes.
The feedback from this review may lead to a trend towards external valuations, to relieve in-house capacity. Overall, governance structures must empower valuation processes that are robust and non-conflicted; if the FCA identifies deficient valuation approaches and firms fail to address these, it has the regulatory authority to mandate improvements.
When examining the valuation practices and governance at your firm, the following should be considered:
- Is there a valuations committee privy to and accountable for the current process(es)?
- Is there an in-house valuations team? Does an information barrier exist between this team and the investment team?
- Is the in-house valuation team sufficiently independent and are potential conflicts such as remuneration incentives mitigated as per FUND 3.9.7?
- Has a clear valuation policy, outlining methodologies, been recorded?
- How are quarterly valuations documented, reviewed and approved?
- How is data verified when sourced from portfolio companies and other counterparties?
- Is there robust evidence supporting key valuation assumptions?
- Are there procedures for identifying and adjusting valuation judgements following material changes?
How IQ-EQ can help
At IQ-EQ, we have decades of experience in private markets and our team of experts is well equipped to provide external valuation reviews and advice, helping clients integrate transparency and best practice processes to perform well under regulatory scrutiny.
To discuss the FCA’s Private Markets Valuation Review, kickstart assessment of your firm’s valuation processes, or simply find out more about the support available from IQ-EQ’s expert compliance consulting team, contact us today.
About the author
Grace is an Investment Analyst at IQ-EQ, based in London, whose experience includes roles with leading consulting and investment management firms. She also holds a Master of Engineering degree from the University of Birmingham.
