Private market valuations: What were the key findings from the FCA’s recent multi-firm review and what should firms be doing to be compliant?

Background

In recent years, private markets have experienced substantial growth, with the UK maintaining its position as the leading hub for private market asset management in Europe. These markets have become crucial for investors looking to diversify their portfolios and discover new sources of returns, as well as for companies seeking long-term capital to support their growth. To meet the increasing demand from both individual and institutional investors worldwide, more asset managers are enhancing their private market capabilities, either by developing them internally or through acquisitions and joint ventures.

Due to the lack of frequent trading and regular price discovery found in more liquid public markets, firms must use judgment-based approaches to estimate the value of private assets to comply with accounting standards. This can lead to the risk of improper valuation of private assets, which may arise from a number of sources including, lack of expertise or poorly managed conflicts of interest, which potentially can harm investors and negatively impact market integrity.

Accurate and fair valuations are essential for investors to understand the performance of their investments and make informed decisions regarding asset allocation and manager selection. Further, when fund structures invest in private assets or firms transfer private assets between vehicles, transaction prices often depend on these valuations. Therefore, robust valuations are crucial to ensure fairness among buyers, sellers, and remaining investors. Additionally, firms may use these valuations to calculate management and performance fees paid by investors.

The FCA’s multi-firm review

In light of the criticality of robust valuation practices the FCA undertook a review assessing 36 firms’ valuation processes and governance. Included in the scope of the FCA’s review were firms managing funds or providing portfolio management and/or advisory services in the UK for private equity, venture capital, private debt and infrastructure assets. There were two phases to the review: an initial high-level questionnaire-style review of the 36 selected firms and then a subsequent in-depth review of a selected sub-set of these firms.

To which firms do these recommendations apply?

The outcomes from the multi-firm review will be of interest to any firms managing funds or providing portfolio management and/or advisory services in the UK for private equity, venture capital, private debt and infrastructure assets. This includes UK Markets in Financial Instruments Directive (MiFID) managers and investment advisers, UK AIFMs and Undertaking for Collective Investment in Transferable Securities (UCITS) funds managers where the UCITS funds hold assets subject to Level 2-3 valuations¹.

The FCA’s findings

The FCA reported on eight main areas: (i) governance arrangements, (ii) conflicts of interest, (iii) functional independence and expertise, (iv) policies, procedures and documentation, (v) frequency and ad-hoc valuations, (vi) transparency to investors, (vii) application of valuation methodologies and (viii) third-party valuation services. The FCA found many examples of good practice in firms’ valuation processes, including good use of third-party valuation advisers to introduce independence and expertise, good quality of reporting to investors and documentation of valuations. However, the FCA also identified areas where firms should make improvements. 

This article focuses on what firms should and should not be doing to remain compliant with the FCA’s expectations.

Governance

The FCA found that most firms have specific governance arrangements in place for valuations and this often includes having a valuation committee responsible for valuation decisions. Firms with valuation committees tended to demonstrate greater independence and oversight of the valuation process.

However, some failures were identified by the FCA, particularly around record keeping where, for instance, some committee’s minutes failed to record details of how valuation decisions were reached.

The FCA’s clear message on governance is that firms should consider whether their governance arrangements ensure there is clear accountability for valuation and robust oversight of the valuation process, including accurate and detailed record-keeping of how valuation decisions are reached.

Conflicts of interest

Potential conflicts can exist between the interests of firms valuing private assets and the interests of investors, or between different groups of investors in a variety of ways. The FCA noted a number of potential issues grouping them into the following groups – investor fees, asset transfers, redemptions and subscriptions, investor marketing, secured borrowing, uplifts and volatility, and employee remuneration. The macro message from the regulator is that firms are generally on top of identifying conflicts in their valuation process around fees and remuneration. However, they are much weaker on other potential conflicts, and this is exacerbated by the fact that they may not document such conflicts in sufficient detail.

Functional independence and expertise

Another core component of the valuation process is independence. The FCA described what some firms have done which clearly demonstrates functional independence, including having a dedicated function or existing control function to lead on valuations which are staffed by people independent of portfolio management and with valuation expertise. These firms also ensured that the valuation committee’s voting membership was made up of independent individuals with sufficient valuation expertise and the committees recorded detailed asset-level valuation discussions that demonstrated an understanding of the asset and the valuation task, including the need for consistency in application of valuation approaches.

However, the FCA found issues with other firms, notably where the valuation function was more of an administrative resource with limited ability to challenge inputs or assumptions. In these firms the FCA found that investment professionals appeared to have greater involvement in the valuation task, such as proposing changes to comparable asset sets or discount rates. The FCA also criticized firms where senior investment professionals were voting members in valuation committees, because their position as voting members may compromise the independence of the decisions made and the independent oversight and challenge. 

Policies, procedures and documentation

Whilst all firms surveyed had valuation policies in place which set the valuation process objective to ensure each asset is appropriately and fairly valued, setting out the roles and responsibilities of the parties involved, the governance arrangements, valuation frequency and methodologies used, not all firms provided detail on the rationale for selecting methodologies and their limitations or the required inputs and data sources as required by the AIFMD Level 2 Regulation².

In relation to valuation models, the FCA noted that most firms used valuation templates to ensure a consistent and clear approach. Firms also demonstrated good practice by highlighting changes in inputs, assumptions and value and provided qualitative information on the context and performance of the asset or maintained logs capturing assumption changes across assets.

Good practice was demonstrated by firms which supported external auditors to perform their role by involving them in the valuation process. Examples of this included inviting auditors to observe valuation committee meetings, raising auditor challenges at the meetings and managing conflicts of interest by rotating audit firms.

Back testing can confirm the accuracy of valuation methodologies and provide firms with insight into the valuation of an asset in different market conditions. It involves comparing the realized value of an asset against the last valuation to assess precision of the valuation and identify limitations in approach. The FCA stated that firms demonstrated good practice when they used back testing to inform their approach to valuations going forward.

Frequency and ad-hoc valuations

The FCA noted that firm’s with less frequent valuation cycles risk having stale valuations. Where valuations are used to charge fees or price redemptions and new subscriptions, stale valuations can lead to greater harm, such as inappropriate fees and investors redeeming at inappropriate prices. The findings noted that, except with respect to debt assets where firms had monthly valuation cycles, the industry has converged to quarterly valuation cycles for most alternative assets. However, the FCA found that most firms did not incorporate ad-hoc valuations into their valuation process. Ad-hoc valuations demonstrate appropriate procedures are in place to accommodate scenarios where there is a material risk of an inappropriate valuation, such as the Russia-Ukraine conflict or the COVID pandemic. The FCA has suggested firms consider incorporating a defined process for these which include thresholds and types of events that may trigger an ad-hoc valuation.

Transparency to investors

The FCA highlighted the importance of transparency to investors including that clear, detailed reporting enables investors to better comprehend judgments made during the valuation process and empowering them to make more informed decisions and exercise greater scrutiny.

Surprisingly, the report showed that over 10 percent of firms provided no disclosure of the valuation policy, almost 80 percent did not disclose the valuation proposal paper or report, and over 55 percent did not disclose any valuation models and/or relevant assumptions, to investors. The FCA noted good practice including reporting quantitative and qualitative information on performance at both fund and asset level, as well as holding regular conference calls with investors.

Application of valuation methodologies

The FCA observed methodologies to vary by asset class and the nature of the asset with the most common methodologies being the “market approach” and the “income approach.” The market approach “uses prices and other relevant information that have been generated by market transactions that involve identical or comparable assets. This can involve valuation multiples derived from quoted prices of public companies or prices from merger and acquisition transactions” whereas the income approach “converts future amounts (for example, cash flows or income and expenses) to a single current (discounted) amount. When the income approach is used, the fair value measurement reflects current market expectations about those future amounts.” The regulator noted the various challenges firms face such as identifying comparable companies or assets and suitable approaches to reflect public market volatility.

Ultimately, the FCA expects firms to apply valuation methodologies and assumptions consistently and make adjustments solely on the basis of fair value. Focus should be given to adjustments by valuation committees to ensure they reach robust decisions. The FCA also noted that there are industry guidelines which could be followed by firms to align with market practice.

Use of third-party valuation advisers

Firms use third-party valuation advisory services for a number of reasons, including to gain assurance of their own valuations, to gain input into their own valuation or to undertake a full independent valuation. The FCA noted that firms need to be aware of the potential conflicts of interest when using these services, and need to ensure the engagement and the professionals are kept at arm’s length to maintain independence. Good practice amongst firms included using third-party valuation services where a conflict of interest had been identified and considering the limitations of the service and ensuring independence. 

Conclusion

The big message for firms working in the private equity and broader private assets market is that FCA is demanding a new level of governance around all aspects of the valuation process. This ranges from the substantive question of how the methodology and consistency of valuation takes place within a firm, through to all of the normal procedural questions surrounding governance. Firms should assess their valuation policies and processes to ensure that they remain complaint with the legislation and are aligned with the FCA’s expectations.