This alert provides an overview of the current valuation process, the reasons for the Review, the potential implications and the next steps for businesses holding or managing private assets. It will be relevant to institutional investors and managers of private assets, such as bonds, real estate, private credit and portfolio companies.

Current valuation process

For UK and EU alternative investment funds (“AIFs”), the valuation of assets does not have to be carried out independently. The FCA’s valuation rules permit the alternative investment fund manager (“AIFM”) to perform the valuation itself, provided that:

a) the valuation task is functionally independent from the portfolio management; and 

b) the remuneration policy and other measures ensure that conflicts of interest are mitigated and that undue influence upon the employees involved is prevented.

A number of potential issues arise in this area. Most notably, where the fees are calculated based on valuation, there is a clear incentive to over-value the assets. Additionally, as valuations are conducted relatively infrequently (often quarterly), they may not reflect the impact of a major market event on the value of assets held by the fund, thereby creating a lag that means some investors can take advantage of a fund's price (where the fund is open-ended and tradeable).

Reasons for the Review

The FCA is concerned about the potential harmful implications of over-valued and under-valued assets for investors. The Review follows on from the FCA’s review last year of asset managers’ liquidity management practices that concluded firms need to increase their focus on liquidity risks. Material changes in the valuations of private assets have the potential to pose challenges for liquidity. Other key drivers of the FCA's Review are likely to include:

• Valuations of privately held investments are subjective because of their illiquid nature and lack of secondary market, meaning there is no single valuation technique.
• There is concern that fund managers may be incentivised to maintain higher valuations on their investments when public markets fall, leading to stale valuations that may impede price discovery and lead to inefficient capital allocation.
• A number of funds (and/or their underlying assets) took on debt at a price much lower than what is currently available in the market. Much of this debt is reaching maturity and requires refinancing at significantly higher rates, which may affect the ability of funds and/or their assets to service their debt obligations, with a consequential impact on valuation levels.
• Sector-specific issues may expose funds to additional risks if valuations are not frequently reviewed to reflect changes in interest rates. 
• Conflicts of interest can arise throughout the life cycle of the fund that can incentivise fund managers and other market participants to make decisions that jeopardise trust in the market or lead to an inefficient allocation of capital.

Areas of focus 

In conducting the Review, the issues of interest to the FCA will include:

• who within a firm is accountable for valuations;
• what information regarding those valuations is passed upwards to the relevant valuation committee and board; and
• what other governance procedures are in place.

It safe to assume there will be particular focus on whether the valuation task is sufficiently independent from the portfolio management and whether there are measures in place to mitigate risks of conflicts of interest and undue influence on employees involved.

The FCA is also interested in understanding how the valuations of private assets feed back into other areas of the financial system, such as banking, insurance or capital markets, and whether there are any data gaps or systemic risks that need to be addressed. The FCA is working with other regulatory bodies, such as the global Financial Stability Board (“FSB”), to identify and monitor these issues.

How will the Review work? 

When conducting a multi-firm review, the FCA will generally choose a sample of 10–20 firms to assess. In this case, the focus will most likely be on managers and funds that invest in more volatile asset classes, where under-valuation could have a wider impact on the market (e.g., large pension funds, asset managers and public sector funds).

Depending on the FCA’s published findings and conclusions from the Review, it may issue rule clarifications, provide guidance and possibly consult on potential amendments to the rules. The format in which the results will be communicated is not yet known but could be in the form of a "Dear CEO" letter and individual letters sent to firms that were reviewed.

Potential implications of the Review

The FCA's Review could have significant implications for the valuation of private assets and the performance and reputation of funds and managers. The FCA may require more transparency and disclosure from funds and managers on their valuation methodologies, assumptions and data sources, which could increase the regulatory burden and scrutiny from investors and auditors.

The FCA may also impose more stringent governance and control processes on funds and managers, such as independent valuations, segregation of duties, valuation committees and risk management policies, which could increase operational costs and complexity. There could also be an increase in enforcement action against funds and managers that fail to comply with the existing or any potential new rules on valuations.

In terms of investor behaviour, there is a particular risk in cases where redemption is possible. If public markets are down materially, there may be an advantage to seek to exit the fund before it is revalued downwards (a “first mover advantage”). This could lead to funds being unable to meet redemptions and suspending redemption requests from the fund, which would likely have negative knock-on effects.

Next steps for firms

Managers of funds should act now to review and evaluate valuation risks and improve their current governance and control processes.

This Review may encourage a move towards outsourcing valuations. For those managers who have an in-house valuation function, it is crucial that governance structures are in place to ensure the valuation arrangements are sufficiently robust and functionally independent from the portfolio management.

Where the FCA concludes that a firm’s approach to valuation needs improvement and the firm does not respond to the FCA's concerns, it can be ordered to make improvements. 

In conducting reviews of their valuation frameworks, firms may wish to have regard to the International Private Equity and Venture Capital (“IPEV”) Valuation Guidelines (published in December 2022) which contains helpful guidance on what constitutes best practice in terms of valuation processes, methodologies and governance. Guidance on the approach to valuation has also been issued by the International Limited Partners Association (“ILPA”). As a starting point, firms may wish to carry out a review based on the following questions:

• If the valuation process is carried out in-house, is there sufficient and appropriate segregation between the valuations team and portfolio managers?
• Is there a robust written valuation policy in place that requires documentation of the procedures and methodologies used to value investments?
• Is there an independent valuation committee to oversee and review the methodologies used and conclusions reached?
• Is there appropriate evidence to support the inputs and assumptions included in the valuation analysis and the rationale supporting conclusions?
• How is data received from portfolio companies verified?
• How are significant market events monitored and are valuations adjusted to account for these?
• What other policies and procedures are in place to monitor and mitigate key valuation risks, such as conflicts of interest?

We are closely monitoring the FCA's Review and will keep you updated on any developments.

Client Alert 2024-053