Private Markets Valuations: FCA publishes its findings and guidance to asset managers

The Financial Conduct Authority (FCA) today published its findings from a multi-firm review of valuation processes for private market assets. This review was conducted due to the significant growth in private markets and the need for robust valuation practices to ensure fairness and confidence.

The FCA's review was carried out in two phases: an initial questionnaire sent to 36 firms, followed by an in-depth review of governance and processes through document requests and on-site visits. The scope of review included firms managing funds or providing portfolio management and/or advisory services in the UK for private equity, venture capital, private debt and infrastructure assets. The FCA found that while many firms demonstrated good practices, there were areas needing improvement, particularly regarding conflicts of interest and the independence of valuation processes.

Key Takeaways

The FCA expects firms to consider the findings from this review, which we explore in more detail below, and identify any gaps in their approach to valuations. Firms should:

• Ensure clear accountability and robust oversight in governance arrangements, including accurate and detailed record-keeping.
• Identify, document, and address all potential and relevant valuation-related conflicts of interests.
• Assess whether they have sufficient independence in their valuation functions and committees.
• Establish comprehensive and consistent valuation policies, procedures, and documentation.
• Incorporate defined processes for ad hoc valuations to mitigate the risk of stale valuations.
• Improve transparency and engagement with investors on valuations.
• Apply valuation methodologies and assumptions consistently, using secondary methodologies to corroborate judgements where relevant.
• Appropriately oversee the use of third-party valuation advisers, identifying and managing potential commercial conflicts.

Governance Arrangements

The FCA found that nearly all firms had specific governance arrangements in place for valuations, with over 90% having valuation committees responsible for valuation decisions. However, some committees lacked detailed record-keeping of how valuation decisions were reached, which could undermine confidence in the oversight of valuation processes. Firms are encouraged to ensure clear accountability and robust oversight in their governance arrangements, including accurate and detailed record-keeping.

Conflicts of Interest

The review identified several potential conflicts of interest in the valuation process, including:

• Investor Fees: Conflicts can arise when fees paid by investors are linked to valuations, particularly in open-ended funds and closed-ended investment companies.  Good practices observed by the FCA included effective documentation of valuation conflicts around fees and the use of fee structures that inherently limited conflicts, such as charging management fees on committed capital in closed-ended limited partnerships.
• Asset Transfers: Valuation conflicts can occur during asset transfers, affecting the interests of buyers, sellers, and remaining investors. 
• Redemptions and Subscriptions: Open-ended funds investing in private assets face potential conflicts when pricing redemptions and subscriptions using the fund’s NAV.
• Investor Marketing: Using unrealised performance to support fundraising for new vehicles can create incentives to show positive valuations. Good practice included separating unrealised and realised investments in marketing materials, making clear that unrealised performance was based on the firm’s approach to valuations, and presenting the components of unrealised value.
• Secured Borrowing: Borrowing secured against a fund’s portfolio can lead to conflicts where valuations might be inflated to attract more borrowing or avoid breaching covenants.
• Uplifts and Volatility: Firms may face conflicts when considering investor preferences for stable valuations or uplifts on exit.
• Employee Remuneration: Linking remuneration to valuations can create conflicts, although most firms had measures to mitigate these risks.      The FCA encourages firms to ensure investment team views were considered but formally separated from valuation decision-making, and to seek additional assurance for in-house valuations through third-party advisers.

The FCA also noted the growing number of asset managers operating competing business lines could increase the potential for conflicts, specifically mentioning continuation funds, co-investment opportunities or partnering with other financial institutions. 

Functional Independence and Expertise

Independence is crucial for robust valuation processes. The FCA observed that some firms had dedicated functions or existing control functions to lead valuations, staffed by individuals independent of portfolio management with valuation expertise. However, other firms had more administrative roles with limited control or ability to challenge inputs or assumptions. Firms are expected to ensure sufficient independence and expertise in their valuation functions and committees.

Policies, Procedures, and Documentation

Clear and consistent policies, procedures, and documentation are essential for robust valuations. The FCA found that while all firms had valuation policies outlining the process, not all provided detailed rationales for selecting methodologies or described safeguards for functional independence. Good practices included using valuation templates, automated third-party valuation software, and involving auditors in the valuation process.

Frequency and Ad Hoc Valuations

Valuation frequency varied across asset classes, with most firms converging on quarterly cycles. However, the FCA noted that less frequent valuations risk stale valuations. Ad hoc valuations, triggered by significant market or asset-specific events, can mitigate this risk. Most firms did not have formal processes for ad hoc valuations, although some had defined thresholds and triggers for such valuations.

Transparency to Investors

Greater transparency increases investor confidence. The FCA found that reporting varied, with most firms providing regular updates to investors. Good practices included reporting quantitative and qualitative information on performance, holding regular conference calls with investors, and using 'value bridges' to illustrate changes in value. Firms should consider improving their reporting to enhance transparency and investor confidence.

Application of Valuation Methodologies

The FCA observed that methodologies varied by asset class, with the market and income approaches being the most common. Consistency in applying these methodologies is crucial. Firms faced challenges in identifying comparable companies or assets and reflecting public market volatility. Good practices included using another established methodology as a sense check and adhering to industry guidelines like the International Private Equity and Venture Capital Valuation (IPEV) Guidelines.

Use of Third-Party Valuation Advisers

Third-party valuation advisers can provide additional independence and expertise. Most firms engaged third-party advisers, with full independent valuations being the most common service. Firms need to be aware of potential conflicts and ensure the independence of these advisers. Good practices included using third-party services for material conflicts and assessing the quality and independence of the service provided.

What's Next?

The FCA will engage with firms and industry bodies on the findings from this review and conduct targeted follow-up work with any outlier firms. They will also build on these findings with further work focusing on conflicts of interest in private markets (a multi-firm review is planned for this year) and consider these findings in their review of the UK Alternative Investment Fund Managers Directive. 

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