Private market valuation practices

Following on from last week’s FCA’s asset management and alternatives portfolio strategy letter regarding the FCA’s supervisory priorities, the FCA has now published its multi-firm Review of Private Market Valuation Practices.

The review was conducted due to the FCA’s concerns regarding firms’ judgement-based approaches to valuing private assets and the risk of inappropriate valuations increasing the risk of harm to investors and market integrity. 

The review makes clear the FCA’s expectations of firms and for many firms, this will be seen as a raising of standards rather than clarity on existing requirements. Given the FCA is meant to be reducing the regulatory burden on firms, it is unsurprising (and in accordance with the latest FCA’s custom) that the regulator took time to explain how its work in this area aligns with the FCA's secondary international competitiveness and growth objective. In this case, the FCA justifies its approach on that basis that robust valuation practices are important for fairness and confidence in private markets and its view that this work will support firms seeking to grow in this space as they invest in capabilities, frameworks and controls.

The FCA’s findings will be relevant to all firms which hold investments in private assets including private equity, venture capital, private debt and infrastructure assets. Although the review did not include UCITS funds, the FCA confirms its findings will be relevant to UCITS funds when holding assets subject to Level 2-3 valuations. The scope of the review is also significant in light of the FCA’s current remit to simplify the FCA Handbook and represent a further shift towards applying uniform requirements across multiple firm types, as discussed in DP23/2: Updating and improving the UK regime for asset management. 

FCA expectations

A key message from the FCA is that robust valuation practices should evidence independence, expertise, transparency and consistency. Firms will need to consider the FCA’s findings in detail, evaluating those practices which are applicable to them and assess where they need to address any gaps in their systems and controls. The FCA urges firms in particular to consider making improvements in: 

• the governance of their valuation process;
• identifying, documenting, and addressing potential conflicts in their valuation process;
• ensuring functional independence for their valuation process; and
• incorporating defined processes for ad hoc valuations.

Governance arrangements

On governance, the FCA found that many firms had arrangements in place on paper, with dedicated valuation committees. However, the FCA commented that there were cases where committee minutes failed to record details of how valuation decisions were reached, and when asked, committee members could not describe examples in practice. The FCA urged firms to 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

Similar to the findings on governance, the FCA’s findings point to firms having superficial conflicts arrangements. The FCA noted that whilst all firms identified conflicts in their valuation processes around fees and remuneration, and in many cases had limited these through fee structures and remuneration policies, other conflicts were only partly identified and mitigated. The FCA was concerned that whilst many firms were able to discuss these other conflicts to some extent they warned that they had not actively considered or documented them in their valuation process in sufficient detail: for example, providing very generic descriptions and failing to specify how the conflicts varied across products or transactions.

The FCA highlighted the following conflicts in particular: 

• investor fees: where fees are linked to valuations. The FCA found that firms had generally identified and documented such conflicts but found that firms did not always document how this varied across different product types;
• asset transfers: where the manager’s valuation determines the price affecting the interests of buyers, sellers and remaining investors. The FCA expects managers to perform these valuations impartially and with all due skill, care and diligence. For continuation funds the FCA found that firms provided for incoming investors to submit a bid which existing investors could either accept or opt for a stake in a continuation fund. The FCA warned that the fairness of this arrangement was heavily dependent on whether incoming investors had sufficient access to information to form their own view on price and valuation;
• redemptions and subscriptions: where open-ended funds investing in private assets have quarterly or month dealing or periodic fundraising priced using the fund’s NAV. The FCA flagged the risk of greater harm where the valuation frequency does not align with the dealing frequency. The FCA found that most firms had identified but had not documented that these products had greater risks around valuation;
• investor marketing: where firms use the unrealised performance of existing funds to support fundraising for new vehicles they may be incentivised to show positive and stable movements in value over time. The FCA highlighted that good practice when using unrealised performance meant documenting this conflict and clearly 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: where loan covenants include a maximum loan to value ratio (LTV) risking firms being incentivised to inflate valuations to secure greater borrowing or avoid breaching an LTV covenant. The FCA found that most firms did not proactively identify and document this potential conflict;
• uplifts and volatility: where there is a conflict due to firms considering investors’ preferences for a certain return profile over time. The FCA commented that firms that demonstrated a strong awareness of conflicts positively discussed these issues in valuation committees and had identified the risk of overly conservative and stable valuations; and
• employee remuneration: where there is a link between remuneration and unrealised performance for investment staff, for example, due to variable pay being linked to the change in NAV or the use of profit sharing schemes when managing vehicles charging fees using valuations. The FCA urges firms to assess if employee remuneration conflicts in relation to valuation are relevant and if so to document them and the mitigating actions taken.

Independence and expertise 

On independence, the FCA reminded firms of their organisational requirements including for alternative investment fund managers to ensure that individuals carrying out valuations are functionally independent from portfolio management and that these are carried out with impartiality and all due skill, care and diligence. 

The FCA considered that to clearly demonstrate functional independence firms required: 

• a dedicated function or existing control function to lead on valuations, including developing models and preparing recommendations for decisions made by valuation committees;
• the valuation function to be staffed by people: (i) independent of portfolio management; and (ii) with valuation expertise. The FCA expects valuation committees to record detailed asset-level valuation discussions that demonstrated an understanding of the asset, models, assumptions and the valuation task, including the need for consistency in application of valuation approaches; and
• where views from investment professionals in the firm are sought, processes to ensure these are segregated and clearly documented and the independent function maintains control of valuation models, including input and assumption changes.

The FCA warned against committees where senior investment professionals represented all or the majority of the voting membership. They were also concerned where valuation functions were performing a merely administrative and operational role and investment professionals had greater involvement in the valuation task, such as proposing changes to comparable asset sets or discount rates. 

The FCA urges firms to ensure substantive oversight by valuation or risk committees: (i) to identify and address conflicts; (ii) to verify that model, input and assumption changes are appropriate; and (iii) to ensure that sufficient independence and expertise is maintained. Where firms use third-party valuation advisers, the FCA also expects their use to be appropriately overseen and potential conflicts managed. 

Processes 

The FCA reminded firms that clear, consistent and appropriate policies, procedures and documentation are core components of a robust valuation process. They highlighted in particular the need for valuation policies to document rationales for selecting methodologies, describe the safeguards for the functionally independent performance of valuations and conflicts in the process. 

The FCA urged firms to consider whether they: (i) document valuation models consistently and clearly across assets; (ii) engage with auditors appropriately; (iii) properly consider insights from backtesting to inform their valuation approach; and (iv) can make investments in technology to improve consistency and reduce the risk of human error in their valuation process.

On valuation frequency, the FCA reported on valuation frequencies in respect of different asset classes. They also considered a key action for firms was to incorporate a defined process for ad hoc valuations which includes the thresholds and types of events that would trigger ad hoc valuations.

Transparency 

On transparency the FCA urges firms to consider to how they can increase transparency and investors’ confidence in their valuation process. In particular the FCA encourages firms to consider where they can improve their reporting to and engagement with investors on valuations, including providing detail on fund-level and asset-level performance. The FCA also expects firms using third party valuation advisers to consider disclosing the nature of the services used to investors, including portfolio coverage and frequency.

Application of valuation methodologies

On methodologies, the FCA was especially focussed on firms’ consistency in applying valuation methodologies and assumptions, particularly where significant adjustments were made. Where firms used different assumptions the FCA was concerned about the ability of investors to compare valuations across firms. 

The FCA has made clear that it expects firms to apply valuation methodologies and assumptions consistently and make valuation adjustments solely on the basis of fair value. Where relevant, firms should consider using industry guidelines to ensure their approach is in line with standard market practice and applying secondary methodologies to corroborate their judgement.

Key actions for firms

Firms will need to undertake a granular assessment of all the FCA’s findings against their own practices to assess any deficiencies in their valuation practices. 

We recommend that firms prioritise reviewing the independence and expertise of their valuation function and, in particular, assessing if they have sufficient resource and expertise, proportionate to the size and complexity of the firm. Getting this right will lay the foundation for firms meeting the FCA’s other expectations. Where firms lack sufficient resource, this should be identified promptly as depending on the extent of additional resource required, this could take time to remedy and delay firms addressing other areas in need of improvement. This will be especially important for smaller fund managers where they have historically applied a proportionate approach to adopting an independent valuation function. They will need to assess if their organisational arrangements continue to be appropriate. 

To address any other gaps in their valuations practices, most firms will not be starting from scratch but they will need to take a hard look at their processes to ensure these are matured in accordance with FCA expectations. A surface level review of conflicts (e.g. simply confirming the presence of a conflicts policy and valuation process) will clearly not be sufficient. Firms are now on notice that the FCA expects a thorough assessment of all conflicts in their business and detailed record keeping of the handling of them through appropriate governance and controls. 

Read our previous article on the FCA's latest “Dear CEO” letter on asset management priorities.