FCA review of private valuations: are you ready?

The Financial Conduct Authority (FCA) has announced that it will carry out a review of the disciplines and governance around private market valuations. The full scope of the review has yet to be published, but it stems from a concern that existing market practice and governance procedures for private asset valuations may not be sufficiently robust, particularly in the current high interest rate environment.

With the end of low interest rates, we have seen market pricing corrections in recent months. The significant rise in interest rates has changed the landscape for leveraged finance and raised concern for the potential impact on illiquid private capital assets. Regulators in this area are therefore looking into future risks that could cause financial instability, and have voiced potential issues arising from the lag on valuations of private assets, which are not priced as frequently as those in the public markets.

First, the Securities and Exchange Commission announced in August that private capital houses are required to provide investors with detailed quarterly reports on performance and increased disclosure on expense, with the aim for greater transparency. This impacts not only US private funds but also managers who have US investors.

You may have seen in our recently published private funds radar that the FCA has now announced that it will examine "disciplines and governance" on valuations, and their review is due to kick off later this year. It is expected that the review will cover private assets such as bonds, real estate and shares, and we think commercial real estate may be a particular area of focus in light of the unprecedented liquidity crisis in China's property sector which is having a significant impact on its economy.

In light of this increasing scrutiny of the private capital industry, we would encourage businesses to act now, to review and evaluate any valuation risks and, where necessary, to look to improve the control processes currently in place. For businesses which already have valuation processes in place, or have established an internal valuations team, this may be a good time to review whether these valuation procedures and decision-making processes are sufficiently robust.

On a practical level, it is not uncommon for investment teams to oversee, or to get actively involved in preparing, valuations of the assets they manage. This may make sense commercially, as investment teams are likely to be well placed to facilitate the valuation process. However it raises questions around potential conflicts of interest, in situations where the investment team has a heavy influence on the valuation processes or inputs, and this is an area we expect the FCA's review may address.

What next?

We will keep you informed of developments in this space as further detail becomes available. In the meantime, these questions are intended to provide a starting point for businesses to examine and navigate, and identify potential risks in this area.

• Does the business have a valuations committee to oversee the valuation process?
• Is there an in-house valuations team? If so, is there an information barrier between the valuations team and the investment team?
• Has a valuation methodology or decision tree been put in place?
• How are the quarterly valuations documented, reviewed and approved?
• How are key valuation risks monitored and controlled?
• Are there control procedures in place for assessing the validity of data received from portfolio companies?
• For each valuation of an underlying asset, is there robust evidence to support key valuation assumptions in the form of narrative and benchmarking analysis?
• Where there are material developments which may affect a particular asset, are there procedures in place to identify such "events" and to make any necessary adjustments to the value?

If you would like to discuss any of the issues raised in this post, please get in touch.