The Financial Conduct Authority (FCA) has identified multiple valuation challenges in its review of private market valuation practices, published today.
The FCA said some asset managers it surveyed discussed the challenge of identifying comparable companies or assets, particularly when a portfolio company “has unique attributes”. In these cases, the FCA noted, “firms might weight multiple comparable sets representing different sectors or use a small number of directly comparable assets”.
The Authority described a “robust valuation process” as one that could evidence independence, expertise, transparency and consistency.
It said it was encouraged to find many examples of good practice in firms’ valuation processes, including the quality of reporting to investors, documenting valuations, using third-party valuation advisers to introduce additional independence and expertise, and consistent application of established valuation methodologies.
“Generally, firms recognised the importance of maintaining robust processes. We saw practices that reflected consideration of investor protections given the judgement required and risks present in valuing private assets.”
Improvements needed
However, the FCA also identified areas where firms should make improvements.
“In a few case studies, we observed firms make discount rate adjustments that resulted in limiting the impact of public market movements. Firms gave rationales for these adjustments, including the uncertainty around current macroeconomic changes, the asset not being ready to list or differences between the asset and public peers.
“We also saw other differences in firms’ approaches. These included areas such as weighting comparable companies, calculating components of a discount rate, and views on discounted cash flow (DCF) models for private equity investments. Some firms did not use DCF models, arguing it required too much judgement, some occasionally used it for corroboration and others used it as a primary approach, arguing it was more specific in outlining assumptions,” the FCA’s report added.
The regulator was clear on what it expects firms to do to redress the valuation discrepancies.
“We expect firms to apply valuation methodologies and assumptions consistently and make valuation adjustments solely on the basis of fair value. We expect valuation committees and independent functions to focus on these adjustments to ensure they reach robust decisions.
“Where relevant, firms should consider using industry guidelines to ensure their approach is in line with standard market practice. Firms should also consider whether they should apply secondary methodologies to corroborate their judgement.”
No easy task
Nalaka De Silva, head of private market solutions at Aberdeen, said: “Valuing a private asset is no easy thing and it’s important to remember there is a difference between price and value. Assets can range from technically complex infrastructure projects to portfolios of private companies at different stages of growth. Therefore a team of specialist professionals is usually required to conduct in-depth analysis, which comes at a significant cost, easily tens to hundreds of thousands per valuation.”
He said: “Given these assets don’t trade as frequently, it naturally means prices are not set as frequently as for public markets. Prices are negotiated and there is less information to make determinations around value.”
He added that because there is no single standard for how to value a private market asset – creating inconsistencies – that he would not be surprised to see the same asset valued differently in two different portfolios.
“For investors, particularly pension fund trustees and retail investors, to get on board with private markets, we need to boost trust. We therefore welcome the FCA’s statement today that there needs to be a continued focus on improving practices in private market valuations. Ideally, we would like to see the creation of some kind of “gold standard” guidance covering how a private asset should be valued, how frequently and who will value it. This may come from the FCA or it may come via industry collaboration – either way it needs to come.”
De Silva is calling for the need for greater market information flow, “something else we believe private markets sorely need”.
“More readily available information around areas such as assets held, risk management strategies and performance of private market funds will be crucial if we want democratisation of this sector to be a success.
“There is lots of noise about the need to invest in long-term assets like real estate, infrastructure and early-stage growth companies – but we need to ensure this is accompanied by an education programme so that individuals understand both the potential risks and the potential rewards,” he explained.
Conflicts identified
The FCA’s report found that “all firms identified conflicts in their valuation process around fees and remuneration”, and in many cases had limited these through fee structures and remuneration policies”.
But other potential conflicts were only partly identified and documented, the regulator said. These included potential valuation-related conflicts related to investor marketing, secured borrowing, asset transfers, redemptions and subscriptions, and uplifts and volatility. The FCA expects firms to identify, document and assess all potential and relevant valuation-related conflicts, their materiality and actions they may need to take to mitigate or manage them.
“Firms had different levels of independence within their valuation processes. We expect firms to assess whether they have sufficient independence in their valuation functions and the voting membership of their valuation committees to enable and ensure effective control and expert challenge,” it added.
The Authority was also concerned that many firms “did not have defined processes or a consistent approach for ad hoc valuations to revalue assets during market or asset-specific events”.
“Given the importance of these valuations in managing the risk of stale valuations, firms are encouraged to consider the types of events and quantitative thresholds that could trigger ad hoc valuations and document how they are to be conducted.
“In some areas, such as transparency and disclosure, we saw good practice that went beyond existing requirements. Firms should consider these examples and whether they might be of value for their firm,” the FCA said.
Galina Dimitrova, director, investments and capital markets at the Investment Association, said: “Private markets are a significant growth area for investment managers and have increasingly become an important part of a diversified investment portfolio. Ensuring firms are carrying out robust and accurate valuations is mission critical for the long-term success of private markets. Getting this right will boost confidence amongst investors whilst encouraging firms to invest in developing their private market capabilities.”
She noted that the IA has “worked extensively” with the government, policymakers, regulators and key industry stakeholders to deliver the benefits private markets can provide.
“We support the FCA’s recognition that a robust valuation is based on independence, expertise, transparency and consistency, and look forward to working with our members and the regulator as the industry looks to implement the FCA’s best practice recommendations,” Dimitrova added.
Targetted approach
The FCA said it will continue to engage with firms and industry bodies on the findings from its review.
“We look forward to discussing the challenges faced by the industry as raised in this review, and the opportunities to further enhance valuation practices to support confident investing in private markets.
“We are mindful of the size of this sector and the different size and shape of firms within it. Not all of the issues identified in this review will be relevant for every firm. We will conduct targeted follow-up work with any outlier firms identified from our review,” it said.
The FCA said it will build on its valuation practice findings with further work “focusing on conflicts of interest in private markets”.
“Rapid growth in private markets and asset managers operating multiple intersecting business lines, continuation funds, co-investment opportunities or partnering with other financial institutions may increase the potential for conflicts,” the report said.
“Good management of them is critical to confident investment in private markets, and we will work to support that.”
Camille Blackburn, director of wholesale buy-side at the FCA, said: “The UK is the largest centre for private asset management in Europe. Investor demand from individuals and institutions has driven significant growth.”
She stated that good valuation practices are key to maintaining fairness and confidence as the market grows, but warned that “there is still more to do, and we expect firms to carefully consider our findings”.
The findings will be used in the FCA’s review of Alternative Investment Fund Managers Directive (AIFMD) as it updates its rules in the Handbook and will inform the FCA’s contribution to IOSCO’s review of global valuation standards to support the use of proportionate and consistent valuation standards globally in private markets.
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