The Financial Conduct Authority (FCA) is set to kick off a review of private market valuations amid a rising interest rate environment and an economic downturn that is putting pressure on private equity firms and their portfolio companies.
The plans to examine asset managers “discipline and governance” over valuations was first reported by FT earlier this week.
Nathan Lightman, senior associate at Charles Russell Speechlys, told IPE: “Everyone has been feeling the squeeze as interest rates rise and the cost of borrowing increases. The FCA is concerned that existing market practice on valuations of privately held assets may not be sufficiently robust.”
He said that owing to the high level of debt used in private finance, the FCA is concerned that the entire industry could be “overexposed” to the rising cost of money.
He continued: ”When coupled with valuations of assets only being updated infrequently, that makes for a potential problem waiting to happen.”
Lightman added that the FCA will be looking closely to check whether valuation processes are “up to scratch”, and may call out any which do not meet its expected standards. He warned that any firms which continue not to comply may then be forced to take remedial action by the FCA.
He continued: “The precise nature of the review hasn’t yet been finalised, but fund managers will do well to check their valuation processes, including thinking about using external valuers, to avoid the embarrassment of any FCA interventions in the future.
“The FCA hasn’t yet commented publicly, but is understood to be keen to prevent bigger problems coming down the track with the impact of rising interest rates,” he added.
Taking to LinkedIn, Jeremy Raybould, partner at investment banking firm Lancea, said the government needs to encourage a proactive stance from the FCA to shape up the private assets market as access becomes a much wider proposition for non-institutional investors.
He said: “There is a clear wish to widen portfolio profiles towards private assets, and not just for high net worth’s but for pensioners-to-be as well.”
In July, Jeremy Hunt, chancellor of the exchequer, made his case clear that British pensioners would need to secure better returns to achieve the retirement benefits they would need.
However, Raybould said that before that takes place, the “private assets cupboards need to be hosed down and scrubbed”.
He continued: “Undoubtedly, there will be a few skeletons jumping out but the private assets industry should take this on the chin. Those skeletons are often related to success. Success breeds success but with it comes inflows, which need to be put to work, and not necessarily at the best price for LPs.”
He pointed out that this was demonstrated in the “heady days” of the venture capital (VC) boom a couple years back.
He added that level-headed VC’s complained about the industry giants collecting commitments “like water from the sea” and paying up forfor concepts that has “hardly got off the ground”.
He continued: “We saw the painful side of that in 2022, hence the need for the FCA, and other regulators to be more than just inquisitive.”
Raybould said that the FCA needs to be careful in not tarring the whole industry with a “grubby brush” and added that regulators and investors should appreciate that private assets are not a ‘quarterly’ investment objective.
He said: “Applying overly strenuous rules on valuations is distracting at best, could reduce the much needed long term vision at worst.”
He added that regulator-led investigation “won’t sort out all the wheat from the chaff but it will concentrate the minds of GPs and LPs alike and could build better foundations for more ordinary investors to participate”.
Vulnerabilities
Earlier this month, in a report the International Organisation of Securities Commissions (IOSCO) highlighted valuations as a vulnerability for private finance, which includes private equity, venture capital and debt funds.
It argued that valuations can be stale – evidenced by a two or three-quarter lag in price in public and private markets – and subjective, potentially leading to overvaluations and inaccurate portfolio weightings for investors.
The IOSCO report calls out several conflicts of interest stemming from the opaque nature of the private markets, including excessive risk-taking by fund managers to meet carried interest targets, preferential treatment, and financial sponsors holding both debt and equity in portfolio companies.
IOSCO suggests that private credit funds may finance portfolio companies that take on levels of leverage that exceed the risk appetite of banks. It argues that this additional debt, alongside leverage incurred at the fund level, could have a cumulative negative impact on the financial system.
Meanwhile, in August, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments to enhance the regulation of private fund advisers and updated the existing compliance rule that applies to all investment advisers.
The new rules and amendments are designed to protect private fund investors by increasing transparency, competition and efficiency in the private funds market.
The FCA did not respond to a request for comment from IPE.
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