FCA Report on Private Asset Valuations

The Financial Conduct Authority (FCA’s) report, which sets out its findings and feedback from its Private Market Valuation Review (PMVR) includes a number of practical action points for firms regarding their private assets valuation practices and processes.

Firms are expected to consider the report and assess their own valuation policies and processes against the FCA’s findings (including examples of good and poor practice) and feedback. Relevant areas for assessment include the governance of valuation processes, how a firm identifies and deals with potential conflicts in its valuation process, functional independence of the valuation committee, and incorporating defined processes and oversight for ad hoc valuations.

The report principally considers valuation practices of private equity, venture capital, private debt and infrastructure assets but the principles which underpin the FCA’s views on the same will be relevant to also other, less liquid asset types where continuous market pricing is not available and some measure of judgment must be applied to valuations.

The key focus areas for the FCA are the following: ensuring appropriate processes for valuation are in place, including for ad hoc valuations: governance of the valuation process, identifying, documenting and mitigating potential conflicts of interest in connection with the valuation process and ensuring functional independence for valuation. A few additional items were also highlighted as relevant for firms to consider in their own practices, discussed below.

Defined Processes for Ad Hoc Valuations

The FCA noted that ad hoc valuations are important to ensure that portfolios are properly and accurately valued at all times, including in response to market conditions or specific events, for example, COVID-19 or the Russia-Ukraine conflict. However, only a minority of firms had defined quantitative or qualitative thresholds for triggering ad hoc valuations, and most firms did not have a formal process for conducting ad hoc valuations. The FCA did not consider waiting for changes to flow through to the next valuation cycle or having investor discussions without changing the reported value of the assets to be consistent with the obligations firms face. The FCA recommended that firms review their ad hoc valuation process and, where one does not presently exist, incorporate a defined process for ad hoc valuations to mitigate the risk of stale valuations, including the thresholds and types of events that would trigger ad hoc valuations.

The FCA acknowledged that valuations are resource-intensive but specified enhancing the valuation process with respect to ad hoc valuations regardless. The practical implementation of changes to valuation policies to reflect ad hoc valuation needs, requires careful consideration to ensure the thresholds and triggers are appropriate and reflect asset types and other specificities relating to the assets. Keeping ad hoc valuation procedures under review to further calibrate triggers over time.

Governance. Although the FCA found that many firms had set up appropriate governance and oversight arrangements, including dedicated valuation committees, it found that, in some cases, committee minutes failed to record details of how valuation decisions were reached, and when asked, committee members could not describe examples in practice. Firms should ensure that their governance arrangements, including Senior Management Functions (SMFs’) responsibilities, ensure accountability for, and proper oversight of, the valuation of different assets and the valuation processes, the valuation policies are clear and up-to-date, and that firms keep appropriate records of valuation decisions and the rationale for the same.

Conflicts. The FCA found that, while conflicts relevant to valuation concerning fees and compensation had mostly been duly identified and mostly limited through fee structures and remuneration policies, conflicts outside of these areas were generally not thoroughly considered, identified and mitigated. The FCA was concerned that other conflicts appeared to have been only superficially considered and the documentation reflected this, e.g. the descriptions of the conflicts limited at a very high level with little or no consideration of the conflicts specific to different products, asset classes or transactions.

In particular, the following conflicts were identified as of particular relevance:

Investor fees. The FCA considered the conflict assessment did not always assess how the conflict varied across different products or asset classes.

Asset transfers. The FCA considered valuation of asset generally to rely on impartial or externally verified valuations, separate teams or committees representing client interests, or market testing as to likely pricing. The FCA noted that standard practices for continuation funds with respect to asset transfers included agreement to asset transfers from the existing fund’s limited partner advisory committee and obtaining an independent fairness opinion for the price at which assets were transferred. Similar approval and external valuation verification practices would be applicable also, with respect to any cross-trading of illiquid or hard-to-value assets in otherwise liquid funds. The FCA cautioned firms 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. The FCA cautioned that where valuation does not coincide with dealing dates this risks investors dealing on prices that do not reflect the correct Net Asset Value (NAV), especially where NAV valuation is judgment based or less frequent than dealing. The FCA identified this risk to be particularly relevant to products that only deal on the secondary markets, and found that most firms had identified, but not documented, the increased valuation risk represented by these products.

Investor marketing. Firms that use the unrealised performance of existing funds to support fundraising for new vehicles may be incentivised to show positive and stable movements in value over time. The FCA identified as good practice when using unrealised performance documenting the conflict and ensuring the marketing materials separate unrealised and realised investments, clearly stating that unrealised performance is based on the firm’s approach to valuations and identifying the components of unrealised value.

Secured borrowing. For borrowing secured against a fund’s portfolio of assets, such as NAV financing, common covenants include a minimum level of diversification within the portfolio and a maximum loan-to-value (LTV) ratio. The NAV depends on how the borrower values their unrealised investments. This can lead to a potential conflict of interest where valuations may be inflated to attract a greater amount of initial borrowing or avoid breaching an LTV covenant. The FCA noted most firms view that a market practice of low LTV ratios reduced the risk of breaching a covenant and, accordingly, the incentive to inflate valuations. Some firms with more restrictive covenants also noted that lenders scrutiny of valuations and other underlying portfolio metrics is a form of mitigant of this conflict. However, most firms had not proactively identified and documented this potential conflict.

Uplifts and volatility. The FCA noted that investors’ preferences for a stable return profile over time with an uplift on exit presents a conflict of interest, potentially disincentivising accurate valuations over time and masking a true level of volatility in the investment. The FCA acknowledged that firms that demonstrated a strong awareness of conflicts actively discussed these issues in valuation committees and had identified the risk of overly conservative and stable valuations.

Employee remuneration. Although the FCA noted that linking investment staff remuneration to unrealised performance (in contrast to realised performance, e.g. carried interest paid on closure of the fund), for example, where bonus payments are linked to changes in NAV over a defined time period or the use of profit-sharing schemes to allow employees to participate in management fees is rare, it noted the conflict in these arrangements. The FCA noted many firms correctly identified the conflict and recognised as good practice the firm seeking additional assurances for in-house valuations. The FCA noted that, usually, additional independence and expertise was obtained through engaging a third-party valuation adviser.

Functional Independence and Expertise

The FCA observed that a few firms demonstrated that their valuation arrangements met the standards applicable to full-scope UK alternative investment fund managers (AIFMs) performing valuations. These standards require functional independence from portfolio management, proper management of conflicts of interest and prevention of undue influence on employees, impartiality and due skill, care and diligence in valuing assets. However, there were firms that fell short of these standards.

In some firms, the valuation function appeared to perform a more administrative and operational role, collecting data and applying valuation models but had limited control or ability to challenge inputs or assumptions. The FCA noted that, in these firms, investment professionals seemed to be more involved in the valuation task, such as proposing changes to comparable asset sets or discount rates. The FCA further observed that such arrangements require greater oversight by valuation or risk committees to ensure they identify and address conflicts, that model, input and assumption changes are appropriate, and that the valuation function is in fact sufficiently independent of the investment function.

The FCA particularly noted that, in some firms, senior investment professionals were voting members in valuation committees and that, while their expertise is important, the FCA will be following up with these firms to understand how their position as voting members is consistent with the independence of the decisions made and whether this compromises independent oversight and challenge. Firms should consider if including investment professionals as voting members ensures appropriate independence and conflict management.

Where the independence of the valuation function fell below the standards expected, the FCA observed the valuation function also had insufficient expertise, e.g. were unable to describe the assets, valuation models or assumption changes in detail. The FCA noted that having senior investment professionals represent all or the majority of the valuation committee voting membership was not consistent with their expectations of independence. Further supervisory or enforcement action for these firms is likely.

Valuation Processes

Valuation policies. The FCA noted that some firms did not provide details on the rationales for selecting methodologies and their limitations, nor the required inputs and data sources, and most did not describe safeguards for functional independence or the potential conflicts. Only some firms described the periodic review of the policies and procedures, escalation measures and the need for consistency.

Valuation models. The FCA criticised the vagueness of recorded rationales for key assumption changes, e.g. adjustments in discount rates and noted that lack of standardisation and structure made it harder to identify the key changes in inputs or assumptions. The lack of standardisation makes it harder to assess the robustness of decisions reached by governance oversight bodies or auditors, or indeed investors undertaking due diligence.

The use of valuation templates to ensure consistency and clarity was identified as a good practice, alongside clearly highlighting changes in inputs, assumptions and value, and providing qualitative information on the context and performance of the asset; as well as maintaining logs capturing assumption changes across assets. Use of automated third-party valuation software to improve consistency and reduce the risk of human error was also recognised as good practice.

Auditors. The FCA noted that good practice includes supporting external auditors to perform their role by involving them in the valuation process, e.g. to observe valuation committee meetings, raising auditor challenges at those meetings and taking proactive measures of managing conflicts of interest involving the audit service provider, such as rotating audit partners and audit firms.

Backtesting. The FCA noted that most participating firms conducted backtesting (comparing the realised value of an asset upon exit to the last valuation estimate to assess the accuracy and precision of the valuation process, and identify any limitations of the valuation model and approach), although it was not relevant to some asset classes, e.g. private credit, where assets are mostly held to maturity rather than sold. The FCA confirmed it was good practice to use the results of backtesting to inform the firm’s approach to valuations, gleaning insights about current market conditions, and potential limitations in models, assumptions and inputs.

The FCA specified that firms should ensure their valuation policies are sufficiently comprehensive such that the valuation process is clear and adherence to it can be tested; assess whether valuation models are documented consistently and clearly across assets, engage with auditors appropriately and properly consider insights from backtesting to inform their valuation approach. Investment in technology should be considered as a further measure to improve consistency and reduce the risk of human error in the valuation process.

Frequency of Valuations

The FCA observed that infrequent or stale valuations present a risk of harm, especially where they are used to charge fees or to price redemptions and subscriptions. The FCA noted that, in contrast to open-ended liquid funds, which have daily dealing and therefore calculate NAV daily, other, less liquid alternative asset classes seem to largely have converged to quarterly valuations, with some variation (private debt valuations often taking place monthly) to more and less frequent valuations, depending on the asset class.

Transparency

Some firms highlighted barriers limiting their ability to share information with investors. Some noted that non-disclosure agreements prevented them from sharing data on portfolio company financials and others noted the commercial sensitivity of sharing valuation models.

The FCA highlighted good practice, including reporting quantitative and qualitative information on performance at both the fund and asset-level, as well as holding regular conference calls with investors to discuss valuations. A further enhancement some firms employed, was to include a ‘value bridge’ which shows the different components to changes in value of the NAV or assets. For example, the value bridge might show illustrations of how much change was attributable to a portfolio company’s underlying earnings, the valuation multiple used, cash proceeds and exchange rate changes. This enhanced transparency allows investors to understand the extent to which changes in value were driven by changes in market movements and valuation judgements compared to changes in a portfolio company’s financial performance.

The FCA suggests firms consider where they can improve their reporting to and engagement with investors on valuations, including providing detail on fund-level and asset-level performance, to increase transparency and investors’ confidence in their valuation process.

Next steps

Firms should review their valuation policies and processes in light of the FCA’s feedback and observations and consider whether enhancements are required. Please reach out to your Akin contact for assistance and to discuss further.