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The FCA announced earlier this year that it will be conducting a multi-firm review of private market investment firms to better understand the governance and practices in valuation. Several firms have already received a questionnaire from the FCA, the scope of which is comprehensive. While the regulator is still in fact-finding mode, it’s worth reviewing these questions to glean its direction of travel and how best to prepare for the possible upcoming changes.
Private market as a broad church
From our review of the questionnaire, we can see it clearly differentiates between classic private equity, private debt, and venture capital to real estate, infrastructure, and natural resources. It also covers some niche private markets, such as art and wine. Respondents have to provide separate input for each of these types of private asset classes, which we hope will lead to a more sophisticated approach to required private asset valuation practices than “one size fits all”.
Governance and conflicts throughout the process under the spotlight
The questionnaire covers the end-to-end process of valuation, with questions posed on the source of data and the methodologies used by the firms for valuation. The four eye review, discussion, approval, and publication processes are also covered.
As one would expect, the governance of the valuation process is a key topic in this review. The questionnaire requires respondents to disclose the parties involved in different stages, from modelling and calculation to reviewing and approving the valuation results. Firms are asked to confirm the types of information provided to the decision makers or Valuation Committee for assessment, and how different views were discussed before coming to an agreement. The FCA also asked firms if the valuation process is subject to review by non-executive directors, other independent parties, or the third line of defence (internal and external auditors).
The regulator seems keen to establish whether there is an adequate segregation of duties and management of conflicts in the valuation process. We expect that the failure to manage conflicts of interest in relation to the valuation process will probably be a focus area after this review.
We recommend reviewing the stakeholders involved in each stage of your valuation process, especially where any parties involved have economic interests in the assets valued or where the valuation results have any direct effect either for your revenue or any individual’s remuneration. The segregation of duties will be an important consideration; while portfolio managers may be needed for their expert input to valuation discussions, it’s unlikely for it to be appropriate for them to have a vote on a formal Valuation Committee.
Optimising methodologies and hitting the right frequencies
As we step into the more technical side of valuation, we’ve noticed that the FCA is concerned about the competence of the stakeholders involved in the design of valuation methodologies. This includes the modelling and selection of data, as well as the review and approval of the valuations. You should therefore ensure those involved have sufficient knowledge and experience to provide adequate and meaningful challenges to the results, which is crucial to the integrity of the valuation process. Similarly, those engaging with third-party valuers should also ensure they have conducted proper due diligence at the point of onboarding and on an ongoing basis.
In addition, we noted that the FCA is concerned with any changes made to firms’ valuation methodologies (such as the risk-free rate benchmark used for income-based models and any filters adopted to the comparable market datasets) for each asset class over the last 3 years; and whether any assets have been valued differently when being held in alternative vehicles. This suggests the FCA would like to understand whether any firms have adopted consistent methodologies over time. It also indicates that periodic review and changes to the methodologies may be necessary where there is a good rationale, so be mindful that moving the goalposts or “reverse engineering” changes to meet certain valuation targets will be frowned upon.
The questions asked by the regulator also look to understand how frequently firms conduct valuations. Amongst the possible options ranging from monthly to annually, we think the regulatory expectations would be on the lower end. If you’re reviewing the valuation of investments only on an annual basis, you risk being accused of having stale values. Consider implementing ad-hoc review mechanisms and objective triggers into your valuation policies to cover off significant events in the market, geopolitics, and the macro-economic environment.
Leverage and financing: another area of interest
The valuation multi-firm questionnaire unsurprisingly touched on the use of financing and leverage.
The questionnaire required the respondents to confirm whether any funds managed or advised by them have used NAV financing facilities, the purposes of such credit facilities, whether it be financing for the portfolio companies or providing investors with liquidity, and risk management and controls on the leverage amounts and levels.
Although in previous public speeches the FCA has stopped short of calling the private market a systemic risk to the UK financial system, this questionnaire shows that the FCA is following IOSCO and the Bank of England’s lead by gathering more information on how the private market achieves investor transparency.
How we can help
To get ahead of the curve, our team can help review your internal policies and procedures to optimise your valuation arrangements and practices.
We regularly conduct health checks or sample reviews that highlight key areas of focus that clients should be working on over the next six to 12 months.
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