1 November 2023
Recently, the FT reported that the FCA would be launching a review of the way investment funds value private assets. The FCA’s CEO Nikhil Rathi, subsequently confirmed that his agency was planning a sweeping review of valuations used across private markets. The government has been pushing for UK institutions to use more private assets in portfolios. For those initiatives to be successful, and fair to investors, we all need more confidence in the value of those private assets. We believe that rising interest rates globally and changes in market conditions for private assets make this review timely. This review will be important for institutional investors and managers of private assets alike, especially on the investor side where there is a reliance placed on valuations to meet regular redemptions, such as in Defined Contribution default funds. We fully expect the review to highlight some of the deficiencies and conflict in the system and look to the FCA to provide stronger guidance on the separation of valuations from manager influence.
Why is this review being conducted?
The FCA have identified some concerns around valuations that could harm investors and the smooth functioning of the market for funds of private assets. Any situation where a fund over-values or under-values its assets could lead to investors, and underlying beneficiaries, buying and selling assets at an unfair price. Particular concerns of the FCA are likely to be around conflicts of interest and the extent of the influence or input that the manager has on the valuation process; the frequency on which valuations are updated and the possible exploitation by some investors of known deficiencies in the valuation. For example, there has been a growing trend for ‘continuation funds’. These are funds that are set up to take on one of more portfolio investments of a fund that is nearing the end of its lifespan in the hope of holding onto investments to make bigger returns at a later date, and to provide an exit for LPs. This introduces a clear conflict that needs to be carefully managed as the manager has a duty to both the old and the new fund and its investors. We expect pricing practices around that process to receive closer scrutiny.
What can investors and asset managers expect from the review?
We expect the review to begin later this year and last for 6 – 9 months. In general, multi-firm reviews are aligned with the main risks of harm that the FCA believes are inherent in the asset management industry. These harms are identified on a two-year basis, the last cycle started November 2022. Whilst there are a number of ways that the results could be communicated, we expect some form of public announcement, likely in the form of a ‘Dear CEO’ letter, alongside individual private letters sent to each firm reviewed. Based on recent multi-firm projects, we should expect results in the second half of 2024, possibly ahead of the next 2-year strategy cycle in November 2024. A typical multi-firm review would involve interviews with some 10 – 15 managers to assess their pricing practices supplemented by prior supervisory knowledge. The FCA will draw conclusions from that work and depending on the findings they could issue rule clarifications, guidance or even seek to amend rules (post consultation).
Some thoughts on the current process
The valuation of private assets is an art, not a science. It is, necessarily, a subjective assessment and two reasonable and experienced individuals could, quite validly, come up with quite different valuations. There are, however, some improvements we think could be made to way funds value their private market assets. For UK and EU authorised funds, the valuation of private assets must be carried out independently of the portfolio managers. However, it is not mandatory to employ an external firm to carry out this function. Under FUND valuation rules (FUND 3.9.7): ‘An AIFM may perform the valuation itself, provided that the valuation task is functionally independent from the portfolio management; and the remuneration policy and other measures ensure that conflicts of interest are mitigated and that undue influence upon the employees involved is prevented’. We expect that those managers who opt to value internally might receive closer scrutiny as to their management of conflicts and their valuation process. Where the fees and, particularly, performance fees are calculated using the valuation, there is a clear incentive to inflate the reported value of assets. Valuation of private assets is usually conducted fairly infrequently – quarterly is common. If there is a significant market event affecting the valuation of listed assets, the valuation of private assets may not change at all for some time, and even then, we often seen values move slowly over a protracted period to catch-up with listed assets. This behaviour is fairly predictable and, if the fund is open-ended and can be traded, it is exploitable by some investors at the expense of others. It is interesting to note that there exists a lively secondary market in PE deals where executed prices are directly observable in aggregate. We also have data points from the world of investment trusts where premiums/discounts to NAV offer a window into market views on harder to value positions. For much of this year, we have observed the markets discounting less-liquid holdings by a fair margin.
How might investors and their behaviour be affected?
In the case of some funds where redemptions are possible, if values are expected to fall, there may be advantage to ‘rush for the exit’. This might lead to funds being unable to meet redemptions and suspending redemption requests from the fund. The FCA is particularly concerned by these sort of events as they can have systemic, knock-on implications when investors need to sell other assets to meet their cashflow requirements. In addition, there is a group of investors for whom the valuation is much more significant: where the private market fund is part of a portfolio held by a fund of funds. Here the fund of funds may well be traded regularly and the price it trades at is reliant on the valuation of the underlying private market fund. This applies to DC pension schemes where new regulations have made it easier to hold illiquid assets in multi-asset ‘lifestyle’ funds. For DC members and trustees, it might be of critical importance to have confidence in the valuation of their private asset funds.
What would we like to see?
Whatever the outcome of the review, changes that give investors greater confidence in the valuations of private assets would be most welcome. We believe that the following measures would be provide for greater clarity and enhanced market function: the use of truly independent valuers; clarity on how conflicts of interest are managed; robust procedures for the valuation process; more frequent assessments of valuation; and procedures for timely reviews of valuations if significant market events occur. The government has been pushing for UK institutions to use more private assets in portfolios. For those initiatives to be successful, and fair to investors, we all need more confidence in the value of those private assets. We look forward to seeing the results of the upcoming review.