FCA private market valuations review identifies room for improvement

With the FCA’s review of UK AIFMD due to kickstart imminently, the FCA has today (5th March)  published its detailed findings from its multi-firm review of valuation processes for private market assets. The FCA’s findings will be taken into account in the FCA’s UK AIFMD process, but the FCA expects firms to take action now in light of the examples of good practice and identified action points in the review.

Background

With the significant growth in private markets in recent years as an important means for investors to diversity investment and seek new sources of return, there is an increasing onus on private market firms to get their own valuations correct – particularly given that private markets lack the frequent trading and regular price discovery present in more liquid public markets. the FCA has in mind therefore the risk of inappropriate valuation of assets resulting in increased risk of harm for both investors and market integrity.  

“Good valuation practices are key to maintaining fairness and confidence as the market grows. We were pleased that firms could usually evidence independence, expertise, transparency and consistency in their valuation process” says Camille Blackburn, director of wholesale buy-side at the FCA, but “there is still more to do”.

The FCA findings, and key actions for firms – in a nutshell

The FCA expects firms take account of the identified examples of good practice and areas for improvement now, in order to identify any gaps in their approach, and consider whether any improvements need to be made to, amongst other things:

• the governance of their valuation process - overall, the FCA identified many examples of good practice in firms’ valuation processes - in areas such as investor reporting, documentation of valuations, the use of third-party valuation advisers, and consistent application of established valuation methodologies and firms should assess their own practices against these findings
• identifying, documenting, and addressing potential conflicts in their valuation process - while 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, other potential conflicts were only partly identified and documented. (including conflicts related to investor marketing, secured borrowing, asset transfers, redemptions and subscriptions and uplifts and volatility).  Firms are expected 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
• ensuring functional independence for their valuation process – with sufficient independence in valuation functions and the voting membership of valuation committees to enable and ensure effective control and expert challenge
• incorporating defined processes for ad hoc valuations – with many firms identified as not having 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

A deeper dive 

Governance Arrangements

Whilst nearly all firms had specific governance arrangements in place for valuations, with many incorporating valuation committees responsible for valuation decisions, in some cases there were inadequate records of how valuation decisions had been reached – or when asked, valuation committee members could not describe examples in practice.  a lack of record-keeping prevents the FCA from having confidence about effective oversight of valuation decisions (and there is also recognition that other stakeholders – e.g. auditors or investor DD committees – would also require more detail).  The FCA expects forms to consider whether their governance arrangements ensure there is clear accountability for valuation and robust oversight of the valuation process, including accurate and detailed record-keeping of how valuation decisions are reached

Conflicts of Interest
The FCA identified that firms identified conflicts in their valuation process around fees and remuneration, and in many cases had limited these through fee structures and remuneration policies.  However other potential conflicts were only partly identified and documented – and in many cases were not actively considered or documented in their valuation process in sufficient detail – or where they were documented this was often in a generic way without consideration of specific conflicts or how they varied across products or transactions.  Whilst conflicts are specific to each firm, examples include the following, and the FCA expects  firms to consider if these valuation-related conflicts are relevant and if they are, document them and the actions to mitigate or manage them:

•    Investor fees – appropriate management of conflicts arising where fees are linked to valuations

•    Asset transfers – with conflicts arising for example where the manager’s valuation determines the transfer price affecting the interests of buyers, sellers and remaining investors. This conflict increases if the manager receives carried interest due to the transfer using unrealised performance. Even where conflicts are limited, the expectation is that managers should perform valuations impartially and with all due skill, care and diligence to reduce harm as value is transferred between investors. This could involve obtaining a third-party valuation or opinion, establishing separate teams or committees to represent client interests, or conducting market testing.  In the context of continuation funds, with the actual transfer price decided by incoming investors submitting bids to existing investors (or existing investors choosing to keep their investment by exchanging it for a stake in the continuation fund) The fairness for incoming investors of the practice of taking their own view on price and valuation when determining their bid, rather than relying on manager valuations is heavily dependent on whether they have sufficient access to information to form their own view on price and valuation.

•    Investor marketing – a key concern here is in the use of unrealised performance of existing funds to support fundraising for new vehicles.  While investor sophistication and reputation risk are relevant, using unrealised performance in marketing can create an incentive to present favourable valuations when valuing private assets, especially when firms are fundraising and do not have a track record of realised performance. The FCA has identified that good practice includes documenting this conflict and clearly separating unrealised and realised investments in marketing materials, making clear that unrealised performance is based on the firm’s approach to valuations, and presenting the components of unrealised value.

•    Secured borrowing – the FCA found that many firms did not proactively identify or document a conflict in this context – for example where there is a risk valuations could be inflated to attract a greater amount of initial borrowing or avoid breaching an LTV covenant.

•    Uplifts and volatility - There is a potential conflict in the valuation process where firms consider investors prefer valuations that display a certain return profile, such as a smooth return profile over time.  The FCA (noting some examples of conservative adjustments in valuation case studies that provided a less volatile valuation profile over time and/or a better opportunity for an ‘uplift’ upon exit) acknowledge that conservative valuations limit the risk of overvaluation over time, however the concern is that exaggerating the stability of valuations can also harm investors by obscuring the true level of investment risk and the current value of their investments.  The FCA note that valuation methodologies that are applied consistently over time can give investors greater confidence that their assets are being valued fairly, even when this would lead to less stable valuations.

•    Remuneration – good practice in this context includes seeking additional assurance for in-house valuations. This could include additional independence and expertise obtained through engaging a third-party valuation adviser.

Functional independence and expertise

Examples of good practice include (i) firms maintaining a dedicated function or existing control function (staffed by people independent  of portfolio management with valuation expertise) to lead on valuations, including developing models and preparing recommendations for decisions made by valuation committees, (ii) where seeking views from investment professionals, these are segregated and clearly documented, with the independent function maintaining control of valuation models, including input and assumption changes; (iii) valuation committee’s voting membership made up of independent individuals with sufficient valuation expertise, with the committee recording detailed asset-level valuation discussions that demonstrated an understanding of the asset and the valuation task, including the need for consistency in application of valuation approaches

Policies, procedures and documentation

Clear, consistent and appropriate policies, procedures and documentation are core components of a robust valuation process.  There are clear expectations set out in the AIFMD Level 2 regulations, but it was evident from firm’s valuation policies and valuation models that not all firms are meeting these obligations.

The use of templates can ensure a consistent and clear approach.  An example of good practice would be clearly highlighting changes in inputs, assumptions and value, as well as providing qualitative information on the context and performance of assets, and the maintenance of logs capturing assumption changes across assets. Some firms are using automated third-party valuation software to improve consistency and reduce the risk of human error.

There is consideration here of how best to support auditors in performing their role, with good practice examples including auditors involvement in the valuation process. Examples included inviting auditors 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.

Finally backtesting is an important process and the results can be used to inform the approach to valuations  such as identifying insights about current market conditions, and potential limitations in models, assumptions and inputs.

Frequency and ad hoc valuations

It is acknowledged that low frequency valuation cycles  can result in stale valuations that no longer reasonably reflect the current condition of holdings – resulting in the risk of inappropriate fees and investors redeeming at inappropriate prices.  In many cases the industry has converged on quarterly valuation cycles (although debt assets also have monthly cycles).  There is recognition however that ad hoc out-of-cycle valuations (particularly if material events significantly change the market conditions or asset performance) can lower risk here – however very few firms have a defined process for ad hoc valuations (and firms should consider incorporating such processes, including the thresholds and types of events that would trigger ad hoc valuations).

Transparency to investors

Firms should 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.

Application of valuation methodologies

The methodologies firms used understandably vary by asset class and the nature of the asset.  Firms are expected to apply valuation methodologies and assumptions consistently and make valuation adjustments solely on the basis of fair value. Valuation committees and independent functions should 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 (as a sort of sense check).

Use of third-party valuation advisers

Third-party valuation advisers can provide additional independence and expertise – however their value as an additional control will depend on how firms use and engage with these providers, and firms must be mindful of any potential conflicts of interest. As third-party valuation advisers provide different levels of service, firms should make their investors aware of the specific nature of the service provided (including portfolio coverage and frequency), its strengths and its limitations.

Resources

The FCA’s findings can be found here
The FCA’s press release is here