Written by Romin Dabir, Partner, Reed Smith
Private market valuations are the subject of increased regulatory scrutiny. Rising interest rates across the globe, introduced to combat inflation, have highlighted issues with valuations in private finance: whilst interest hikes have significantly affected the values of both government debt and listed equities, the impact on the reported values of private, unlisted assets held by alternative investment managers has been far less severe.
This has raised pressing questions over the valuation processes employed by such firms. The International Organization of Securities Commissions (IOSCO), for one, has recognised valuations as a notable point of risk for the financial sector. Against this backdrop, the FCA has announced a review into the approach to valuations at these firms.
This unease is unsurprising. Valuations play a crucial role in upholding market confidence, helping investors monitor the performance of their investments, as well as underpinning the assessment of potential investments. Accordingly, it is essential that all stakeholders have confidence in their reliability, including regulators (such as the FCA) that are responsible for supervising the financial soundness of firms.
Firms that can demonstrate rigour in their approach to valuation are likely to be at a competitive advantage when it comes to attracting investment. Given the importance of valuation to their business models and investor confidence, firms holding private assets need to begin preparing for possible changes to valuation requirements now. But what should fund managers and financial advisers be doing to prepare?
What issues have been identified with the current regulatory framework for valuations?
A key issue is a lack of consistency. There is no standardised method for valuations, and no requirement for them to be carried out by an independent third party. An element of subjectivity in valuations is inherently inevitable in valuations, given that privately held investments are illiquid and there is no ready secondary market.
By way of example, in the US, the SEC is targeting the wide-ranging approaches to valuation used to ‘mark’ loans by the private credit industry, with certain funds holding the line on valuations even as their rivals slash values.
Further, because valuations are typically only refreshed quarterly, they do not necessarily reflect the latest market conditions, resulting in potentially distorted information coming to market.
These disparities may lead to damaging consequences. For one, on a case-by-case basis there is the danger that capital will be allocated inefficiently based on inaccurate or stale valuations. For another, a perceived lack of rigour in valuations undermines confidence in the market – and if investors and financial advisers become more cautious, growth at a macro level could be stunted.
What are the potential changes – and how can firms prepare now?
The results of this review will likely include stricter governance requirements for funds and their managers, focussing on (i) improved clarity and communication regarding valuation methods, (ii) the use of market data to inform valuations, and (iii) the assumptions underpinning valuations. In advance of the review’s conclusion, fund managers should be taking action without delay to ensure their house is in order to mitigate the impact of the more onerous requirements that are likely to come.
In the first instance, firms should audit their current valuation methodologies. Next, an independent valuation committee should be set-up to supervise and regularly review all approaches used and determinations reached. The committee should also watch for market events that will affect valuations and ensure that these are fed in to minimise the current time lag that often occurs. The valuation committee should also seek to identify and mitigate any conflicts of interest that may affect the integrity of valuations, with the committee’s independence in itself going some way to achieve this end.
Underpinning this work should be robust valuation and risk management policies. Where valuations are carried out in-house, these policies should impose appropriate separation between portfolio managers and the valuation function. The policies should also require all assumptions and data (whether generated in-house or supplied by portfolio companies) used in valuations to be validated and recorded. This will mean that, if valuations are queried by the FCA or investors, all determinations can be backed up by rigorous evidence. The valuation committee could have a role in ensuring that these policies are adhered to in practice.
By starting their preparations now, fund managers will be well-placed to transition to what will likely be a more onerous set of requirements and navigate the increased operating costs and administrative burden that will come with them.
If firms do not actively prepare for the FCA’s stricter new regime, they will face an arduous task when trying to update their policies and procedures rapidly and reactively. The stricter valuation requirements could well be accompanied by an increased appetite for regulatory enforcement, making the need for timely and adequate preparations even more important.
