The UK's top finance regulator has raised concern about valuation methodologies employed within private markets that are based on unchecked conflicts of interest, poor records keeping, and artificial volatility smoothing. The Financial Conduct Authority (FCA) has found widespread lacunas within private market entities' valuation techniques that pose risks to market integrity and investor trust.
Main findings of the FCA inquiry
The FCA probe revealed that valuation committee meeting minutes rarely contained explanations regarding how key decisions were reached. Justifications provided for significant changes—such as to discount rates—were typically ambiguous or absent.
A consistent theme throughout the report was the lack of identification and handling of conflicts of interest by the firms. The probe, conducted on 36 private credit, venture capital, private equity, and infrastructure management firms, saw that though the firms did acknowledge conflicts that concerned fee and compensation issues, other possible conflicts remained unreported.
Fewer than one third of the companies exhibited strong awareness and control of all the possible conflicts that we would expect.
Regulatory Scrutiny and Broader Implications
The FCA began this review last summer amid growing concern about unbalanced valuation methodologies. With interest rates higher and more use of financial engineering, there are worries that the hidden leverage within the market has the capability to bring about greater financial consequences if suddenly released.
Other global regulators like the US Securities and Exchange Commission (SEC), the European Central Bank (ECB), and the Bank of England have also warned about valuation risks in private markets. The entities mentioned above indicated that unsound valuation methodologies are a source of systemic risks to the stability of the financial system.
Weaknesses in Transparency and Good Governance
While the FCA acknowledged good practices in investor reporting and third-party valuation, it identified several areas requiring improvement, including:
Market to asset holders
- Secured borrowing and asset transfer
- Subscription and redemption mechanisms
- Volatility management and valuation uplifts
A top priority was the absence of official procedures to perform "ad hoc" valuations triggered by market shock events such as economic crises or geopolitical events. The majority of the companies lacked specific guidelines to reassess asset values during disruptions.
Furthermore, some firms employed conservative valuations to dampen volatility in the near future and create a more appealing "uplift" upon redemption. The FCA warned that artificially stabilizing valuations risks confusing investors about the underlying risk and value of the investment.
Apprehensions about Net Asset Value (NAV) Financing
The FCA also pointed to the widespread use of Net Asset Value (NAV) borrowing, where the funds borrow against the portfolios. The majority of the companies did not account for the conflicts this produces, as higher asset valuations enable them to borrow more at better interest rates—one incentive that can distort fair valuation.
Regulatory Expectations: The Future
Camille Blackburn, the FCA's Director of Wholesale Buy-Side, emphasized:
“Sound valuation principles are essential to maintain fairness and trust during market expansion. Even if the companies are generally able to demonstrate the process, there is still work to be done, and the companies are to take our findings fully into account.”
The FCA report serves to remind that there will be more scrutiny from the regulator if valuation transparency and governance are not enhanced.
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Source: livemint.com
