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‘The FCA is also wary of savvy investors exploiting known deficiencies in the process to buy or sell assets at prices that benefit them, which could make trading unfair.’
The lead UK regulator revealed it was preparing to run a full-scale review into private markets valuations in the latter half of 2023 as part of a joint evaluation with international regulators of the risks the non-bank sector could pose to financial stability.
Prashant Gupta, associate director at Acuity Knowledge Partners, said the initiative evidenced “the importance of private markets maintaining robust and transparent internal valuation procedures”.
Although the full scale of the inquiry has yet to be revealed, Stewart Heggie, commercial director for Scottish Mortgage, said the FCA had “identified concerns” regarding the impact higher interest rates were having on private equity valuations.
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This comes at a time when “sums managed in private markets have soared over recent years, and we have seen an influx of retail investors keen to have more exposure to these attractive asset classes”, he added.
SMT has invested in the private equity space for decades, making some of the earliest UK investments in TikTok parent firm ByteDance, Elon Musk’s SpaceX and payment platform Stripe.
Gupta noted the regulator is expected to focus on “conflicts of interest and the influence of fund managers over asset valuation, as well as the frequency of valuation updates”.
Valuing privately listed assets accurately brings unique challenges compared with public listings due to the infrequent trading of the market, the experts explained.
Anna Baráth, chief investment officer at Bite Investments, described the valuation procedure as an “inherently subjective process, characterised as an art rather than a science”.
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“Reasonable individuals may arrive at different valuations, there is room for improvement in the way funds appraise their private market assets,” she said.
“The infrequent nature of private asset valuations, often quarterly, can lead to delayed adjustments even in the face of significant market events, creating exploitable opportunities for investors.”
Gupta noted the FCA is also wary of savvy investors exploiting “known deficiencies” in the process to buy or sell assets at prices that benefit them, which he said “could make trading unfair”.
According Gupta, the review is a “wake-up call” for the asset managers, trustees and other parties involved in the investment chain to review their practices and highlight areas for improvement.
Relation to LTAFs
Parallel to the review, the UK financial watchdog has been focused on the new Long-Term Asset fund, which is designed to allow a degree of access to less liquid investments for retail investors.
“It is perhaps not surprising that said regulator – prudently – is therefore planning to launch a review into private asset valuations,” said Baráth.
LTAFs have been available since November 2021, and marked the UK’s response to the European Long-Term Investment fund (ELTIF).
Baráth argued the government had also “taken note of the megatrend”, after it was announced that LTAFs would be included in Innovative Finance ISAs, alongside open-ended property funds with extended notice periods.
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“The government is encouraging more conservative UK institutions and professional investors to include more private assets in their portfolios,” Baráth said.
“For this strategy to succeed and be fair to investors, there is a crucial need for confidence in the value of these private assets, especially when it comes to handling regular redemptions, which interval fund structures (such as the LTAF) allow for.
“The FCA is possibly concerned about not only the potential issues in private asset valuations that could negatively impact investors’ trust, such as potential conflicts of interest, managerial influence on valuations, the frequency of updates and the exploitation of known valuation deficiencies, but also the systemic implications to the market if it prompts investors subsequently rush for the door ‘en masse’.”
She added that internal valuations by asset managers “may face closer scrutiny” in the review, particularly around the potential conflicts of interest and the incentive to inflate reported asset values for performance fees.
“The FCA may subsequently decide to offer clearer guidance on separating valuations from managerial influence,” she said.