UK Probe Exposes Poor Valuation Practices Across Private Markets

(Bloomberg) — Valuations in the rapidly-growing private markets arena can suffer from unmitigated conflicts of interest, poor record-keeping and smoothing of volatility, the UK’s top financial regulator warned. 

Valuation committee minutes’ failed to record how decisions are reached on multiple occasions, the Financial Conduct Authority’s probe found, and “vague” rationales were recorded for key changes to appraisal models, such as the discount rate. A failure to adequately identify and manage conflicts of interest was a recurring theme across the report on practices at the 36 unnamed private equity, venture capital, private credit and infrastructure managers and advisers. 

“Only a few firms demonstrated strong awareness and control over all potential valuation-related conflicts that we would have expected,” the watchdog said, adding that while all firms recognized competing interests related to fees and remunerations, “other potential conflicts were only partly identified and documented.” 

The Financial Conduct Authority, which oversees Europe’s largest center for private markets, launched a sweeping review of appraisals in the industry last summer amid concerns about inconsistent practices. Regulators have also been worried by the industry’s rising use of financial engineering after interest rates rose, sparking fears that an unwinding of hidden leverage could ricochet across the wider financial sector.

Other watchdogs including securities regulatory standards body IOSCO, the Securities & Exchange Commission in the US, the European Central Bank and the Bank of England have previously called out valuation issues in private markets and the potential threat to global financial stability from an unanticipated blow up. 

On conflicts of interest, the FCA said while firms had generally good practices for things like investor reporting and the use of third party valuers, there are shortcomings in several other areas where it will now push for improvements. Those include marketing to asset owners, secured borrowing, asset transfers, subscriptions and redemptions, and volatility and uplifts. 

Many firms lack processes for “ad hoc” valuations triggered by events like a pandemic or war, the report published Wednesday found. Fund managers and advisers were further criticized for having “not actively considered or documented” some conflicts of interests in their appraisal discussions.

The FCA said it saw some examples of firms using conservative valuations to limit the risk of volatility over time “and/or a better opportunity for an ‘uplift’ at redemption.” Exaggerating the “stability of valuations can also harm investors by obscuring the true level” of risk “and the current value of their investments,” said the watchdog, which oversees 42,000 companies across the broader finance industry. 

The use of Net Asset Value financing, which allows funds to borrow against their portfolios, was widespread among the group. However, the FCA said that most did not identify and document the potential competing interest this causes, since funds can borrow more at better rates if their assets are appraised higher.

“Good valuation practices are key to maintaining fairness and confidence as the market grows,” said Camille Blackburn, director of wholesale buy-side at the FCA, adding that while firms could “usually evidence” that they were doing things properly, “there is still more to do, and we expect firms to carefully consider our findings.”

More stories like this are available on bloomberg.com