The private equity and venture capital industry has been bracing itself for regulatory scrutiny when it comes to valuation. And it came in the FCA’s announcement of an impending multi-firm review. 

The intention to conduct a review was included in the regulator’s interim update (Dear CEO letter) on its asset management and alternatives supervisory strategy. The FCA pointed out that it is important for valuations to be robust and reliable in all market conditions. The concern is that the lack of transparency of valuation, together with the unfavorable macroeconomic environment, may impose unacceptably high risk to investors accessing the private markets.

This concern aligns with a report published by the international body IOSCO (International Organization of Securities Commissions) in September 2023, which flagged that the opaque nature of private markets investments gives rise to risk to the sector, portfolio companies and the real economy.

The report stated that the stale and lagging nature of private asset valuation may lead to overvaluation or undervaluation during the different stages of the economic cycle. And the lack of an observable, public market and a standard methodology of valuation may create uncertainty around the accuracy of valuation. And, in some cases, private assets may be valued to an excessively high point that may never be realised, which in turn affects investors’ exit and rebalancing.

With these risks in mind, alongside the specific areas that the FCA plans to investigate, there are several points to consider to stay ahead of the curve.

Personal accountabilities for valuation practices

The Senior Managers and Certification Regime (SMCR) requires firms to allocate responsibilities to individuals with the aim of encouraging senior managers to take personal responsibility for their actions. We expect the FCA to review whether firms have allocated the valuation responsibility to the appropriate individuals, and how the individuals responsible for valuation carry out their duties to ensure the firm’s valuation practices are appropriate.

The individual responsible for valuation should be asking themself:

• Are the valuation policies and procedures in place adequate and proportionate to the firm’s size, business and risk profile? Has the firm reviewed these documents periodically?
• Has the firm applied consistent valuation methodologies to funds with similar types of underlying assets? Are assets valued at a suitable frequency and in a fair and proper manner?
• Are there appropriate escalation arrangements in place to report any anomalies relating to valuation?

Governance of valuation committees

Good governance is an overarching requirement across a few areas covered by the Dear CEO letter, including valuation. While it is a common practice for asset managers to establish valuation committees to oversee the firms’ valuation practices, the arrangements may vary.

When looking at the governance around valuation, asset managers should ask themselves:

• Are the members of the valuation committee of sufficient seniority and authority?
• Has the firm documented the responsibilities the valuation committee and its members clearly, for example through a terms of reference or a charter? Does the valuation committee follow such documented requirements in practice?
• How does the firm manage conflicts of interest in relation to valuation, including having transparent and fair pricing structures for management and performance fees as well as having clear procedures for transfers of assets between funds and the use of Continuation Funds?
• Is the valuation of assets performed by functions independent from investment/portfolio management? If the firm engages external parties in the valuation process, has the firm exercised due skill, care and diligence in selecting the external parties?

Board reporting and oversight of valuation practices

The ultimate responsibility of an FCA-regulated firm’s valuation practices sits with the Board of Directors or the governing body of the firm. The Board should ensure it receives appropriate management information and provides sufficient challenge to the firm’s arrangements and practices.

When looking at the adequacy of board reporting and oversight, ask yourselves:

• Is the management information comprehensive and prepared and presented in a timely manner to the Board? Does it include input from external and independent parties?
• Has the firm documented the discussion of the Board report properly?
• Are the follow-up actions / remedial measures implemented as planned?

Documenting your processes

The Dear CEO letter requires the chief executive of a firm to discuss the letter with the Board, consider whether any risks or harms in relation to valuation exist in the firm, and implement remedial measures to mitigate them. We recommend that private asset managers should document a formal review of their valuation policies, practices and arrangements.

Abi Reilly leads Bovill’s specialist Funds practice and Ronnie Kwok is a consultant in the Funds practice, London .