Financial Conduct Authority (FCA): Private Markets Valuation Review

This post is second in a series looking at the changing landscape for private market valuations, following a recent review conducted by the FCA. In this first deep dive, we will look at the use of ad-hoc valuations. This refers to the process by which a valuation procedure is initiated in reaction to a market event or a change due to a company specific event or trigger. Undertaking ad-hoc valuations, or regularly commissioning Third Party Valuations (which will be the subject of a subsequent blog) can help assist managers meet their responsibilities around the fair valuation of assets.

In their review, the FCA identified that “many firms did not have defined processes or a consistent approach for ad hoc valuations to revalue assets during market or asset-specific events”. It is normal for firms investing in assets in the private markets, to value assets on a regular, often quarterly, basis. There may be a need for a valuation to be performed outside this regular cadence, on an ad hoc basis, triggered by a specific event. The FCA set an action for firms to define a process for ad-hoc valuations, which includes defining thresholds and events that would trigger and ad-hoc valuation process to take place.

Private markets are facing a period of unprecedented uncertainty. Geopolitical instability, fuelled by conflicts and trade tensions, casts a long shadow on the global economy. In this volatile environment, accurate and timely valuations are not just good practice – they are essential for maintaining trust and transparency with investor and an important aspect of ongoing portfolio monitoring and investment decision-making. If not already doing so, firms should consider whether recent events would be a trigger for an out of cycle, ad hoc valuation for private assets.

The Need For A Robust Ad-Hoc Valuation Process

Ad-hoc valuations, conducted outside the regular valuation cycle are crucial for reflecting material changes in the economic landscape and their impact on a business's performance. These valuations provide a real-time snapshot of an asset's worth, irrespective of whether it is an equity or debt investment, allowing investors and fund managers to make informed decisions in a rapidly changing market, and not to rely on stale valuations and outdated information.

As we see in the market currently, changes in trade policy can disrupt supply chains, increase costs, and create uncertainty for businesses with exposure to these markets and impact the long-term future of businesses.  Public markets will react almost instantly to market shocks, whereas private markets do not have such a dynamic. Public markets are often referenced as an input into private market asset valuations and so such a scenario represents a clear trigger event for an ad-hoc valuation. By promptly reassessing the value of assets impacted, fund managers can mitigate the risk of inappropriate valuations, and ensure that they have an accurate picture of their portfolio's performance and manage potential risks effectively.

Identifying Trigger Events And Outlining An Appropriate Response

The FCA review underscored the importance of establishing clear processes to identify trigger events that necessitate an ad hoc valuation. These triggers can be internal or external and should be tailored to the specific risks and characteristics of the investment held. Often, these triggers are considered only when there is negative news, but fair value assesses both overvaluation and undervaluation, and so events that would indicate a positive movement in the fair value should also be considered.

Examples of potential trigger events include:

• Geopolitical events: Wars, tariffs and sanctions, and significant political instability in key markets.
• Economic downturns: Recessions, significant currency fluctuations, changes in interest rates, and inflation above pre-determined thresholds.
• Industry-specific events: Technological disruptions, regulatory changes, and shifts in consumer behaviour.
• Company-specific events: Significant changes in the financial performance of the company being valued, mergers and acquisitions and restructuring, loss of key contract, banking covenant breaches, fraud or other legal matters.

By proactively identifying and documenting these triggers, and defining thresholds, firms can establish a robust framework for conducting timely ad-hoc valuations, ensuring they are equipped to respond effectively to market volatility.

The thresholds a firm applies will depend on the risk appetite of the firm and the investment horizon for the asset. If the investment strategy of a particular firm is to hold assets for longer periods, short term market shocks may not form a trigger event, or if your investment risk appetite is very low, your sensitivity to market events may be heightened. These factors should be set out as part of the risk management framework of an organisation.

Once a trigger event is identified, it is also important to outline an appropriate response. This will be subjective and often dependent on the trigger event itself as certain events may warrant a full revaluation whereas other scenarios may only require a change in certain assumptions and so the ad-hoc valuation processes may be more streamlined than a regular valuation.

Transparency and Investor Confidence

The current climate of uncertainty has heightened investor sensitivity to valuation practices. Investors are increasingly looking for greater transparency and clarity regarding the valuation process and the rationale behind valuations. Ad hoc valuations, conducted in response to material events, play a crucial role in meeting these demands.

As with regular valuations, the clear and comprehensive documentation of the key judgements and decisions made is key when conducting ad hoc valuations. This documentation should outline the rationale for the valuation, the methodologies used, the key assumptions made, and the potential impact on the overall portfolio. This level of transparency not only fosters trust with investors knowing that managers are actively monitoring the value of their portfolio on an ongoing basis, but also provides valuable insights for decision-making.

In conclusion, the volatile global landscape demands a proactive and agile approach to valuation in the private markets. Ad hoc valuations, triggered by clearly defined events, are essential for providing investors with an accurate and timely reflection of asset values. By embracing this approach and prioritising transparency, firms can navigate uncertainty effectively, make sound investment decisions, maintain investor confidence, and ensure the long-term health of their investments.