On March 5, the Financial Conduct Authority (FCA) published the findings of its Private Markets Valuation Review, assessing valuation practices across private equity, private credit, venture capital, and infrastructure. The review covers both good industry practices and areas requiring improvement, with a particular focus on governance, valuation methodologies, transparency, and third-party valuation processes.

Summary:

The multi-firm review assessed valuation practices in private markets with an emphasis on key challenges, risks, and best practices for private market firms.  With respect to private credit, the review emphasises the need for granular credit risk analysis in valuation methodologies to reflect the unique challenges of custom loan structures, covenant terms, and borrower risk profiles, highlighting the need to:

• Incorporate borrower financial health, cash flow analysis, and covenant performance into valuation models.
• Adjust discount rates based on credit risk, macroeconomic conditions, and lending structures.
• Use stressed scenarios to assess downside risks in distressed or non-performing loans.
• Clearly document the rationale for loan valuation marks, especially when deviating from observable benchmarks.

Other areas of focus include:

Governance and Oversight: The FCA underscores the importance of strong governance frameworks to manage potential conflicts of interest in private market valuations. Good practice recommendations include:

• Establishing independent valuation committees separate from portfolio managers.
• Implementing formal review processes to challenge assumptions.
• Maintaining detailed valuation policies and procedures with clear escalation mechanisms.
• Ensuring senior management oversight and periodic internal audits

Methodologies and Assumptions: The FCA found inconsistencies in how firms apply valuation techniques (internal models, market proxies, and borrower-specific factors) across assets. Good practice recommendations include:

• Using multiple valuation methodologies (e.g., discounted cash flow, comparable transactions, yield analysis).
• Regularly updating and calibrating models based on new market data.
• Providing clear justification for valuation inputs, particularly for illiquid or distressed assets.

Use of Third-Party Valuation Agents: While many firms in the review use external valuation providers, the FCA found varying levels of reliance and independence in these assessments. Good practice recommendations include:

• Establishing criteria for selecting valuation agents and ensure independence.
• Regularly benchmarking internal valuations against third-party assessments.
• Documenting challenges and overrides of third-party valuations.

Data, Market Inputs, and Transparency: Firms must strike a balance between using available market data and making reasonable adjustments. Good practice recommendations include:

• Using market-based inputs where possible, such as secondary trading data or peer comparables.
• Enhancing data validation procedures to ensure accuracy.
• Improving transparency in documenting assumptions behind valuations.

Valuation Adjustments and Challenge Processes: The FCA found that valuation adjustments, such as liquidity discounts, credit risk spreads, and macroeconomic adjustments, were applied inconsistently across firms. Good practice recommendations include:

• Apply systematic and well-documented adjustments to reflect credit and liquidity risk.
• Introduce structured internal challenge mechanisms to prevent biased adjustments.
• Ensure valuation adjustments are independently reviewed.

Investor Communication and Disclosure: The FCA found that some firms provided insufficient disclosure on valuation assumptions and methodologies. Good practice recommendations include:

• Improving investor reporting clarity, including valuation methodologies and sensitivities.
• Providing consistent disclosures across funds to ensure comparability.
• Disclosing key assumptions and judgment areas, particularly for private credit portfolios.

For further information please contact Nicholas Smith ([email protected]) or James Hopegood ([email protected])