News
Private Markets Fail to Police Conflicts of Interest, UK Finds
(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.
“There are changes happening in the structure of the system which means that it’s important that these processes continue to be done well through periods of change,” Camille Blackburn, director of wholesale buyside at the FCA, told Bloomberg of both the macro outlook and the rapid growth of private markets. “When there is market volatility or when there’s geopolitical volatility it’s important that people understand what the processes are, who the decision makers are and how they can get good support through decision making.”
Continuing Focus
“Firms should expect to see that there is a continuing focus in this area,” she added. “We will be talking to not only firms and their governing bodies about this, but also advisers and investors.”
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.
“The FCA is doing its job,” Kurt Bjorklund, executive chairman at Permira Holdings, said in an interview with Bloomberg Television. “It is our job to responsibly, and in a way which is aligned with our investors, value it and to govern it and then to report it to our investors and we do so.”
Blackburn said the FCA found no evidence of “egregious” practices among the firms that took part in the exercise, which spanned a variety of business models and sizes, but that there were several areas for improvement.
The FCA is not planning any rule changes as a result of the exercise, and instead hopes that flagging ‘best practices’ will lead to improvement. Conflicts of interest is a key priority, and the organization has already announced follow up work in this area.
The watchdog said that while firms had generally good practices for managing those competing interests in 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.
--With assistance from Francine Lacqua and Lauren Tavener.
(Updates with comments from FCA official from fifth paragraph.)