Legal briefing | 25 Apr 2025 |

Travers Smith's Alternative Insights: The UK regulator's approach to valuation

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A regular briefing for the alternative asset management industry.

KEY INSIGHTS

Navigating Subjectivity: Private asset valuations are inherently subjective and give rise to a risk of conflicts of interest.

Regulatory Challenge: The UK's FCA has set some challenging expectations to ensure robust and compliant valuation practices.

Action Needed: Many firms will need to evolve their reporting policies and procedures to ensure consistent valuation processes and mitigate conflicts of interest, especially when fundraising.

There are few things more fundamental to asset management than understanding an investment portfolio's current value. In liquid public markets, valuation is often straightforward, informed by high volumes of visible arm's length transactions. The value may not be intrinsically correct, but at least it can be objectively determined, grounded in market consensus. However, valuation of private market assets is harder and usually more subjective, giving rise to obvious conflicts of interest.

Although a matter of concern internationally – IOSCO highlighted concerns about "opaque valuations" in 2023 – private market valuations have been a particular focus for UK regulators over the last year or so. The most recent, and – for UK firms – very important publication, is the feedback to the FCA's Private Market Valuation Review, published last month.

In one sense, the industry may be relieved by the FCA's findings. No systemic failures were identified and, at subsequent industry events, the FCA has welcomed the improvements it has observed since 2018.

But firms should not assume that there are no issues to address – the FCA has set out action points and expects firms to perform a gap analysis against them. Although larger, well-resourced firms may find many of these issues manageable, they are not without their challenges. Smaller firms, in particular, may struggle to meet the identified best practices.

One issue is that the sample of firms included in the FCA's review has led to its conclusions being framed according to practices typically adopted in larger organisations. Although the report includes a cursory nod to proportionality – stating that firms should consider their size when reviewing the findings, a point reiterated in subsequent presentations – it offers little guidance.

It is therefore not obvious how the observations should apply in firms with fewer resources and less ability to implement strict operational segregation of their valuation and investment functions.

The situation is particularly concerning for "sub-threshold" sponsors. These firms, which fall below the assets under management thresholds in the EU-derived Alternative Investment Fund Managers Directive (AIFMD), are exempt from its detailed valuation provisions. But there are concerns that the FCA may be constructing an analogous set of requirements under the guise of its broadly phrased Principles for Businesses instead. Without clearer direction on these points, smaller firms may face real difficulties in translating the FCA's expectations into practical actions.

Reporting and marketing practices may need to evolve. The FCA report notes that firms might be incentivised to inflate valuations during fundraising periods to present more attractive (unrealised) performance metrics. Conversely, when reporting on the performance of assets generally, many firms adopt conservative valuations, aiming to lessen volatility and facilitate the value uptick on exit that investors may have come to expect. The FCA's concerns seem to be borne out by academic research: studies by Jenkinson, Sousa and Stucke (2013) and Baik (2024) found statistically significant valuation uplifts during fundraising, compared with more conservative valuations outside of those periods. Sponsors should consider safeguards to ensure that valuation processes are consistently applied through the fund's life cycle.

The FCA's concerns seem to be borne out by academic research: studies [have] found statistically significant valuation uplifts during fundraising, compared with more conservative valuations outside of those periods.

The FCA's emphasis on ad hoc, interim valuations and the requirement for defined triggers – such as changes in market multiples – raises substantial challenges. Establishing relevant triggers will be complex, as firms will need to avoid excessive interim valuations prompted by overly sensitive criteria. A fair amount of discretion, within certain parameters, seems appropriate.

In any case, managers of closed-ended funds, whose fees are not based on NAV, will argue that the risk of investor detriment from stale valuations is minimal. Furthermore, many LPs would likely prefer to avoid frequent fluctuations in apparent value unless these changes are sustained over time.

The FCA also endorses the use of fairness opinions in the context of continuation funds. Although fairness opinions are often used to confirm a market price when a sponsor is on both sides of the deal, an opinion may be unnecessary where there are other (more reliable) ways to market test the price. The SEC's ill-fated Private Fund Advisor Rules had proposed to mandate fairness opinions – a proposal that received significant pushback from both LPs and GPs. It is to be hoped that the FCA's observations will not entrench that requirement in the UK in circumstances where such an opinion is superfluous.

Most managers will already have identified potential conflicts where staff remuneration is directly linked to judgement-based asset valuations. However, the FCA's focus on whether valuations and unrealised performance affect "the perception of individual performance" of staff seems to be a new angle. It is unclear how far the FCA expects firms to extend this logic – in many private market firms, at least some parts of a deal executive's performance during the life of a fund will have to be assessed by reference to unrealised investments. The FCA has conspicuously failed to outline the expected fix here, so firms will have to consider how to meet the FCA concerns. For many, conscious awareness of the risk – and implementing the other controls around valuations – may suffice.

The UK FCA's review of valuations policies and processes has resulted in a broadly clean bill of health. However, there are some potentially tricky points of detail that need to be worked through on an individual basis by all UK-regulated firms – including those where the valuations are undertaken by another firm in the group. Given the broader FCA focus on conflicts of interest in its asset management supervisory strategy letter, firms should confront these issues sooner rather than later.