Private markets assets have shown price resilience against a wider backdrop of capital market turmoil. This makes the FCA concerned. Tony Alfonso, of Apex Group, explains why and offers thoughts on how the regulator will respond.
Despite the sense that inflation may have peaked, macroeconomic uncertainties continue to keep central bankers and politicians up at night. Acutely aware of the property bubble that seemed to take the economic establishment by surprise in 2008, the UK’s Financial Conduct Authority (FCA) has turned its attention to private markets.
As an asset class, private equity has grown significantly in recent years. Private equity raised over $2 trillion in the period 2019–22, rising to about $5 trillion with leverage, according to data from Pitchbook. With concerns that this investment spree was rooted in a low-interest rate environment and that the pressures of higher interest rates and a tougher macroeconomic environment could spell trouble for the sector, the FCA launched a review of private equity valuations.
In particular, the FCA has been galvanised by price resilience in private markets. While stock and bond markets have been on something of a rollercoaster over 2023, private markets have held up well. This has led some at the FCA to wonder whether valuations are off, which could indicate significant risk.
The price is right?
So, why are private market valuations proving resilient while so many other asset classes are struggling? Are valuations in this sector really so far off the mark?
This is a difficult question and one that the FCA will be looking to shed some light on. When it comes to valuing private assets, inconsistencies in what information is available pose a significant challenge. While publicly listed stocks are subject to consistent information disclosure requirements, private markets are not. In fact, disclosing too much information could potentially impact competitiveness, thus impacting the value of the asset.
Alongside this, private market investors may be minority investors and, therefore, do not have information rights on the assets that they own. This has a direct impact on the private market valuation process. So, in a nutshell, with little information to go on, it’s difficult to make a call on the accuracy of valuations at present.
Banking on risk
The above complexities that surround private market valuations will be of little comfort to the FCA as it assesses risk in this asset class and considers ways to limit any of that risk spreading into the wider banking sector.
Over the coming weeks, the regulator will be trying to understand where risks might have built up, how valuations are governed, and how that might feed back into other parts of the financial ecosystem, such as banking. This follows a major review of asset managers’ liquidity management following last year’s UK bond market upheaval.
The FCA initiative is part of a broader, global trend of increasing regulatory scrutiny of non-banks, with 2023 already having seen regulators in the EU and the US taking a stronger interest in the sector. The non-bank sector, including funds and private equity firms and private markets, now accounts for about half the world’s financial sector, so any structural risk has the potential to impact well beyond private markets. With private markets having grown so dramatically, it’s likely that the banking sector has significant exposure.
For example, a bank heavily invested in corporate real estate might have contractual clauses that trigger the revaluation of property assets in the event of defaults. If this were to happen at scale, given more home working and the impact of high-interest rates on the commercial property sector, it could be a catalyst for property reappraisals, potentially leading to lower valuations and, in turn, affecting a bank’s loan-to-value ratio. This is just one potential scenario that will be weighing on the FCA’s mind as it takes a closer look at private market risk.
As is clear then, growing interest in private markets can only be sustained with better disclosure. For private markets to realise their full potential and give regulators the assurance they need, these information gaps will need to be closed.
It’s unsurprising, therefore, that globally we see ever greater disclosure requirements being applied to private funds and a growing appetite for independent, third-party analysis. More frequent valuations (i.e., monthly vs quarterly or annually) will also become more popular to reduce the lagging effect inherent in private investment valuations.
The FCA’s probe could prompt funds of all sizes to consider outsourcing valuations. As we have seen in the world of ESG, even the largest private markets participants will no longer be able to “mark to their own homework” – or, in this case, valuation models – with greater integrity and oversight provided by an independent verification process.
Private markets have seen impressive growth in recent years, and much of this has been a result of the agility and entrepreneurial investment opportunities the sector offers. As disclosure requirements grow, the challenge for the sector will be to maintain the things which make private markets appealing – such as fleet-footedness and commercial dynamism – while also ensuring regulators and investors can be confident that valuations are accurate.
This will present a challenge to the sector but is also a crucial step towards full maturity in this market and the FCA’s interest should be welcomed.
*Tony Alfonso is head of valuations at Apex Group.
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