Private market investments

Valuations are in the supervisory spotlight. In the UK, the Financial Conduct Authority (FCA) is conducting a review of valuation in private markets, while in the EU, the European Securities and Markets Authority’s (ESMA) recent Common Supervisory Action (CSA) on valuation⁹ highlighted particular risks for private equity and real estate assets. Key concerns include subjectivity and potential conflicts of interest in the valuation process, and misalignments between the frequency of the net asset value (NAV) calculation, the asset valuation, and the availability of up-to-date data. Accurate valuations are especially important if investors can exit the product early or trade it in the secondary market.

In our view, firms should particularly focus on governance, which should provide challenge at key stages of the valuation process, from the methodology used, to the validity of the inputs, and the reasonableness of material judgements used to determine valuations. This challenge needs to be independent and to have the right level of seniority and expertise. Some firms are considering greater use of third-party valuers – this can provide more independence but firms should be aware that it does not absolve them of responsibility.

We think that governance committees should ensure that the assumptions behind valuation models are robust and periodically back-tested and that firms use high quality data as inputs. It will also be important for the valuation process to be clearly documented, and for individual responsibilities to be set out clearly, including for senior managers subject to the Senior Managers and Certification Regime. Although not applicable to investment managers, the PRA’s principles for model risk management¹⁰ provide a good starting point for model governance.

EU managers of private credit funds will need to consider their business strategy in light of the Alternative Investment Fund Managers Directive’s (AIFMD) new harmonised regime for loan origination funds. This creates new opportunities for these funds to lend on a cross-border basis across the EU, which will make it easier for managers to scale their operations. Nevertheless, the new regime introduces some significant new requirements which will reduce flexibility for managers, including leverage limits, risk retention requirements and a requirement to have a closed-ended structure unless they can demonstrate appropriate liquidity management practices for an open-ended structure. Funds that do not currently meet these requirements will need to review their investment strategy and/or structure to ensure they remain attractive to investors.

This dynamic is very likely to change in the UK with the FCA’s Sustainability Disclosure Requirements (SDR) published at the end of 2023. Prescriptive requirements underpinning the use of sustainable investment labels alongside strict marketing restrictions mean that firms may need to consider the viability of their sustainability ambition in light of increased regulatory and reputational risk. SDR compliance will be a particular challenge for private market firms due to the lack of availability of ESG data from private companies. To mitigate greenwashing risk, firms will need to take the lead in ensuring that private companies have the right arrangements to produce high-quality ESG data – they can leverage regulations that require corporate disclosures i.e. the Corporate Sustainability Reporting Directive (CSRD) for EU (and some non-EU) companies, and the UK’s upcoming Sustainability Disclosure Standards (SDS). Since ESG data is a key source of greenwashing risk, it is crucial for firms to identify gaps in ESG data in order to manage their own reputational and liability risk, and to produce accurate disclosures. Separately, firms subject to the Task Force on Climate-related Financial Disclosures (TCFD) reporting deadline of June 2024 should ensure that they pro-actively document how they identify and manage climate risks and opportunities in their portfolios – seeking climate related data from private companies at short notice is likely to be challenging.

While the expansion of private market investments creates significant new opportunities, firms will need to ensure that they have robust processes and controls and that their risk and compliance functions are appropriately resourced as they grow. In 2024, we expect a particular supervisory focus on valuation, private credit, protections for retail investors and greenwashing risk. EU managers of private credit funds will also need to make important decisions about their business model ahead of the implementation of AIFMD II.