What are the key challenges facing the private assets market?
The bigger you are, the more attention you draw, and it seems last year that the explosive growth of leverage – both at the asset level and at the fund level – has finally turned the eagle eye of the regulator towards private assets and markets.
Particularly, the need for more transparency has been cited by both institutional investors and advocates for retail investors as a motivation for increased regulatory scrutiny on alternative investment funds.
This hinges on private valuations, and it is here that fund managers can gain a first-mover advantage. ‘What is measured can be managed’, as the saying goes, and the Financial Conduct Authority is inevitably going to focus on the ‘measurement’ of private assets as a tool for managing the market.
The process of valuing private assets has always been a complex and subjective matter, with regulators, auditors, and investors all raising eyebrows at reported valuations due to the lack of transparency in the market.
But how do you value an asset in good faith and in a way that demonstrates good governance to both investors and regulators alike?
Robust governance, reliable valuation methodologies, and innovative solutions may be the answer.
The current landscape
A key concern for fund managers now is how to handle private assets in this current economic climate.
Many investors and regulatory bodies find themselves perplexed with the apparent stability of these values, struggling to comprehend how such assets manage to achieve coveted uncorrelated returns amidst volatile market conditions.
Moreover, the ripple effects of escalated borrowing costs extend beyond financial implications, posing elevated risks at both the portfolio company and fund levels, particularly for funds utilising subscription lines and leverage facilities.
To tackle these current challenges, it is important that the industry adopts a multi-faceted approach, attacking the issue from all angles.
This is also significant because the numbers reported for these assets will soon need to be more transparent, with particular risks when such assets are held in funds that do not allow investors to pull out their money at any given time.
With new and complex ways to let more people invest in these assets, including retail investors gaining access to private investment funds through various schemes or fund of fund vehicles, there are increasing numbers of investors joining these funds, meaning more investors that may be unfortunately spooked by inconsistent valuations in a fund that they cannot easily exit.
Consistency will be essential, and that requires accuracy and governance.
The key challenges
The challenge of private asset valuation is not as straightforward as it may appear and places a significant burden on the valuer’s judgment. Consequently, the governance surrounding the valuation process is hugely important.
Recognising the complex nature of this issue and external factors, it becomes apparent that a single solution cannot suffice to ensure the credibility of private asset valuations. As a result, a holistic approach, encompassing a spectrum of measures, is vital to ensure there is trust and reliability in the valuation process.
Amid these challenges, there is a reliance on third-party alternative investment fund managers in important financial hubs like Luxembourg and Dublin. This adds an extra layer of complexity.
The worries raised by the Commission de Surveillance du Secteur Financier, Luxembourg's main financial regulator, and the Bank of Ireland as they investigate how things are valued in their areas highlight how important it is to watch and control the way we figure out the worth of private assets.
Adding to the complexity, the US Securities and Exchange Commission’s new rules further enhance the regulation of private fund advisers and update the existing compliance rule applied to all investment advisers. This requires annual audits for every private fund in order to avoid asset misappropriation and guarantee accurate valuations.
The SEC’s additional rule aims for a more fair valuation and reduction of fraud by bringing in an independent provider led by a registered adviser. As a result, there will be a substantial increase in administrative work but also valuable time needed from internal or third-party professionals.
Moving forward
To tackle these current challenges, it is important that the industry adopts a multi-faceted approach, attacking the issue from all angles.
For example, fund managers must refine and be able to better articulate their valuation policies to all stakeholders – investors, auditors and regulators in particular.
Ensuring that these policies are transparent and comprehensive enough to consider unique current characteristics of different private assets is pivotal.
Additionally, it is important that fund managers enhance their internal independence by managing any conflicts of interest to maintain an unbiased approach to valuations.
To support this, fund managers should also look to leverage third-party valuation firms to get an objective perspective and significantly improve the overall credibility of valuations.
Consistency will be essential, and that requires accuracy and governance. Third-party valuation firms offer streamlined workflows for front and middle-office teams, supporting investment and operations teams in efficiently utilising vital investment data.
This enables them to proactively monitor portfolios, conduct scenario analysis, automate valuations, and benchmark investment performance.
Through investment in high-quality technology and upholding these high standards, stakeholders can operate in a robust and valuable valuation framework for private assets. A framework that is fit for purpose and ready for the FCA review.
As fair value impacts asset allocation, which then drives returns, cash flow and internal rate of return, being able to estimate this requires consistent and highly experienced judgment. Therefore, it is crucial to partner with a reputable third party that can ensure credibility of the valuation process, further improving trust within the industry.
This joint effort ensures a sustainable and reliable approach to navigating the complexities of private asset valuation amidst the fluctuations of the market. It sets you at an advantage when the FCA ups compliance requirements.
It means that your investors – and fund managers – can sleep easily, knowing that the net asset values upon which they rely are supportable and defendable.
Ryan McNelley is a managing director at Kroll
