The financial times reported last week that the UK’s financial markets regulator, the FCA, has been holding conversations with private equity groups following recent turmoil in public markets. The consultation demonstrates the importance the FCA places on oversight of privately held investments which are subject to the same underlying market conditions as public companies, but whose value impact is not observable in real time.

The FTSE 250 has fallen by 25% since the start of the year (as of 28 October) and a concern of the regulator is that many private company investments will have suffered similar value impairment which may not yet be reflected in carrying values, leaving pension funds and other institutional investors exposed to further write-downs as fund valuations are updated.

It does not necessarily follow that a sharp decline in listed company values translates like-for-like to private company values. The liquidity of quoted shares allows fund managers to move quickly to rebalance portfolios by selling shares they expect to fall, potentially leading to values being driven down in part by speculation as opposed to belief in underlying fundamentals, whilst sell decisions may be taken very quickly without full consideration of company specific impact.

Nonetheless, with the current economic challenges being systemic in nature, and with many private equity investments being exposed to higher borrowing costs due to the use of leverage, regulator concern in understandable. Valuation in a volatile market is far more complex than in a stable market and soundings from other parts of the governance sphere highlight the need for extra valuation diligence in dislocated markets.

Following the prior round of public market turmoil (Covid-driven) a special guidance paper issued by the International Private Equity & Venture Capital Valuation Guidelines noted that: “Every investment will need extra analysis” and “strong valuation processes should continue to be followed”, whilst the UK’s largest auditor noted that: “The big question for firms is whether your results will stand up to intensifying investor, regulator and auditor scrutiny, particularly around the effects of the pandemic on the value of your portfolio investments.”

Valuation policy differs across the private equity industry with some funds conducting annual processes, some quarterly, and others something in between. Firms also differ in their use of independent valuation advisors with some utilising third-party expertise across the portfolio, others on specific investments only, whilst some retain the entire function in-house.

With the degree of subjectivity involved in private company valuation and the increased scrutiny that comes in a volatile market, a fresh look at valuation policies and procedures may be a healthy governance exercise for funds to undertake.