Focusing on private assets

October 2023

The regulatory direction of travel

For several years, securities regulators and (particularly) central banks have been concerned about the growing role of the non-bank sector, including asset managers and their funds.

After property fund suspensions in the UK in 2016 and subsequent issues with specific funds, global market events in March 2020 triggered a series of reviews by the Financial Stability Board (FSB) and IOSCO. These resulted in recommendations for money market funds (MMFs) and consultations on changes for open-ended funds. National supervisors have also made their own policy adjustments and completed supervisory reviews. In the UK, the authorities proposed enhancements to swing pricing and liquidity bucketing, invited views on the future of the MMF regime, and reviewed fund managers' liquidity management practices.

However, reviews to date have largely focused on what the FCA would call “mainstream” asset management — for example, funds that invest in public equities, fixed income or emerging market securities. In comparison, relatively little attention has been paid to the activities of private asset fund managers. This is now changing, given the significant growth of the private asset fund industry, the challenging macroeconomic environment, and regulators' concerns about the potential interconnection with public markets.

For the first time, in its 2023 work programme (PDF 0.24 MB) IOSCO identified private assets as a priority area of focus. Subsequently in September, IOSCO published the findings (PDF 0.59 MB) of its thematic review, alongside proposed good practices (PDF 0.70 MB) for market participants in the context of leveraged loans and collateralised loan obligations. Its review noted the “inherent opacity” of private markets and focused on potential conflicts of interest and valuation challenges — in particular around stale valuations, a lack of standardised valuation principles for investments that lack an observable market, and potential vulnerabilities. IOSCO's work programme noted it will undertake follow-up work into 2024.

Meanwhile at national level, some regulators are already introducing new requirements for private assets fund managers. For example, the US SEC has adopted wide-ranging new rules to increase transparency and enhance investor protection. And the EU is contemplating a new framework for loan-origination funds as part of the nearly-final review of the AIFMD. 

The FCA's priorities for private assets fund managers

In parallel with increasing opportunities for fund managers and investors (e.g. through creating and adjusting the LTAF regime), the FCA most recently set out its supervisory priorities for the UK alternatives industry in August 2022.

In the FCA's priorities there was a clear focus on retail investors, mitigating conflicts of interest and ensuring market integrity. However, in a potential departure from the portfolio letter, recent news reports suggest the FCA is now planning to review private assets fund managers' valuation frameworks and potential risks. Publicly, the FCA has argued there is a need for greater oversight and transparency needed when it comes to the regulation of private markets:

Looking ahead

The market's increasing use of DeFi could be moving us towards a future of reduced middlemen and increased customer independence. Moreover, a subsequent uptake of the regulatory approaches described above would mark an important shift away from traditional entity-based supervision towards activity-based supervision, in financial services.

However, it remains unclear how plausible this DeFi future really is. We may instead be moving towards a future of permissioned proof-of-stake blockchains — an outcome that has been repeatedly predicted by international standard setting bodies, including the BIS and IMF (one, two and three). In fact, the BIS (PDF 1.3MB) has even suggested that the future monetary system will involve central bankers and the incumbent financial system adopting the best of the technology to offer many of the same services that crypto and DeFi participants are offering today.

For now, we will have to wait and see.

Importantly, the FCA has previously evaluated fund managers' approaches to “hard to value” assets, including private assets. Fund managers should have performed a review of their own governance arrangements against these findings and documented the findings and any enhancements made.

On a related topic, fund managers should also be reviewing their approach to liquidity risk management in line with the FCA's latest findings. As part of the liquidity review, the FCA noted that “internal challenge to valuations was seldom evident”.

Proactive actions for private assets fund managers

Private assets fund managers should take proactive steps to continue to tighten up existing practices, complying with the underlying rules for AIFMs in FUND 3.9, as well as taking account of wider rules and the supervisory reviews noted above.

Fund managers should focus on the following areas as part of a front to back review of their valuation framework:

• Governance: Whether undertaken internally or externally, a proper and independent valuation of the fund's assets should be performed. Assisted by decision-useful MI, the valuation committee should provide robust, effective challenge to portfolio managers (particularly where they input into valuation models), alongside effective challenge from the second line of defence. Roles, responsibilities and accountability for the valuation process should be clearly defined, and firms should review the composition of their valuation committees and whether the chair is independent. Good practice also involves rotating the appointment of external valuers.
  
  
• Policies and procedures: Documentation should be coherently organised, regularly updated, and should ensure that valuation methodologies are applied consistently and fairly. Where relevant, firms may find it helpful to ensure that procedures align valuation methodologies with IOSCO's valuation principles and industry guidelines such as IPEV¹. 
  
  
• Conflicts of interest: Firms should consider where conflicts can arise and how they are managed fairly — this includes at the different stages of the fund lifecycle and between different stakeholders. Conflicts should be avoided, managed or disclosed — examples can include conflicts between investments in the same underlying company (e.g. both equity and credit-related investments), conflicts between investors, and conflicts arising from a fund's fee structure. Remuneration policies and other measures should contribute to mitigating conflicts.
  
  
• Valuation model risk management: Notably, private assets span a wide variety of different investments. Where firms have a different valuation model across these different asset classes, then governance arrangements to manage the model valuation process should be consistent and robust.
  
  
• Skills and expertise: The FCA expects firms to have relevant valuation expertise in the first and second lines of defence to ensure that valuation is performed with appropriate due skill, care and diligence. Wider expertise that goes beyond traditional financial services expertise can provide additional assurance — for example with identifying potential reputational risks in portfolio companies.
  
  
• Valuation frequency: Firms should consider and document the appropriateness of valuation frequency in the context of a fund's underlying assets and its redemption frequency. 
  
  
• Due diligence: Where firms appoint an external valuer, they should perform and document appropriate due diligence.