When UK regulators probe what private assets are really worth, they are likely to find a mix of rigour, guesswork and wishful thinking, industry insiders say.
The Financial Conduct Authority is expected to begin its review this year — a critical moment of scrutiny for a sprawling asset class that pension funds and other investors piled into as they hunted for returns during the long era of low interest rates.
Tracking the value of publicly traded stocks and bonds is easy. But private debt and equity and assets such as real estate and infrastructure are generally valued manually, and quarterly, using a wide range of techniques. Academics at business school Edhec wrote in a consultation paper submitted to the UK government last month that some of those methods for valuing infrastructure are “akin to fraud”.
“[It is] fundamentally a problem of data, which data is being used and how reliable is this data,” said Frédéric Blanc-Brude, founder of Scientific Infra, an offshoot of the French business school.
“Each one of those assets should say in the annual report how they are valued, all the details. If those numbers are strange or they never change, then that would prompt them to ask some questions and maybe avoid nasty surprises later on.”
His concern is primarily habitual poor practices on infrastructure valuations rather than the “rare” people who “may try to cook the books”.
Even so, the FCA review reflects growing concern from global regulators about the potential for shocks in private assets, whose value hit $11.7tn last year, according to consultants at McKinsey.
Regulators have three reasons to be worried.
Private assets more than doubled between 2017 and mid 2022, accounting for a record share of global financial assets, leading to fears that an upset there could ricochet across broader markets.
Rising interest rates and slowing economic growth represent a danger to some private equity models, as highlighted by regulators including Iosco, which recently warned about difficulties in refinancing assets and potential fire sales.
The method for valuing the assets is a grey area. Owners are required to hold assets at “fair value” under accounting rules. Typically, private equity firms will use the valuations of comparable public companies as a guide for audits and investors. How accurate these are will only be determined when the asset is sold.
Carl Astorri, head of investments, Europe at AustralianSuper, Australia’s largest superannuation fund with about A$9bn in UK private markets, welcomed the review but said there is “an element of judgment in any valuation and its inputs. That, after all, is what makes a market.”
He added that AustralianSuper’s valuations are independently checked.
Judgment carries risks, especially when managers are incentivised to present a rosy picture for as long as they can, particularly if they are seeking to raise money from investors. It often also suits investors such as pension funds to cling on to upbeat, but stale, valuations.
“Private equity has the luxury of being able to kick the can down the road and hope for brighter tomorrow,” one valuations expert told the Financial Times, asking not to be named so he can speak freely on what he sees as questionable practices.
Valuation gaps are most apparent in listed private equity trusts, which trade on stock exchanges and should trade close to the value of their assets.
UK private equity trust net asset values are currently about 30 per cent above share price valuations, data from the Association of Investment Companies shows. That gap is close to a historic high, suggesting that share prices are cheap or asset valuations far in excess of what could be achieved in a sale tomorrow.
Nick Britton of the AIC said the private equity managers are “all saying the same thing: the valuations at which they’re holding investments on their balance sheets they believe are conservative and the evidence they’re presenting is that when they’ve exited investments in the last decade, it’s consistently been at an uplift to their valuation”.
While listed private equity has traded at a discount since the financial crisis, “they’re struggling to understand how extreme it is at the moment”, he added.
Real estate and infrastructure are particularly sensitive. Interest rate rises and infrequent valuations mean “there is potential for there to be some inaccuracies”, said Nick Knight, executive director of valuation advisory services at CBRE.
Infrastructure valuations rely on assumptions about future cash flows, which are heavily dependent on the inputs that Edhec says should be made public. If the inputs are outdated, valuations can miss an impending crisis, as illustrated by investors’ fears of collapse at Thames Water.
The British Private Equity & Venture Capital Association said its members’ valuation methods were subject to regulation and annual external audits, and followed relevant accounting standards. Its members deliver “robust valuations to ensure global institutions can invest confidently in the asset class”.
But experienced market professionals describe issues in an industry increasingly targeting rich individuals alongside large institutions such as pension funds, and one with an influx of relative newcomers.
A valuations specialist recalled a call earlier this year with a private equity manager seeking advice on whether he would have to cut the value of an asset because of new regulations.
When the specialist said the cut was unavoidable, the chief financial officer of the private equity manager asked his team, also on the call, to “see which other assets we can increase the value of to offset this”.
Another issue, the valuations specialist said, was that private equity owners often presented investors with confusing marketing.
Chris Addy, chief executive of Castle Hall Diligence, a provider of due diligence services, said some private equity managers will “try to manipulate information and present the auditors with data . . . when the reality is that the underlying businesses are struggling in the market and may not be able to service their debt”.
The outcome of the UK’s review is not likely to become clear until the middle of next year, but regulators privately say they may act sooner on individual bad practices.
Still, while private equity firms face their worst year for exiting their investments in a decade, the good news for them is that they are under no pressure to sell.
“The advantage of investment companies is that they don’t have a limited life, they are evergreen unless shareholders decide to wind up, so no pressure to sell investments at a disadvantageous time. Clearly it’s a long-term investment,” said Britton.
“We’d say you’d look to hold this for 10 years at least. You’d expect these things to resolve themselves over time, rates normalise . . . but things can always get worse before they can get better.”
Additional reporting by Costas Mourselas, Will Louch, Chris Flood and Akila Quinio
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