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Paying high fees to park your cash away for several years, into funds with assets of uncertain value, sounds like the antithesis of any investment 101 lesson plan. But for private capital fund managers — who put investors money into equity, credit, real estate and other alternative assets that are not publicly traded — it has been a lucrative business model. As interest rates bottomed out following the global financial crisis, institutional investors flocked to the higher returns offered by private assets. But with central banks now signalling that rates will remain higher for longer, regulators are understandably concerned about hidden risks in the opaque sector.
Assets under management in private funds globally have grown more than fivefold since 2008 to about $13tn now. Private markets have also historically achieved greater returns, on average. But the economic environment has become much less supportive. Lofty valuations and funding are no longer backed by low rates. Private equity portfolio companies may now have more trouble getting loans and making profits, amid the economic slowdown. Defaults on private loans, fire sales to raise cash, and falling valuations are mounting risks.
With private finance interlinked with the broader financial system, any fallout could also have broad implications. Indeed, on Friday the world’s financial stability watchdog announced a probe into leverage in hedge funds, which themselves often hold private assets.
Valuations warrant particular scrutiny. Private assets are usually valued on a quarterly basis, meaning sharp market corrections only feed through with a lag. Fund managers have some discretion over the pricing of their assets because their holdings are not subject to the daily swings of public market sentiment, as listed assets are. After all, valuing quirky start-ups entails some judgment.
But the legroom can incentivise fund managers to present overly rosy results, including by overstating values and understating risk, derisively called “volatility laundering”. While it is unclear how prevalent this is, there are still concerns that private valuations have been unrealistically high relative to publicly listed assets. Corrections now could mean returns plummet.
The industry already has rules and standards in place for valuations. The International Private Equity and Venture Capital Valuation Guidelines set out best practice. European regulations also require annual audits on valuation methodologies, alongside quarterly appraisals. The US Securities and Exchange Commission recently responded to concerns by ordering funds to make more extensive disclosures to their investors too.
Regulators nonetheless need to develop a deeper understanding of the risks in private capital markets. A lack of clarity on the nature and extent of any poor valuation practices means the authorities need to ascertain how well existing standards are being applied before deciding if they need tightening. Plans by the UK’s Financial Conduct Authority to review fund managers’ valuation governance processes are welcome.
Some argue that sophisticated private market investors do not need protections. But given the potential systemic implications, a push towards greater transparency both in private capital markets, and across the non-bank sector more generally, is essential.
Private capital markets support economic growth by providing long-term financing. Efforts to diagnose and mitigate valuation risks in the sector need to avoid being overly prescriptive or unnecessarily costly. Pricing unlisted assets will always involve interpretative differences and some divergence from public markets. But that should not give fund managers free rein to ignore reality. Opacity may be a feature of private markets; it must not become a bug that infects the broader financial system.
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