“Private equity is one of the financing options we need to have available. But we must ensure that investors also have confidence in these financing vehicles.”
Verena Ross, chair of the European Securities and Markets Authority (Esma), was and was careful not to say that the next financial crisis would come from private equity. Nor did she suggest that this booming sector was fudging the value of its assets to attract other investors. But the German economist did say that she was alert to signs of vulnerability in private equity. Particularly in terms of valuation.
For a fund, it is much more complex to put a value on private assets than on listed assets, due to the absence of directly observable market prices and the need to rely on assumptions and projections. Calculating the net asset value (Nav) for funds investing in infrastructure projects, such as a biomass plant, can take several days… and still leave an impression of subjectivity, even arbitrariness. Ensuring correct Navs is as much a necessity as it is a challenge.
The exercise revealed certain risks in terms of the relevance of valuations.
Under the leadership of Esma, the EU’s national competent authorities carried out a joint supervisory action in 2022 concerning valuation within funds. In each country, a sample of fund managers with less liquid investments, including private equity, responded to a questionnaire covering their general organisation, valuation policies and processes, the models used, the controls in place and the validation of the data used in the models. The responses to the questionnaire were then reviewed by the competent national authorities.
The result: an overall satisfactory level of compliance, but gaps and vulnerabilities. “The exercise revealed certain risks in terms of the methods and relevance of the assessments,” explained Ross. “Some assessments were out of date, which we found particularly worrying in a rapidly changing market environment.”
Better definition of roles
In Luxembourg, the Luxembourg Financial Sector Supervisory Commission (CSSF) has communicated to the market its results of the joint supervisory action in July 2023. It highlights several areas for improvement. The head of prudential supervision and risk management in the UCI (investment fund) department, Alain Hoscheid, believes that valuation models require greater attention: “It is essential that they are subject to independent review before use and reviewed periodically to ensure their continued relevance.”
In some cases, according to the CSSF, the valuation policies in place at manager level can also be improved: “Managers must clearly define the roles and responsibilities in the valuation policies and ensure that these policies are sufficiently detailed. It is also important that all valuation methodologies used are clearly indicated and that all fund assets are covered.”
Different players involved
Fund managers are far from the only ones involved in valuation. As such, they may call on the services of specialist service providers, all of which are also overseen by the fund’s board of directors. The depositary bank has a supervisory role. And then there is the approved statutory auditor (réviseur d’entreprises agréé) who, in addition to its statutory audit, may carry out specific checks on valuation, among other things. “The CSSF’s supervision is based on this whole ecosystem”, explained Hoscheid.
The backbone of this supervision: the CSSF ensures that a good organisation and adequate control systems are in place at the level of the various players, who must have the necessary human and technical resources. This robustness is verified at the time of the authorisation procedure for these players, and is then monitored thereafter. In this respect, the CSSF relies on various reports sent to it by stakeholders. This supervision is carried out through off-site work and on-site inspections.
Sanctions if necessary
“Prudential supervision is based on a risk-based approach,” said Hoscheid. “The risk profile of the players and the fund will determine our supervision. For a private equity fund, whose assets do not have a directly observable price, the CSSF will in particular check, on the basis of the reports and information provided, that the valuation models are robust, that they are independently reviewed, that they are based on up-to-date and representative data, etc.”
When shortcomings are observed, such as those revealed by checks on the 2022 financial year, remedial action is required. The range of supervisory measures is diversified, from a simple letter of observation to sanctions if necessary.
The regulatory and supervisory framework for valuation is solid.
Although based on established methods, private equity valuation can seem subjective, given the weight of assumptions in determining Nav. “I understand this impression, but the regulatory and supervisory framework around valuation is solid,” he stated. “It is crucial for managers not just to make assumptions, but also to check them on an ongoing basis. In our control processes, we monitor–on the basis of the reports provided–the adequacy of the valuation over time. If any exceptions are identified, the CSSF intervenes with the parties involved.”
In practice, when investing in less liquid assets such as private equity, there comes a time when these assets are sold. “This sale allows us to check our assumptions against the reality of the market and to verify that the prices obtained correspond to the prior valuations”, commented Hoscheid. “On the other hand, there are private equity transactions that take place in similar markets or segments, providing useful points of comparison.”
Nav errors
An incorrect valuation of the Nav can have a significant impact, but this differs depending on the type of fund, explains the supervisor: “Open-ended funds, such as Ucits, normally calculate a Nav on a daily basis, allowing investors to enter or exit the fund each day. An incorrect valuation can therefore lead to inappropriate payments when investors enter or leave the fund. In this case, it is imperative to correct the Nav and compensate the injured parties.”
Conversely, closed-end funds–which are the norm in private equity–are not required to notify the CSSF directly of Nav errors, according to a brand new circular, published on 29 March 2024. “These funds generally calculate value once a year to inform investors. As investors do not enter or leave the fund during its lifetime, the implications of an incorrect valuation are less significant,” said Hoscheid. Other types of error, such as those relating to fees, must be reported for closed-end funds. In all cases, the CSSF requires any errors to be corrected.
This framework, concludes the supervisor, should be able to reassure the sceptics: “We are not permanently sitting behind the person who calculates the Nav, but we make sure that it respects the legal and regulatory framework by ensuring the robustness of the organisation in place and by carrying out specific checks.”
Originally published in French by and translated for Delano