Such a review could examine how valuations for unlisted assets are being understood and whether any risks could spread into the banking sector.
Despite rising interest rates and inflation, prices of assets in the $13trn private markets have remained relatively high, raising questions about how their valuations are conducted and if a correction is due.
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FCA chief executive Nikhil Rathi said that the regulator anticipates that an adjustment in private markets valuations will emerge in a higher interest rate environment, following the prolonged period of low interest rates and borrowing costs.
FCA scrutiny
The FCA is looking at how risks are managed by participants in private markets to understand where risk might have built up, how valuations are governed, and how that might feed back into other parts of the financial ecosystem, such as banking.
This follows a major review of asset managers' liquidity management following last year's UK bond market upheaval.
The work is the latest sign of how regulators globally are consistent in their growing scrutiny of non-banks, such as funds and private equity firms and investors private markets, that now make up about half the world's financial sector.
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US regulators at the SEC have also recently responded to concerns about private markets by ordering private funds to make more extensive disclosures about their performance and expenses.
The industry should welcome this interest from the FCA and other regulators, as while private markets may appear to be resilient, the industry cannot afford to become cautious or complacent.
Private markets and valuations of unlisted assets are, by their nature, not exposed to the daily volatility that one sees in the public markets.
In the public markets, securities are quoted and traded throughout the day and prices are readily available.
In private markets, the underlying securities do not have the daily volatility since the securities are typically "marked to market" on a quarterly basis. Thus, there is an inherent lagging effect in the reporting the impact of market conditions on valuations.
Valuation complexities
One of the key challenges of valuing (and therefore regulating the valuation) of private assets is the inconsistency in available information.
Public securities have consistent information disclosure requirements in place that private markets do not have.
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Furthermore, a private market investor may be a minority investor and not have information rights on the asset that they own, and by contrast a public market investor will have this information through regulatory filings even if the investor is a minority investor.
This has a direct impact in the private market valuation process.
Read across to banking sector
The issue with private investments is not isolated or solely contained in the private fund space, with issues within the banking system which relate to both valuation and the accounting of investments.
For example, a bank that is heavily exposed to corporate real estate investments may have clauses whereby certain events of default may trigger reappraisals of a property asset.
The current hybrid working environment is resulting in higher-than-normal vacancy rates and coupled with high inflation, and higher operating costs increase the risk of default on the loan.
These factors can become the catalyst for a reappraisal that would lead to a lower valuation impacting the loan-to-value ratio for a bank.
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Small banks or banks that are heavily concentrated in corporate real estate loans are most at risk.
From an accounting perspective, banks are required to mark to market securities that are "available for sale" (AFS) these instruments are purchased with the intent of selling before maturity and are generally used to satisfy deposit withdrawals from customers.
Another accounting classification for securities are "held to maturity" (HTM) as the name implies, these securities are purchased with the intent of holding them to maturity.
These securities are not required to be marked to market.
In a rising interest rate environment these fixed income securities experience unrealised losses (valuations are down, but not recorded on the balance sheet) since the coupon rate is lower than one can purchase in the current environment.
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If a bank has enough securities in the AFS category to meet customer withdrawals, then there may not be an issue.
The risk exists if a bank does not have enough AFS securities to liquidate if a bank experiences a "run on deposits".
Should that be the case, HTM securities would likely need to be sold, thus converting unrealised losses to realised losses.
One way to possibly counter these risks would be from the various banking regulators increasing the amount of required regulatory capital.
Demand for independent valuations rises
The factors outlined above present challenges in forming a reasonable solution to close the information gaps in private market asset valuation.
A growing trend that we are seeing globally is the growing disclosure requirements for private funds and/or requiring that the investments be valued by an independent third-party (with appropriate credentials) to remove any biases in the valuations.
So too could more frequent valuations (i.e. monthly vs quarterly or annually) reduce the lagging effect inherent in private investment valuations.
The FCA's probe could prompt funds of all sizes to consider outsourcing valuations.
As we have seen in the world of ESG, even the largest private markets participants will no longer be able to "mark to their own homework" - or in this case valuation models - with greater integrity and oversight provided by an independent verification process.
Tony Alfonso is global head of valuation at Apex Group