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Too big to fail? The FCA takes a closer look at PE valuations

03 June 2024

Following the 'Dear CEO' letter of March this year, the FCA has returned to the subject of PE valuations, reiterating the regulator's concerns in stark terms. 

In a recent high profile speech given by FCA Chief Nikhil Rathi, he was keen to highlight the potential for systemic financial risk due to perceived lending over-exposure to private assets. He went on to warn private equity firms that the FCA expects increased transparency and data sharing, and that failure to comply may result in regulatory measures.

The recent speech to the Association of Corporate Treasurers called for private equity firms to provide more detailed information on valuations and risk exposures. This initiative aims to enhance the regulator's ability to assess risks accurately within the sector. The FCA underscores that while immediate regulatory action is not the preferred approach, comprehensive data is essential to evaluating potential vulnerabilities.

Private equity and venture capital portfolios have faced increased valuation pressures over the past year. The effects of inflationary pressures, rising energy costs and a global economic downturn have impacted performance and reduced asset values; whilst rising interest rates have increased debt servicing costs. This environment has strained the sector's cash generation capacity and, combined with fewer portfolio exits, has brought increased scrutiny of valuation processes from regulators and investors alike.

While the FCA has not yet classified the issues within private equity as systemic risks, there is growing concern in respect of the banking system's exposure to private equity and private credit funds in particular, as the failure of multiple portfolio companies could lead to severe unforeseen losses for banks. The growth in the provision of private credit in the low interest rate environment also has the potential for causing distress in light of continuing uncertainty in the debt markets, and with portfolio businesses finding themselves needing to refinance term debt facilities over the next 12-18 months.

In this context, the Bank of England has instructed banks to conduct stress tests to evaluate their exposure to private equity. The FCA is collaborating with the Bank of England to ensure comprehensive risk assessments are conducted, aiming to mitigate potential threats to financial stability.

These signals may be a pivotal moment for the private equity industry, which is now seen as a significant component of the financial sector. The emphasis on transparency and proactive risk management may represent a significant shift in the operations of some private equity firms. Senior managers and compliance teams of private equity firms and regulatory hosts who act as third-party AIFMs, should ensure that they are in a position to respond promptly to meet these regulatory expectations in order to prevent more severe regulatory interventions; and demonstrate to both the regulator and investors that they are in a strong position to assess and respond to the risks posed.

DWF's dedicated Financial Services Regulatory and Investment Funds teams work closely with fund managers across the industry, alongside our multi-disciplinary Private Equity and Venture Capital groups. We are ideally placed to advise affected firms when considering the implications of these directions, and to provide assistance to ensure FCA and investors' expectations are being met.

We would like to thank Simon Lewin for his contributions to this article.

Further Reading