UK pension funds are swiftly offloading unlisted assets, often at reduced prices, due to their heavy exposure to the opaque global private market, valued at $12 trillion, as regulators

raise questions about the true worth of investments spanning real estate to private equity, according to industry insiders.

Global regulatory bodies are expressing concerns about the valuation of private market assets, including major infrastructure projects. Their values have yet to be adjusted downwards, while listed markets, such as bonds, have experienced a historic decline due to rising borrowing costs.

One sector feeling the impact of owning difficult-to-value illiquid investments as financial conditions tighten is the £1.5 trillion ($1.8 trillion) defined benefit, or final salary, pension fund industry, which triggered a UK market downturn a year ago.

Pension providers in this sector, which promise guaranteed retirement income to public sector retirees and some private company employees, are selling office properties and private equity holdings at substantial discounts compared to the values on their balance sheets, as per multiple individuals within the industry.

The Financial Conduct Authority (FCA) of Britain is among the regulators growing uneasy about the market. It is in the process of conducting a review of how private asset valuations are conducted, including whether any risks of overvaluation could have ripple effects on banks, central to the financial system.

Valuing such assets has become challenging, particularly in real estate, where commercial transactions have declined sharply.

Con Keating, Head of Research at Brighton Rock Group, an insurance firm for pension schemes, remarked, "There's been very little marking down of (private) assets. It's cloud cuckoo accounting."

Final salary retirement schemes faced difficulties a year ago when a surge in government bond yields left them scrambling for cash to cover margin calls on derivatives. These financial bets had been placed to cover pension obligations, assuming a relatively stable low-yielding bond market.

As bond yields approach levels seen before the global financial crisis, their overexposure to illiquid assets could leave them short of immediate funds in another crisis, according to industry sources. The sale of these assets at discounts also impacts their funding positions.

Henry Tapper, founder of pension market analysis group AgeWage, said, "No one knows where the next big blow-up for pensions will come from, but we are unsure about private market valuations."

Rushing to divest, UK final salary pension funds are selling illiquid assets at discounts of up to 40% compared to their book values, according to Paul Kitson, EY's UK Head of Pensions Consulting.

Kitson stated that the substantial selling of commercial real estate and private equity stakes by pension schemes raises doubts about the valuations of private capital.

Real estate markets in countries like Germany and Sweden have faced significant pressure, and London office vacancies are at a three-decade high. Yet, the global real estate fund returns index produced by Burgiss only saw a 0.7% decline in the quarter ending June.

Ben Leach, Head of Private Markets Solutions at investment consultant Willis Towers Watson, noted that pension funds are selling office buildings at 35% discounts, adding, "It's the right approach to obviously put some scrutiny on private market valuations."

In a recent report, global securities regulator IOSCO stated that such valuations were "inevitably stale," with many private funds assessing asset values quarterly or even annually, compared to the minute-by-minute assessments of listed securities.

Private equity is another sector under scrutiny. The Burgiss index of private equity buyout performance showed global managers reporting a 2.8% gain in both the first and second quarters of 2023. However, in transactions where private equity firms and investors buy and sell portfolios of investments, assets are being valued lower.

Wilfred Small, Senior Managing Director at private equity firm Ardian, mentioned that stakes in buyout funds have been selling at around 85 cents on the dollar in the secondary market since "early 2022," when central banks began raising rates. Sellers are accepting discounts in return for liquidity.

UK-listed investment trusts holding private equity portfolios trade at an average discount of 27% compared to the net asset values they report for their portfolios, according to Numis Securities. The average discount across the investment trust sector is 15%. Photo by Andreas Lehner, Wikimedia commons.