For example, the ‘herd’ or ‘bandwagon’ effect or ‘momentum
investing’, as it is politely referred to, can lead to asset price
bubbles and, ultimately, financial crashes. This unfortunate
pattern has been well-documented ever since the price of tulips
soared in Holland, only to later collapse, several centuries ago.
People have invested because other people have and because
they thought there was safety in numbers. Doesn’t everyone hate
missing out on a sure thing?
Similarly, much has been written about loss aversion being a
stronger investing emotion than the prospect of future gain which
may, in part, explain the enduring appeal of fixed-income products,
particularly in the wake of the financial meltdown in public equities
that happened in 2008-2009. Behavioral finance suggests that
the memory of those losses incurred by institutional and retail
investors alike will reverberate for many years to come just as
those memories continue to affect those investors’ allocations to
particular underperforming asset classes, notably venture capital.
But, what does this mean for private capital markets? Are they
immune from the thought distortions to which the public capital
market seems prone? In short, no, they are not.
The place to start is with the very word, ‘private’. Various
dictionary definitions associate ‘private’ with: ‘exclusive’ and
‘reserved for a particular person or group only’ and ‘not for
everyone’. “Private” then conjures up a mental image of being
for special, favored people. Look no further than those arms
of the leading banks, insurers and mutual fund companies
that offer ‘private wealth management’ and ‘private banking’.
Then, there’s the buyout industry which much prefers to be
called ‘private equity’.
In every day life, people send their children to ‘private’ schools
and pay for ‘private’ tutoring and seek to join ‘private’ dining, golf
and ski clubs while enjoying sports events from their ‘private’
boxes. Aside from a few folks of the Groucho Marx variety (“I
wouldn’t want to join any club that would have me as a member.”),
a large portion of the population, including investors, finds
intrinsic appeal with the ‘private’ in private capital. This appeal
is further reinforced by the terminology surrounding ‘accredited’
or ‘sophisticated’ investors. By extension, other investors must
therefore be ‘unsophisticated’ - a category that no one would
admit to wanting to be in.
Private capital markets enjoy a natural advantage over
public capital markets by virtue of nomenclature alone. But, is
this a sustainable advantage? Once again, looking to the insights
provided by behavioral finance may prove revealing.
Recent behavioral finance literature has come to focus on
those emotions that dictate whether or not to invest in particular
securities or funds, particularly trust and confidence. Some suggest
these actually outweigh performance in the minds of investors.
The ways in which these operate can include:
• Whether or not a financial advisor’s recommendations are
• Whether or not investors trust that their money will be
invested according to their instructions;
• Whether or not there is trust that financial returns are
• Whether or not capital markets can be trusted to be ‘fair’ to
• Most importantly, whether or not investors trust their advisers
to act in their best interests.
The challenge, and the opportunity, for private capital
markets is to identify the ways in which trust and confidence can
be enhanced. Of course, this issue of trust is at the very centre of
what has been happening across the financial services industry for
the past several years. As the incoming chair of the CFA Institute’s
Board of Governors recently put it, “ Investors who do not trust the
industry are unlikely to invest.” A 2013 CFA Institute and Edelman
Investor Trust study of more than 2,100 retail and institutional
investors in Canada, the U.S., Britain, Hong Kong and Australia
revealed that financial services sits at the bottom of industries
most trusted among clients.
On this score, the private capital industry could take several
• Working to banish the words “Exempt Market Dealer”, just
as the PCMA has itself moved away from its old association
name (Exempt Market Dealers Association) and perhaps
replace it with “Regulated Private Capital Dealer”;
• Highlighting the Professional Development activities of the
• Re-committing to the highest ethical standards of conduct;
according to the CFA-Edelman study, the number one
reason investors say they are losing trust and confidence
in the financial services sector is the lack of ethical culture
within global financial firms;
• Above all, recognizing that trust is the single most valuable
asset the industry possesses and that it must be jealously
and continuously protected.