CFA Institute

Private markets’ meteoric growth since the Global Financial Crisis has attracted the attention of regulators around the world, some of whom have reacted with urgency. Interestingly, the US courts recently vacated sweeping and controversial rules for private fund advisers that were adopted by the Securities and Exchange Commission (SEC). But the matter is far from closed. Indeed, as the private investment sector enters a new era of not-so-cheap money, the absence of stringent regulations makes industry best practices and self-governance even more important.  The CFA Institute Research and Policy Center’s report, “Private Markets: Governance Issues Rise to the Fore,” illuminates how private markets function and makes recommendations for both investors and policymakers. The report is based on a global survey of CFA Institute members. Its objective is neither to endorse nor to censure private markets, Stephen Deane, CFA, senior director for capital markets policies at CFA Institute and the report’s author, told Enterprising Investor. Increased inflation and interest rates have jolted private markets into a new era, elevating the importance of governance issues, Deane asserts. Those issues involve the relationship between fund managers (general partners) and fund investors (limited partners), as well as other relationships and potential conflicts of interest. Despite increased scrutiny, there remains a dearth of public information on how private markets function, which may help explain the wide divergence of views on private markets’ regulation, according to Deane. This report focuses on private funds, including private equity, credit, venture capital, real estate, and infrastructure funds — funds in which redemptions are limited if allowed at all. Deane says he was motivated by a confluence of factors to write the report, which has value for investment professionals, policymakers, and academics. It consists of two main parts: the survey results and a primer on governance-related issues. “The idea is to explain the findings, to contextualize those findings to allow a deeper appreciation of the issues based on what others have written, and to provide talking points for experts and academics. We also talked to chief investment officers of pension funds and trade association leaders. We’ve turned to a variety of sources to inform ourselves on what’s going on.” Ballooning Private Markets “Private markets have become increasingly important because of how much bigger they’ve become. That makes them more important to the economy — it involves a lot of jobs at companies that, for example, are owned partially or totally by private equity or funded by private credit. So, it’s a much bigger part of the economy,” Deane explains. “And with the end of the era of cheap money, there is a question: are there potential risks to financial stability as a result? That was yet another reason for CFA Institute to be interested.” Because private markets are not public markets it cannot be surprising that there is limited information available on them compared to public markets, Deane says. “So, it is understandable — but perhaps ironic — that we have polarized views. We’ve got increasing regulatory interest in the US, in the UK, in the EU, in China, there’s a closer inspection of what is going on, and yet we don’t have much information on the market.” Deane recommends that regulators proceed with caution, if at all, in allowing greater retail access to private markets. It can seem unfair to keep retail investors out, he notes. On the other hand, the solid framework for investor protection in the public markets is missing in the private markets, he points out. US Courts Rein in Regulator The SEC Private Fund Adviser Rules were struck down by the US Court of Appeals for the Fifth Circuit on 5 June. The court’s ruling can be found here.  Also, Appendix 3 in the report: “Dueling Court Briefs: The SEC’s Private Fund Adviser Rules,” has a summary of the opposing positions placed before the court. “The court struck down the entire package of rules, but it did so on the narrow basis that the SEC lacked the authority to adopt the rules. So, there is still a question of whether the rules were a good thing regardless of whether the SEC had the authority from Congress to adopt them,” Deane maintains. Now that the SEC rules have been struck down, it’s incumbent on the industry to demonstrate how private ordering can work.  “Can it craft private ordering arrangements — including proper disclosures and resolution of potential conflicts of interest — that are for the benefit not just of the fund sponsors and the fund managers, but also of the fund investors who in turn in many cases have their own beneficiaries, who are ordinary people — firemen, teachers, police?” Is there some way CFA Institute can help? Deane says he has no illusions that the organization is suddenly going to fill all the information gaps. “We can’t do that, but can we at least contribute to begin to fill in some information. That was a personally motivating thing — I thought that it would be interesting to do.” CFA Institute Global Membership Survey CFA Institute conducted its global survey in October 2023 to gather information about investment professionals’ views and practices regarding private markets. The survey represented all members, including those with experience as LPs and GPs. It focused on fundamental governance issues rather than market outlook. According to Deane, “We asked several questions with a spectrum of options to choose from — basically, things are great, things are terrible, or in between. Most survey respondents picked that middle, moderate response both on their view of how private markets are functioning and their view of what the regulatory and policy intervention should be.” He says most survey respondents, including LPs and GPs, on balance do support more regulation, but there’s a caveat: regulation should be limited. “They want more disclosure, and they are willing to support regulations to mandate that disclosure.  But they don’t go so far as to say you should forbid a specific practice.” Most respondents expressed a moderate point of view

Financial influencers, aka finfluencers, have amassed an enormous following on social media, particularly among Gen Zs aged 18 to 25. Some finfluencers leverage social media to promote sound financial education, thereby providing significant benefit for society at large. But some others are bad actors, doling out questionable advice for monetary gain or social media fame.   Our job as a community is to promote content creators who have a genuine interest in financial education and knowledge sharing. This is easier said than done. Social media platforms reward the loudest finfluencers who make the most extraordinary claims, because they drive traffic and elicit large volumes of likes and shares. A recent academic study analyzed more than 29,000 tweets on the X platform and found that some financial content creators have “negative skill.” These “antiskilled” finfluencers have more followers and more influence than skilled financial content creators, they point out. The authors from the University of California, Berkeley, Louisiana State University, and Swiss Finance Institute-HEC Lausanne, maintain that there could be economic benefits to taking investment positions against the recommendations of “antiskilled” finfluencers. The implication is that the poor quality of their advice can be so consistent that betting against it may be profitable. The authors found that 28% of finfluencers are skilled, generating 2.6% monthly abnormal returns; 16% are simply unskilled; and 56% are “antiskilled,” generating -2.3% monthly abnormal returns. They conclude that social media users often follow finfluencers not based on their financial acumen as demonstrated through their posts but due to behavioral biases. Namely, the tendency to follow advice that aligns with their own pre-existing beliefs or behavioral traits. They caution that bad actors can harm investors and distort market functioning. Influencers, Knowledge Sharers, Though Leaders But not all financial content creators on social media are created equal. A broad differentiation can be made between influencers, knowledge sharers, and aspiring thought leaders. An influencer’s goal is to gain followers to generate revenues from endorsements. An influencer constantly pushes to become “more viral” – for his or her content to be liked, shared, and engaged with. A knowledge-sharer, on the other hand, is someone who divulges tangible knowledge with the goal of educating others. Knowledge sharers may seek to monetize their efforts via subscriptions to online classes, book sales, and newsletter subscriptions. Financial professionals like Mohamed El-Erian harness LinkedIn to showcase their thought leadership. Young professionals do the same, creating quality educational content with the hopes of elevating their careers. Some — like Ignacio Ramirez Moreno — collaborate with CFA Institute Research and Policy Center to highlight the importance of promoting the right kind of financial content on social media. While the capacity to engage users is a goal for everyone using social media, charlatans tend to gain higher exposure. This is intuitive: social media algorithms give enormous advantage to people who make loud announcements and extraordinary promises because their posts get clicks, likes, and shares.   This trend reaches its pinnacle in the crypto space, where scores of influencers with no knowledge, expertise, or credentials are not only recommending, but sometimes even launching crypto “projects.” Some of these are nothing more than “new tech” Ponzi schemes, enabling backers to use their “influencer” credibility to “pump and dump” newly minted coins. They gain followers by touting schemes to “play” the stock market and achieve unbelievable returns. Popular knowledge-sharers, on the other hand, gain followers by being entertaining and helpful, teaching skills like building power point presentations. The danger is that non-relevant, often misleading information will crowd out genuine financial education and knowledge. Creating a Space for Knowledge Sharers Financial education is an area in which social media could provide enormous benefit for society at large, but this can only truly happen if knowledge sharers with genuine interest in educating users are valued and promoted. We need to click, like, and share their content and ignore the content creators with exaggerated claims. The most important pillar in discerning insightful educators from noisy charlatans is the ability to evaluate information. While engagement and likeability are key for social media success, insightful educators tend to be more transparent and grounded with their views. Social media can serve as a powerful tool for financial literacy and democratize access to investment knowledge, rather than promulgate exploitation and misinformation. Perhaps launching new platforms built solely for educational purposes is the answer? source

Two institutional managers I know — one at a Fortune 500 defined benefit pension fund and another at a municipal pension fund and later an endowment — believe in going all-in on active management. To them, a 100% active allocation is not only okay but desirable. Of course, anyone with any knowledge about the statistical odds of selecting outperforming active managers knows how unbelievable and wrongheaded this approach is. Which is why I ask active management’s true believers to share their academic and professional insights on why active is the better path. I’ve found it startling that so many in our industry, when they offer any opinion on it all, provide so little in the way of strong and substantiated sources to back up their perspective. For my part, I have six observations, detailed below, that help guide my approach to the active vs. passive question. Of course, they are far from exhaustive. After all, manager selection is hardly a simple process. At bottom, it begins with the assumption that active managers can outperform and that those managers can be identified ahead of time. To be sure, the manager selection literature has a vocabulary and a reasonable framework to think about the challenges, but the holy grail of the dilemma — knowing when to go active and when to go passive — remains elusive. Indeed, active analysis hinges on reasonable forecasts of ex-ante alpha and active risk both in terms of optimizing alpha and strategic asset allocation. To serve our clients well, we have to keep our eyes wide open on these issues. Active management’s record is dismal. The SPIVA research paints a pretty troubling picture. So does Winning the Loser’s Game by Charles Ellis, CFA, and “The Active Management Delusion: Respect the Wisdom of the Crowd” by Mark J. Higgins, CFA, CFP. Just last month, Charlie Munger described most money managers — that’s us — as “fortune tellers or astrologers who are dragging money out of their clients’ accounts.” While Munger is always great for one-liners, the criticism stings and maybe hits a little too close to home for many of us. Yet, I have not forsaken all active for passive. But I am taking a hard look, along with others in my firm and in the industry, at how to work through these challenges. Make no mistake, our industry will continue to bend toward passive. But there are possibilities for active. When it comes to manager selection and the active vs. passive debate more generally, I recommend keeping the following in mind: 1. There Are No Bad Backtests or Bad Narratives. This is especially true coming from sales or business development personnel. But while it is easy to sound good and construct a compelling story, it is much harder to present a quantitative approach that dissects attribution ex-post and understands ex-ante how that process can materialize into alpha. It is a tall order and no pitch that I have heard has ever done it well. Investors should not have to figure it out on their own. It is reasonable for them to expect active managers to define and measure their ex-ante alpha, especially if they are simply extrapolating it from the past. But investors have to evaluate that ex-ante expectation or have a well-developed forward view of where that alpha will come from. 2. Non-Market-Cap Indexing May Help Identify Market Inefficiencies. This extends active management into index selection and management. Even small disparities can make a big difference when it comes to how a sub-asset class performs in an index. For example, while market-weighted and designed to reflect the small-cap universe, the S&P 600 and Russell 2000 have very different inclusion and exclusion criteria that can lead to material differences. Moreover, index variations may seek to capture the well-known factors documented in academic and practitioner research — the so-called “factor zoo” — that too many have summarily dismissed. 3. Are Our Biases Our Friends? If we truly question the efficiency of a market, we may have a basis to prejudge a particular corner of the investment universe and invest accordingly. But such beliefs must go beyond the general and the obvious: We need something more concrete and specific than “the markets cannot be efficient because people aren’t rational.” 4. When in Doubt, Go Passive. We are all imperfect, but the strength of our convictions matter. If on an ascending 1 to 10 confidence scale, we are only at 7 or even an 8, we should go passive. Given the odds, “warm” is not enough of an inclination to go active. 5. Expenses and Manager Ownership Can Make for Good Screens Does an active manager charge exorbitant fees? What does the fund’s ownership structure look like? If the answers do not reflect well on the manager or fund in question, it may be a good idea to avoid them. 6. Consider a Core-to-Satellite Approach This gives us a mistake budget. We can, for example, limit our active exposure to no more than 20% to 30% of our policy allocation. This way our passive exposure will always give us reasonable expectations of returns in the top-quartile over the long run. Top-quartile is impressive. On a larger level, it may make sense to reframe the whole active vs. passive debate. The question — active or passive? — may not be the right one to ask. Am I getting exposure to the market that I cannot get through a benchmark? Is there a real inefficiency in this market? Perhaps these are the questions we should be asking ourselves. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author(s). As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Kkolosov Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including

In the history of every great catastrophe, you will find some masterly bit of stupidity set fire to the oil-soaked rags.[1] —EDWIN LEFEVRE, author of Reminiscences of a Stock Operator Private markets have entered what may be the most precarious phase of a decades-long speculative cycle, defined by questionable valuations, governance concerns, and aggressive marketing to retail investors. While institutions have already committed trillions to these opaque vehicles, many are now quietly heading for the exits — just as individual investors are being drawn in by the promise of stable returns and enhanced diversification. Yet the warning signs are piling up. From valuation inflation to fee extraction on unrealized gains, today’s market bears striking resemblance to the late stages of past financial manias. This post draws heavily on more than two centuries of US financial history to show how those patterns are resurfacing in private markets. Consider, for example Jason Zweig’s June 6 Wall Street Journal article, which raised serious questions about valuation practices at Hamilton Lane Private Assets Fund. In it, Zweig interviews Tim McGlinn, owner of The AltView, whose work continues to be a valuable resource for those interested in the structural dynamics of private markets. Zweig revealed Hamilton Lane’s use of a valuation methodology that enabled the Private Assets Fund to record generous mark ups on secondary investments — often within days of purchasing them. According to the article, the fund recorded significant markups shortly after acquiring positions — a method akin to purchasing a home for $1 million and then marking it up to $1.25 million based on an external estimate. Such a move, while not unheard of in private markets, may result in perceptions of artificially boosted returns. Yet, despite already earning a 1.40% annual management fee on nearly $4 billion in assets under management (AUM), Hamilton Lane proposed a notable change in March 2025: Shareholders were asked to waive the fund’s 8% preferred return hurdle and allow for the distribution of incentive fees on unrealized gains. This change resulted in a $58 million payment to management, a figure that appears to be heavily supported by the earlier described valuation approach. The motivations behind shareholder support for such a revision are unclear. However, the governance implications are significant. The move suggests a broader trend worth watching in the current market environment — one in which investor protections may be subordinated to fee extraction. McGlinn and Zweig‘s work underscores the need for vigilance and transparency, especially as private markets evolve to attract new classes of investors. While the Hamilton Lane Private Assets Fund targets individual investors, the underlying valuation and incentive dynamics mirror those seen across segments of the institutional private markets landscape. The Rhythm of History Can Be Felt in Private Markets Zweig’s article was unnerving but hardly surprising. This kind of behavior is typical in the late stage of a speculative cycle, and the United States has experienced many over the past 235 years. The first one occurred in 1791 when frenzied traders speculated in “scrip” granting them options to purchase shares in the initial public offering of stock in the First Bank of the United States. Americans have since experienced many more manias and crashes. Each episode felt unique at the time, but viewed across centuries, a familiar pattern emerges. In 2025, there are clear signs that this pattern is repeating in private markets — and that we’ve entered its most dangerous late stage. So, how did this happen? Private markets, which include investments such as venture capital, buyouts, real estate, hedge funds, and private credit, were all the rage among institutional investment plans over the past two decades. Mesmerized by the exceptional returns of the Yale University Endowment at the turn of the 21st century, trustees began shoveling substantial amounts of capital into these markets. Multiple red flags steadily emerged, but they were largely hidden by the slow passage of time. Today, there are seven red flags which strongly suggest that private markets are in the late stage of a classic speculative cycle. At best, this means they are severely overvalued; at worst, it means that at least some segments may qualify as a bubble. Signs of Late Stage Speculation: 7 Red Flags in Private Markets Red Flag #1: Widespread Acceptance of a Flawed Narrative There is no national price bubble [in real estate]. Never has been; never will be.[2] —DAVID LEREAH, chief economist of the National Association of Realtors Beneath the foundations of history’s worst bubbles were widely accepted narratives that ultimately proved to be dead wrong. In the 1810s, American farmers believed that wheat and cotton prices would remain at astronomical levels for many years. In the late 1920s, Wall Street speculators believed that using short-term debt to purchase stocks was safe because the markets would never suffer a sustained decline. In the late 1990s, Americans believed that any company with a “.com” placed after its name offered a sure path to riches. In the early 2000s, Americans believed that real estate prices would never decline on a national level. In the 2020s, it seems almost every institutional and individual investor believes that private markets offer a foolproof way to enhance returns and/or reduce portfolio risk. Few question the validity of this narrative despite mounting evidence that not only is it unlikely to be true in the future, but there is also strong evidence that it failed to materialize in the past. A paradox of investing is that speculative excesses happen only when most investors believe they can’t happen. It is reminiscent of a famous scene in the movie The Usual Suspects, when a shadowy villain Keyser Söze explained how the myth of his existence enabled him to achieve maximum surprise. After completing his crime spree, Söze ended the movie by declaring, “The greatest trick the devil ever pulled was convincing the world he didn’t exist.” Speculative episodes thrive under similar conditions. Red Flag #2: Presence of a Complacent and Siloed Supply Chain What are the odds that people

The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. 2021. Eswar S. Prasad. ‎The Belknap Press of Harvard University Press. Today, you can’t turn on the television or the radio without hearing an ad for cryptocurrencies or crypto exchanges. Numerous celebrities are touting crypto trading platforms, including professional athletes LeBron James and Tom Brady and actors Matt Damon and Larry David. Are cryptocurrencies the next big investment, a fad, or a currency that will transform the economic and financial landscape? What are some of the advantages and shortcomings of digital currencies? Who will benefit from these new currencies? Eswar S. Prasad attempts to address these questions in The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. Prasad, the Tolani Senior Professor of Trade Policy at Cornell University and the author of several books on currencies, provides an interesting and insightful exposition on the shifting landscape from traditional paper notes to digital currencies. Prasad begins his discussion of the future of money with a quote from Cecilia Skingsley, the deputy governor of Sweden’s central bank: “If you extrapolate current trends, the last note will have been handed back to the Riksbank by 2030.” Skingsley is not the only government official who sees a grand future for digital currencies. China is another country that has been moving away from paper currency. In the United States, President Biden, recognizing the importance of new digital assets, signed an executive order to ensure digital assets’ responsible development in March 2022. The book is divided into four parts. Part I, “Laying the Bedrock,” looks at the future and promise of digital currencies and provides an introduction to finance for those with little background. Part II, “Innovations,” focuses on the history of fintech and the crypto revolution. Part III, “Central Bank Money” makes a case for central bank digital currencies (CBDCs). Part IV, “Ramifications,” considers the potential consequences for the international monetary system. The “Innovations” section of the book begins with a chapter titled “Will Fintech Make the World a Better Place?” Here, the author takes us through the history of fintech, which he points out is a catchall term for novel financial technologies. It was first coined in 1993 with Citicorp’s creation of the Financial Services Technology Consortium. However, some innovations, such the ATM, have become so ubiquitous that we forget these were once novel technologies. The history includes an interesting look at newer innovations, such as M-PESA, which allowed individuals in Kenya to conduct banking through a mobile phone, as well as peer-to-peer lending, crowdfunding, and on-demand insurance. Many of these new services will pose challenges to traditional financial services companies. Today, fintech is most closely associated with cryptocurrencies, such as bitcoin and Ethereum. However, a discussion of cryptocurrencies cannot begin without understanding the blockchain and how this technology is transforming business and finance. Blockchain technology has been touted as the future of finance and of numerous other areas of business, including securing of medical records, non-fungible token (NFT) marketplaces, and supply chain and logistics monitoring. Most investment professionals will be aware of the blockchain and the concept of a decentralized ledger across a peer-to-peer network, but many may not understand the technology thoroughly. Prasad provides a detailed but accessible explanation of how the blockchain works, from its historical origins to the technology underlying the system. The term “blockchain” is associated with a variety of cryptocurrencies. However, the protocols used to validate transactions differ for various blockchains. Furthermore, each protocol has advantages and weaknesses. Will many alternative protocols continue, or will one emerge as the standard for the industry? Bitcoin uses a “proof-of-work” protocol to validate transactions, which requires block creators, known as miners, to solve a randomly generated cryptographic problem. The approach allows transactions to be validated without a trusted third party. However, this method requires significant computing resources, which need large amounts of electricity to power the computers. Another downside of this approach is that it allows only a relatively small number of transactions to be validated simultaneously. Ethereum uses a “proof-of-stake” protocol. Proof of stake was created to deal with some of the inefficiencies of the proof-of-work approach. Here, the privilege of validating a block is based on how much has been “staked” by competing nodes. However, as Prasad points out, this less resource-intensive approach is not without its shortcomings. Prasad debunks some of the myths of crypto and other digital currencies. For example, many view using cryptocurrencies, such as bitcoin, as a way to maintain anonymity. The reality is that, unlike cash, digital currencies require identifiers for consumers to receive the goods purchased with digital currencies, which removes the anonymity. Blockchain has also been viewed as a secure technology. Although this technology offers greater security than other methods, Prasad points out ways that individuals can hack the various protocols. Like all new technologies, the fintech revolution has brought with it a whole new language to define the new offerings, including hashing, security token offerings (STOs), smart contracts, initial coin offerings (ICOs), hash time locked contracts (HTLCs), and stable coins. The Future of Money allows investors to learn the new vernacular of this field and consider which innovations may offer the greatest investable opportunities. Reading through the book is unlikely to provide any insights into how to value cryptocurrencies or how digital currencies, such as bitcoin, are likely to replace government-issued money as a store of value, a medium of exchange, or a unit of account. However, Prasad offers a glimpse into the potential for digital currencies in the chapter “The Case for Central Bank Digital Currencies.” He maintains that CBDCs can improve efficiency on the wholesale side by improving the way central banks distribute reserves to commercial banks for payment, clearing, and settlement. On the retail side, CBDCs may offer several benefits, including providing a backup payment system, promoting financial inclusion, and improving monetary and fiscal policy. Although these chapters may seem to be of greater interest to monetary economists and central

Activist investor interventions with small, newly public companies can improve their stock performance, a Financial Analysts Journal study finds. In “Shareholder Activism in Small-Cap Newly Public Firms,” Emmanuel R. Pezier and Paolo F. Volpin analyze a private dataset of a UK fund’s engagements with small-cap newly public firms and demonstrate that “behind-the-scenes” engagements resulted in 8% to 10% in cumulative abnormal returns. They attribute these returns to engagements, not stock picking.  I spoke with Pezier, an associate scholar at Saïd Business School, University of Oxford, for CFA Institute Research and Policy Center for insights on the authors’ findings and to produce an In Practice summary of the study. Below is a lightly edited and condensed transcript of our conversation. CFA Institute Research and Policy Center: What is new or novel about this research?  Emmanuel R. Pezier: I suppose there are two novel elements. First, we study small-cap recently IPOed companies. So, the question is, Does the activism “magic” work in small companies, as we already know it does in large-cap firms? And we are bringing entirely new and previously private data into the literature to test that question. Why are small-cap IPOs interesting? Well, they are very important to the functioning of the wider economy, so studying them, their agency and liquidity problems, and how these problems might be resolved by shareholder activism seems worthwhile.  Second, the activist we study is highly unusual in the way it raises its funds. A traditional activist fund, or regular fund, for that matter, raises cash from investors on day one, then uses that cash over time to invest in firms that it chooses, using its stock-picking and activist engagement skills to generate returns. But then the natural question is, How much of their returns has to do with their stock-picking ability and how much of it has to do with their activist interventions? By contrast, the fund we study receives unwanted stock holdings — for example, payments in kind, rather than cash — from investors on day one. And, importantly, it has no say in which stocks it receives. Hence, the returns are unlikely to be due to stock picking, as there is none, and more likely to be due to activism. So, we get a slightly cleaner shot at measuring “how much” the activism magic works.  What motivated you to conduct the study?  We wondered if the kind of activism techniques that are used by high-profile hedge funds in large-cap companies happen in small-cap companies and if they are effective in generating returns. And we answer those questions. The answer is yes, they are, and yes, they are effective.  What are your study’s key findings? There are good returns to be had by engaging with the management of companies that have recently gone public and that are small. And the returns attributable to interventions in these small-cap companies are large. We can’t really generalize and say this type of activism happens on a widespread basis. All we can say is that the fund that we study is intervening behind the scenes and achieving good results, which suggests that activism works in small-cap stocks, like we already know it does in large-cap stocks. Who should be interested in your study’s findings, and why?  I think anyone who has invested in small-cap IPOs could be interested in this paper. Large institutions are being asked to buy more and more of these, oftentimes “premature,” small-cap IPOs because of changes in stock market regulations aimed at encouraging capital formation in young, high-growth entrepreneurial companies. This isn’t going away if you’re an institutional investor — if anything, you are likely to be facing more and more of these IPOs in the years to come. In what ways can the industry use the research findings?  The research delivers insights into how to engage with small firms that have high levels of insider ownership — meaning the scope for agency conflicts is high. These insights should be of value to institutional investors that routinely invest in small-cap IPOs but might lack experience in shareholder activism. What follow-on research does your study encourage or suggest?  Future researchers may wish to examine activist engagements that exploit potential “fault lines,” such as gender, ethnicity, or nationality, which may exist within the board or senior management. In our study, we find that fault lines may exist between the chair and CEO when one of the two is the founder of the firm and there is a large age gap between the two individuals. We believe these fault lines help explain why certain engagements become confrontational and why confrontational engagements unlock the largest returns. For more on this subject, check out the full article, “Shareholder Activism in Small-Cap Newly Public Firms,” from the Financial Analysts Journal. If you liked this post, don’t forget to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Buena Vista Images Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

Investors’ faith in the genius of private equity (PE) fund managers has reached ever greater heights amid new records in fundraising, deal volume, and asset valuations. These trends have continued in 2022 despite — or perhaps because of — worldwide public market losses. Aside from maximizing fee income, the ultimate goal of leveraged buyout (LBO) operators is to optimize returns on the capital they manage on behalf of LP investors. While the subtlety of the craft is not restricted to financial tricks, success in PE has long been marketed via masterful delivery and finessing of the internal rate of return (IRR). What’s in an IRR? PE firms have a repertoire of tools at their disposal to achieve their target returns. The following drivers represent the five pillars of value creation from the fund manager’s standpoint: 1. Maximize Leverage at Inception and Refinance the Capital Structure Frequently That is, recapitalize by raising further debt in order to pay out dividends — hence the term “dividend recap.” With this move, the PE firm partially realizes its investment. This can be controversial. Excessive indebtedness and frequent recapitalizations can stretch a borrower’s balance sheet and inhibit its ability to meet loan obligations or adequately fund growth. 2. Complete Bolt-On Acquisitions This is best performed at lower entry multiples than that originally paid to buy the portfolio company, which makes these add-ons value accretive. Value can then be harvested through the synergies accomplished by merging the acquirer and the targets. This is often the main rationale of buy-and-build strategies for LBOs in the $50 million to $500 million enterprise-value range. 3. Improve Performance and Bolster Cash Flows This is vital during the ownership period. Operational gains can be effected by: Increasing margins through better cost management — relocating production facilities to lower-cost countries, for example — and economies of scale by growing volume. Boosting cash generation by reducing working-capital requirements, cutting capital expenditures, minimizing cash leakage, and entering into sale and leaseback agreements. Discontinuing or disposing of unprofitable or low-margin activities. This practice earned some early LBO players the moniker “asset-stripper” and was common in the 1970s and 1980s when conglomerates with unrelated and underperforming divisions were sold off piecemeal. Nowadays, few targets suffer from the same lack of focus. Growing sales through refined price point strategies, new product launches, etc. 4. Aim for Positive Multiple Arbitrage This implies exiting a portfolio company at a higher valuation multiple than the one paid at the initial investment stage. Such arbitrage depends on the economic cycle. In up cycles, PE managers will emphasize their skills in securing any gain. When such arbitrage turns negative, however, they will blame poor market conditions. Frankly, multiple expansion is heavily cycle-dependent. 5. Optimize the Investment Holding Period This is perhaps the most important pillar. Because of the time value of money, most fund managers seek to partially or completely exit investments as soon as they can. What is meant by the time value of money? That time holds value and that a dollar today is worth more than a dollar a year from now. Why? Because that dollar can be put to work for the next 12 months, earning interest or, through productive investments, growing into more than one dollar over the course of the year. It can also lose some of its purchasing power due to increases in the cost of living over the same period — a critical point today amid rising interest rates and high inflation. This value driver also explains why financial sponsors are obsessed with dividend recaps. While all experienced PE firms place this parameter at the core of their investment strategy, it is both controversial and paradoxical. How can PE firms claim to be long-term value creators if they seek a quick exit at the first opportunity? Early portfolio realization, whether full or partial, greatly contributes to superior returns. Building the Value Bridge PE firms include a graph called the “value bridge” in private placement memoranda. Fund managers use these documents to raise money by demonstrating how they will apply the above factors to create value for their LP investors. One of my previous employers, Candover, was a top-10 European PE shop before being liquidated four years ago. Candover used slightly different metrics from the five pillars listed above in its value bridges, preferring to break out value accretion across four dimensions: sales growth, margin improvement, cash generation, and multiple arbitrage, or some combination thereof. Using this procedure, a value bridge might resemble the following graph: Vintage Fund 2012: Hypothetical Value Bridge, in US$ Millions Without precise methodologies to apportion value across the various drivers, value bridges can be constructed and calculated in countless ways. In its 2016 “Evaluating Private Equity’s Performance” report, KPMG outlined a value bridge that only analyzed value creation across three dimensions: increase in EBITDA, increase in multiple, and change in net debt and interim distributions. The Swedish investment group EQT gave a pithy indication of how portfolio value enhancement was derived in its 2019 IPO prospectus, explaining that “98 percent . . . resulted from company development (i.e., sales growth, strategic repositioning and margin expansion) versus 2 percent from debt repayment.” When going public last year, the UK firm Bridgepoint stated that “From 2000 to 2020, an estimated 77 per cent of value creation across profitable investments has been driven by revenue growth and earnings improvement . . . with a further 25 per cent driven by multiple expansion at exit as a result of the repositioning of portfolio companies for growth and professionalisation, slightly offset by (2) per cent from deleveraging.” Watch Out for the Downturn Excluding loss-making investments from the value bridge is a common trick among fund managers to massage performance reporting. Candover rationalized this behavior, stating that “attributing the loss of value to the different value drivers would be an arbitrary exercise.” It failed to explain why attributing the gain of value to different value drivers wouldn’t itself be arbitrary! Bridgepoint’s public filing describes “value

Disregard all the hype around crypto in general and bitcoin in particular. Blockchain represents the real opportunity that investors should be talking about. The post Let’s Talk Blockchain, Not “Crypto” appeared first on CFA Institute Enterprising Investor. source

Three investment return trends related to the green transition concern me. These apply across all sectors but to automotive in particular. Here is how I see it. 1. Pricing is challenging. The strong automotive demand during the COVID-19 pandemic was fueled largely by wealthier customers and is on the wane, especially for electric vehicles (EVs), which are often second vehicles priced as premium products. Until recently, automakers experienced bottlenecks with their finely tuned production systems. The mismatch between supply and demand adjusted pricing upward to reestablish equilibrium. Cheap financing and a shortage of used vehicles exacerbated this trend. According to Kelley’s Blue Book, US EVs cost US$58,940 on average in March 2023, around $11,000 more than their counterparts with internal combustion engines (ICEs). Despite the 30% increase in new vehicle prices during the pandemic, the monthly lease payments and consumer end cost was lower. This “goldilocks” scenario is now unwinding, with interest rates climbing, residual values falling, and supply chain bottlenecks dissipating. Incentives have sent new car prices lower, especially for EVs. As additional supply hits the market, we can expect a broader mix of lower priced vehicles. And that is before Chinese EV manufacturers with spare capacity more fully enter global EV markets. Historically, the first sign of automotive market weakness tends to manifest in the much larger used vehicle market. Despite the limited supply of prime off-lease vehicles during the pandemic, used vehicle values in the United States have clearly headed south after a period of extraordinary strength. US Used Vehicle Pricing Turned Negative in Late 2022Manheim US Used Vehicle Value Index Source: Cox Automotive Manheim Tesla was the first automaker to recognize that the COVID-19 auto bubble had burst. Despite government incentives — the US government’s Inflation Reduction Act (IRA) offers up to US$7,500 to entice consumers — EV pricing is still a constraint for many purchasers. China is now by far the largest EV market and is also globally dominant in related industries. A recently launched BYD Seagull EV with a range of 300 kilometers and base price of US$11,300 demonstrates this. Pricing pressure in the Chinese market is intense, making exports an attractive outlet. According to Automotive News China, Ford’s Mach-E electric crossover’s starting price in China is US$30,500. That is now a third cheaper than the Mach-E’s price tag in the United States. 2. Supply is plentiful. With automotive industry supply chain disruptions largely in the rearview mirror, EVs are now readily available for purchase. Amid a continued focus on high inflation, automotive oversupply and deflation may be on the horizon. Chinese automakers pivoted a decade ago towards EVs as the government injected an estimated US$120 billion. By unleashing its excess capacity, China may lead in automotive exports for the first time in 2023. While Tesla continues to dominate the Western EV markets, it only controls around 10% of China’s. EVs are designed for global distribution in a way that ICE vehicles never were, since regional emission regulations are redundant. While there has been excitement about new EV entrants to the US market, BYD is the great pretender to Tesla’s global EV crown. Overtaking Tesla on sales of total EVs, including plug-in hybrid electric vehicles (PHEVs), in 2022, BYD has extended its lead in 2023, outpacing Tesla China by 29% in EV sales in the first six months. BYD Is the Largest Player in Global EV SalesEV Titans Sources: Bloomberg NEFBYD includes BEV and plug-in hybrid vehicles (PHEV); Tesla BEV only And supply is only going to keep increasing. The global addressable EV market grew from under 200,000 in 2013 to more than 10 million in 2022. Bloomberg NEF estimates EV sales will hit 35 million in 2030. Tesla plans to increase production to 20 million vehicles from 1.4 million today. According to Zach Kirkhorn, Tesla’s chief financial officer, the capital required to make that leap is US$175 billion over the next seven years. President Joseph Biden’s IRA offers $369 billion in green subsidies, and the CHIPS and Science Act $52 billion in funding for US chipmakers along with manufacturing tax credits worth about $24 billion. We have identified US$33 billion of announced individual EV investments related to the IRA through early 2023. That’s the equivalent of more than a decade of capital raising at Tesla. But this is just the start, according to Atlas EV Hub; vehicle manufacturers and battery makers plan to invest US$860 billion globally by 2030. Tesla Total Capital vs. IRA Motor Commitment Sources: S&P Capital IQ, Automotive News The North American market participants are planning what amounts to a big bang expansion for every step of the EV value chain. The accelerated pace of the expansion will eclipse Tesla’s capital allocation over the last two decades towards building 1.4 million units of global production per year in 2022. Tesla represents a 13% share of the global EV market, including BEV and plug-in hybrid electric vehicles (PHEV). Investment under the IRA, and the US$33 billion already committed by automotive producers, will likely lower returns on capital. Ford expects to lose around US$4.5 billion in 2023 on EVs, an enormous sum on limited production. While losses are typical in the early stages of a lifecycle, investors have to question the potential for positive returns on capital. 3. Will Investors Expect Higher Returns? Using Tesla’s current capital base of US$52 billion as a proxy, the US$860 billion of estimated investments would be the equivalent of 17 Tesla-sized firms. This would lead to substantial additional production capacity on top of stranded existing ICE capacity, with tepid global demand. Tesla took two vehicle generations to report a positive EBIT. Investors in EV production capacity may learn from past mistakes, but they are still likely to wait a vehicle generation, or seven years, before they see positive returns. Given recent price reductions and competition in China, that Tesla’s returns on capital may fall in 2023 is understandable, but we also wonder if the cost of capital will remain elevated. Tesla Has Made Steady Progress

Demand Destruction ≠ Disinflation Global central banks have made an “all-in” effort to front-load policy tightening to dampen demand. But softer economic data in the United States and the eurozone have exacerbated recession fears. As the growth outlook dims, many anticipate demand destruction to lead to lower inflation. That is, tighter monetary policy and the associated higher funding costs will cut into demand and offset the supply shortages resulting from geopolitical instability and supply chain disruptions. This view hinges on the belief that inflation outcomes are largely driven by central bank policies. However, “muted” inflation in recent years, especially during the 2014 to 2016 crude crash, has demonstrated inflation’s insensitivity to demand-side policies. Even the European Central Bank (ECB)’s quantitative easing (QE) in 2015 failed to stoke demand in a way that reduced excess supply. The US Federal Reserve’s dovish policy stance in the decade before the pandemic pushed the Atlanta Fed’s Wu-Xia Shadow Federal Funds Rate below zero multiple times, yet the Fed’s preferred price measure, personal consumption expenditures (PCE), was less responsive to such policy shifts than to the end of the Cold War or China’s entry into the WTO, among other catalysts. Personal Consumption Expenditures vs. Shadow Federal Funds Rate Sources: Federal Reserve Bank of Atlanta, US Department of Commerce, Kekselias, Inc. Similarly, recent quantitative tightening and rate hikes have not created enough demand destruction to counteract geopolitics-related commodity scarcity. Instead of following central bank policy over the last two decades, inflation largely co-moved with commodity prices, or both demand and supply-side factors. Eurozone, US, and UK Inflation vs. Commodity Index Sources: Eurostat, UK Office for National Statistics, US Federal Reserve, Bloomberg, LP, Kekselias, Inc. This casts doubts on the “rates-determine-activities-determine-inflation” framework and suggests that domestic monetary policy cannot lift or dampen inflation on its own. Other factors must come into play. 1. Fiscal Spending = Higher Demand Given QE’s long and variable trickle-down effect, pandemic-era policies sought to counter the demand shortfall by expanding balance sheets and through fiscal stimulus, or printing money and mailing checks directly to households. This drastically decreased the transmission time between central bank easing and realized inflation. The deployment of “helicopter money” rapidly revived demand. As pandemic disruptions eased, the anticipated fiscal tightening never materialized. Instead, fiscal-monetary cooperation became the norm and cash payments a regular policy tool. Following its Eat Out to Help Out Scheme, for example, the UK government announced a £15 billion package to send £1,200 to millions of households. As UK energy prices spiked, Liz Truss, the frontrunner to become the next prime minister, proposed an emergency fiscal spending package to ease the public’s financial stress. On the other side of the Atlantic, many US states have announced stimulus payments to soften the pain of high inflation, and President Joseph Biden has introduced a student loan relief program. The lesson is clear: Central banks are no longer the only game in town when it comes to economic stimulus. 2. Geopolitical Events = Supply Disruptions As multinationals regionalize, near-shore, and re-shore supply chains and prioritize resiliency and redundancy over cost-optimization, energy scarcity in the eurozone has created new disruptions. German chemical production is set to fall in 2022, that could export inflation abroad. As geopolitical instability contributes to domestic economic challenges and more fiscal stimulus is deployed, inflation may be much less responsive to traditional monetary drivers. Under such circumstances, a rigid framework equating tight monetary policy and high prices with demand destruction and disinflation will no longer be operable. For investors calibrating portfolio risks, such conditions may offset the disinflationary pressures of slowing growth. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Pavel Muravev Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source