In the relentless quest for high returns, some investors might be tempted by the potential of small-cap public stocks. Small-cap public stocks, which are publicly traded shares of companies with a market cap of less than $2 billion, have gained financial media attention for their potential to outperform large-cap stocks in certain market conditions.
Proponents of these investments argue that they offer greater growth prospects and often fly under the radar of institutional investors. However, while small-cap stocks may offer a degree of diversification and the chance for higher returns than their large-cap counterparts, they fall short compared to private equity.
With private equity firms generating higher average returns, alongside lower volatility, increased control over investee companies, and access to unique deals, it is evident that small-cap stocks struggle to hold their ground.
Private equity offers higher returns
From 2000 to 2020, private equity handily outperformed the Russell 2000, with the former producing average annual returns of 10.48%, compared to 6.69% for the latter. US buyouts, in particular, have produced extremely attractive returns, generating an average net return of 13.1% over the last 30 years.
The outperformance of private equity investments is especially evident during bear markets. A University of Chicago analysis found that only 2.8% of buyout funds historically experienced catastrophic losses during recessions, compared to 40% of stocks. This resilience can be attributed to the nimble nature of buyout firms and their ability to take advantage of market dislocations by buying cheaply and selling when the market recovers.
Moreover, the diversification benefits of private market investments have also been observed in VC funds. An NBER study found that VC funds in the 2nd quartile also have public market equivalent (PME) values above 1.0 for pre-2001 and post-2000 vintages. This suggests that even mediocre VC funds can outperform the broader market on average, highlighting the potential for higher returns in private markets than public stocks.
One of the reasons private markets consistently provide higher returns is the ability to capitalize on market inefficiencies. Private companies are less researched and less efficiently priced, leading to potential mispricing and opportunities for private equity firms to uncover hidden value.
Private equity firms can also take a more long-term approach to business decisions. Unlike publicly traded companies, which often face pressure to meet short-term financial targets, private companies have the luxury of focusing on long-term growth and value creation.
Further, private equity firms have demonstrated expertise in turning around underperforming businesses. With access to capital, management know-how, and operational experience, these firms can identify struggling companies, acquire them, and implement changes that lead to improved profitability and growth.
Private equity has lower volatility
There's a seeming paradox regarding private equity: how can it generate higher returns while having lower volatility? The answer lies in the concept of excess volatility, as explained by Robert Shiller, who received the Nobel Prize in 2013 for his work in this area.
Excess volatility is a concept that suggests stock prices are more volatile than can be justified by changes in underlying fundamentals, such as corporate earnings and dividends. According to Shiller, this excess volatility can be observed in large- and small-cap stocks. However, small-cap public stocks are particularly susceptible to this phenomenon due to their lower liquidity and higher sensitivity to market sentiment and news events.
In contrast, private equity investments are not subject to the same level of excess volatility because their valuations are based on the underlying companies' long-term growth prospects and performance, rather than being heavily influenced by short-term market fluctuations. This results in a more stable and predictable return profile for private equity compared to small-cap public stocks.
Furthermore, private equity firms have greater control over their portfolio companies, allowing them to make strategic decisions to maximize long-term value creation. PE firms can appoint management teams, implement operational changes, deploy “buy and build” M&A moves, and more. They can also leverage their network and expertise to guide and support their portfolio companies. This active management approach helps to mitigate risks and further reduce volatility in private equity investments.
In summary, while small-cap public stocks may offer some potential for higher returns, their susceptibility to excess volatility and market sentiment makes them less attractive than private equity. With its combination of higher returns, lower volatility, and active management, private equity stands out as a more compelling alternative for investors seeking to maximize their long-term investment performance.