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The case for listed small-caps

Joseph Mariathasan finds evidence that the listed small-cap and mid-cap market could be a better place for investors to start when considering a move into private equity 

At a glance

• Private equity and smaller companies have a complex relationship.
• The fees involved in private equity bring down real returns.
• The extent of leverage distinguishes private equity investment.
• Listed small and mid-caps may provide better risk-adjusted returns after fees.

Smaller companies represent the cutting edge of capitalism, as new companies start as private entities, grow and usually, at some stage, are listed in the public markets. Within institutional investor portfolios, private equity has long been regarded as a separate and alternative asset class to the listed markets. But has that left investors possibly wrong-footed in their choice of vehicle to tap the small-cap sector?  

The small-cap effect is well documented in academic studies, although, like all financial market anomalies, it can be elusive and its possible existence subject to controversy. Proponents of private equity argue that private equity general partners (GPs) can bring expertise and strategy to their investee companies which, in turn, brings added value.

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A significant distinguishing feature of private equity has been the extent of leverage utilised by private equity firms. In contrast, as Brian Chingono and Daniel Rasmussen, two academics, argued in a recent paper, value investors eschew leverage. The guru of value investing, Benjamin Graham, they point out, once described corporate debt as an “adverse economic factor of some magnitude and a real problem for many individual enterprises”. His disciple, Warren Buffett, later said: “I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt.” 

Yet, as the academics add, leveraged buyout firms have for years realised that increasing leverage can boost returns. “The spectacular track record of the private equity industry and the clamour of pensions and endowments to invest further in private equity funds speaks to the attractive returns generated by buying companies with borrowed money,” they say. While some may dispute the existence of spectacular risk-adjusted returns in private equity, their research points to the ways in which leverage enhances a small-value strategy. 

“Investors have a well-documented pattern of leverage aversion, which we believe contributes to the excess returns to be found in leveraged small-value stocks.” They do, however, argue that it is critical for investors to select firms whose management is already making responsible capital allocation decisions. 

The greatest challenge that Chingono and Rasmussen see to their leveraged small-cap value strategy is the volatility of returns, which is significantly higher than broader market indices. “Private equity has solved this problem by taking the companies private and thus masking the price volatility,” the say. That subterfuge has certainly fooled many commentators who have taken valuation data at face value. 

Even the idea of purchasing secondary deals at a discount to net asset value (NAV) can be misleading when NAV figures may be months old. No-one purchasing equities in the listed markets would be claiming a discount because the prices were higher three months ago. But in comparisons between private equity and listed markets, it is not just the masking of price volatility through a lack of frequent mark-to-market pricing that is the issue. Critics have argued that leveraging listed small-cap equities provides a better bet than private equity funds.

Some academic evidence has seemed to indicate that for long periods of time, at least, the average buyout fund outperforms the S&P 500. But Ludovic Phalippou, an associate professor of finance at Oxford University’s Saïd Business School, argues that such results should be viewed with scepticism. “The S&P 500 has been generally underperforming mid-caps whilst private equity buyout funds mainly invest in mid and small-cap value companies,” he says.

Phalippou agrees that, overall, the private equity model does make sense in terms of areas such as the corporate ownership, the focus on cash generation and the lack of the requirement for continuous trading. But he argues that the private industry has a tendency to “game the IRR [internal rate of return]” figures by adjusting cashflows, analogous to the criticisms of listed companies on their stated earnings. 

But the most damning criticism Phalippou makes is that despite the strengths of the model and often attractive gross returns, the total fee level can be upwards of 7% a year. In a world of low returns, such fee levels look not only excessive but immoral when a substantial fraction is hidden. Phalippou and others have estimated that private equity firms charged $20bn of such ‘hidden fees’ to almost 600 companies they owned – and hence whose boards were controlled by them – in the past two decades. 

California’s public sector pension fund, CalPERS, used to have as its private equity benchmark, a return target of S&P 500 plus 3%. That benchmark has not been beaten in recent years by its private equity portfolios, says Phalippou. But while CalPERS looks to establish an alternative benchmark for its private equity portfolio, Phalippou argues that private equity returns after fees should be compared with a more suitable benchmark than the S&P 500. This can be done by adjusting for the size premium to bring the average buyout fund return in line with small-cap indices and with the oldest small-cap passive mutual fund (DFA Micro-Cap). If the benchmark is changed to small and value indices, and is levered up, the average buyout fund underperforms by 3.1% a year, Phalippou finds. 

Not surprisingly, there has been a great deal of controversy in recent months over the fee structures charged by the private equity industry. Phalippou estimates that CalPERS paid about $2.6bn (€2.4bn) in hidden fees in addition to its bill of $3.4bn for carried interest in the period 1991-2014. The reaction of some investors has been to try to capture the gross returns that may be available within private equity investments through undertaking deals in-house, avoiding the excessive fees structures in the industry. But, as Phalippou points out, the competition for private equity investments is increasing, so that the returns are becoming less attractive. “Private equity returns have been going down every year since 2001 whilst since 2005 the average fund has underperformed the S&P 500,” he says.

What is the future for the private equity duet with the listed markets? Given the controversy over private equity fees, perhaps it is more of a dance of death, with the private equity boom being a bull market phenomenon like venture capital in 1999, and leveraged buyouts (LBOs) during the 1990s. S&P valuations have reached historical highs, at a time when private equity funds are flush with cash.

“The interplay between private equity and the listed markets is a double-edged sword in terms of the companies we look at,” says Chris Berrier, portfolio manager at Brown Advisors. “When you have a ton of innovation within the private market, those companies tend to become public soon, which spurs a dynamic investable universe for us to go after.” But, as Berrier points out, given the state of the world today, with rates at zero and a lot of capital chasing what are fewer and fewer bold new ideas, it has caused elevated valuation levels particularly in the pre-initial public offering (IPO) rounds within the private equity and venture capital community. 

“There have been some innovative companies coming to market, but some of them are coming with excessive valuations where the demand is so high that, as a public investor, it presents a challenge to build up a position at an attractive price from a risk/reward perspective,” says Berrier. “Innovation fuels the universe we look at. That is a great thing for the long term, but from time to time, you have what some would call a bubble in the private markets. Capital is chasing ideas but the elevated and persistent levels of valuation can certainly impact the valuations we see in the younger public companies.” 

Investing in listed small-caps can provide an alternative approach to harnessing many of the same drivers of return that investors are seeking in private equity. Before moving into private equity, examining exactly what the opportunities are in the listed small-cap and mid-cap marketplace may be a better place to start.

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