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Joseph Mariathasan: The pas de deux of private equity and small caps

IPE contributing editor Joseph Mariathasan compares the merits of private equity with those of small caps

Small-cap companies represent the cutting edge of capitalism as new companies form as private entities, grow and, usually at some stage, are listed on the public markets. The listed and private equity markets cover much of the same space, and the two have engaged in a scintillating pas de deux over many years. 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 them wrong-footed in their choice of vehicle to tap the small-cap space? 

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 general partners (GPs) can bring expertise and strategy, among other things, to their investee companies, which brings added value. But a significant distinguishing feature of the asset class has been the extent of leverage utilised by private equity firms.

Private equity masks price volatility because of the lack of daily valuations. That subterfuge has certainly fooled many commentators into taking valuation data at face value. Even the idea of purchasing secondary deals at a discount to net asset value (NAV) can be very misleading when the 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 that is the issue. Critics have argued leveraging up listed small-cap equities provides a better bet than private equity funds.

Some academic evidence seems to indicate that, for long periods of time at least, the average buyout fund outperforms the S&P 500. But Ludovic Phalippou at Oxford University’s Said Business School argues such results should be treated with scepticism. He says the S&P 500 has generally underperformed mid caps, while private equity buyout funds mainly invest in mid and small-cap value companies. Phalippou does agree that, overall, the private equity model does make sense in terms of corporate ownership, the focus on cash generation and the lack of the requirement to have continuous trading. Of course, the private industry does have a tendency, he argues, to “game the IRR” 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 overall strengths of the model and often attractive gross returns, the total fee level – including management fees, performance fees and hidden fees – charged to companies by private equity managers can be upwards of 7% per annum. In a world of low returns, such fees look not only excessive but immoral when a substantial fraction are hidden. Phalippou and others have estimated private equity firms charged $20bn (€17.6bn) in such “hidden fees” to almost 600 companies they owned and hence whose boards are controlled by them in the last two decades.

CalPERS used to have a return target of the S&P 500 plus 3% as its private equity benchmark. That benchmark has not been beaten in recent years by the pension fund’s private equity portfolios, Phalippou points out. But while CalPERS looks to establish an alternative benchmark that its private equity portfolios can presumably beat, Phalippou argues that the asset class’s post-fee returns 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% per annum, 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 CalPERS paid around $2.6bn 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 by undertaking deals in-house and avoiding the excessive fees structures in the industry. But, as Phalippou points out, the competition for private equity investments is increasing while the returns are becoming less attractive – private equity returns have been going down every year since 2001, while the average fund, since 2005, has underperformed the S&P 500.

Private equity may be the wrong vehicle for many investors to tap the small and mid-cap equity space. While top private equity managers may be able to produce historical figures showing they have outperformed the public markets, this does not appear to be generally the case. Even private equity managers’ claim that their investments are not merely leveraged plays on illiquid and hard-to-value companies – that their management expertise creates value – should be treated with caution. Most public companies in the US are well run and have high returns on equity. US small-cap investing can provide an alternative approach to investing many of the same drivers of return investors are seeking in private equity. Yet private equity is attracting huge inflows. Are they justified? They may be, but seeking out exactly how firms are able to add value is critical. Before moving into private equity, examining exactly what the opportunities are in a like-for-like comparison with the listed small cap and mid-cap market may be worthwhile.

Joseph Mariathasan is a contributing editor at IPE

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