The Private Equity Myth: Why Public Small Cap Equity May Trump PE
Private equity investing is often touted as a superior alternative to public equity investing, with studies citing private equity’s historical outperformance vis-a-vis the S&P 500 Index. However, these studies frequently do not adjust for issues such as 1) appropriate benchmark selection, 2) current market valuations, 3) illiquidity, and 4) high fees. For these reasons, I believe that a public equity small cap value strategy may be a viable alternative to private equity investing.
We define “small cap” generally as any company with a market capitalization less than $5.0 billion.
Private Equity Overview
Private equity funds typically invest directly in private companies or acquire public companies to take them private. These funds are typically structured as partnerships in which a general partner manages the fund and makes investment decisions while the limited partners are passive investors in the fund. Each private equity fund holds a number of individual portfolio companies, and a typical fund exists for around a decade. General partners are compensated based on total assets managed and the amount of money they earn for their limited partners.
Academic studies claim that private equity has generated historical total returns 3-5% higher than a large cap equity index such as the S&P 500 (Source: Mercer, “Understanding Private Equity – A Primer,” 2015).
However, these statistics leave out a number of important factors that may make public market investing a more attractive option, particularly in the current investing environment.
Concerns for the Private Equity Investor
Benchmark Selection & Historical Returns
Private equity investors typically purchase portfolio companies with debt and then subsequently pay down this debt throughout their holding period. While this strategy creates attractive tax advantages, it also makes returns more volatile. Given such high leverage, the typical private equity investment does not look like your average S&P 500 company.
Nonetheless, the returns of private equity funds are often compared to the returns of the S&P 500 when it would be more appropriate to compare the performance of private equity funds to a small cap index. One study indicates that, after adjusting to a more appropriate benchmark, private equity funds actually underperform by 1.2% annually. Further, after adjusting for both the benchmark and the leverage of the individual portfolio companies, private equity funds in this study actually underperformed a small-value index by 3.1% annually (The benchmarks used in this calculation were the six Fama-French indices, which are portfolios assembled by firm size (small or large) and book-to-market ratios (growth, mid, and value). In particular, the 3.1% underperformance was calculated against the small value-weighted index. These research portfolios are available on Ken French’s website).
High Asset Valuation
A key determinant in the return earned by a private equity fund is the initial price paid for each portfolio company. As an example, a Wells Fargo study shows that funds originated in 2009 (when purchase prices were low) outperformed those funds originated in 2006 (when purchase prices were much higher) with median fund IRRs of 13.0% and 8.0%, respectively (Source: Wells Fargo, “How Have Private Equity Funds Performed Across Cycles,” 2018).
More recently, McKinsey reported that purchase price multiples in U.S. leveraged buyout transactions rose to an all-time high of almost 11.0x EBITDA in 2017. In addition, McKinsey reports that private equity funds hold record amounts of “dry powder,” or unused capital, meaning that the committed capital chasing attractively valued companies is at an all-time high. Given this, it difficult to see how private equity funds in the current environment will achieve the attractive returns often cited in private equity historical studies.
Private equity is an illiquid investment with funds that generally have a term of 10 years, and, once invested, an investor cannot get capital back except at the manager’s discretion (Source: Mercer, “Understanding Private Equity – A Primer,” 2015).
This lack of liquidity stands in stark contrast to the daily liquidity offered by public markets. Illiquidity might be a good reason that private equity funds should generate a better return than comparable public stocks, but as we’ve discussed already, this isn’t necessarily the case.
Private equity has some of the highest fees of any asset class. Private equity firms primarily make money through both management fees, based on the size of the fund, and performance fees, based on profits generated by the fund. Management fees are most commonly in the range of 1.76% to 2.0% with performance fees typically 20.0% of profits once a hurdle return is achieved (Source: MJ Hudson, “Private Equity Fund Terms Research,” 2018).
These fees greatly reduce a limited partner’s net returns.
Advantages of Public Small Cap Equity
High Asset Valuation
While private equity funds are purchasing companies at all-time high valuations, public company funds have the ability to invest in companies trading at much cheaper levels. The average developed market small cap company trades at just 4.7x EV/EBITDA. Therefore, it is quite feasible for a global small cap value fund to be entirely composed of stocks with valuations that are less than half the level at which private equity funds are paying today. With valuations being a key determinant in future returns, it seems that public equity investors have an enormous advantage over their private equity counterparts.
As discussed, private equity funds on average have 10-year lock ups. In contrast, public market strategies such as mutual funds or ETFs typically offer investors daily liquidity or more frequent redemption options. Whether executed via mutual funds and ETFs or other investment vehicles (such as limited partnerships), a public market strategy would provide much greater liquidity than the typical private equity fund.
Alternatives to private equity are available at a fraction of the cost of private equity funds. According to Morningstar, U.S. open-ended mutual funds and ETFs have an asset-weighted average expense ratio of 0.67% (Source: Morningstar, “US Annual Fund Fee Survey,” 2018). Even limited partnerships that invest in public equity typically charge lower fees than private equity, with the average management fee at 1.5% along with a 17.0% performance fee (Source: Jefferies Capital Consulting, 2018).
Any of these public equity options would provide investors access to investment strategies at a discount to the typical private equity fund.
In my view, a portfolio of levered, small cap stocks could be an attractive alternative to a more expensive, less liquid, and harder to access private equity fund. I believe that a small cap value strategy has the potential to outperform private equity strategies moving forward, particularly given the elevated valuation levels of transactions occurring in the private equity industry today. A strategy that invests in small cap, levered public equities with the willingness and ability to pay down debt should be an attractive alternative to private equity investing.
The views are those of Matthew Blume as of the date of publication and are subject to change and to the disclaimers of Pekin Hardy Strauss Wealth Management.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.