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Are Microcaps a Good Proxy for Private Equity?

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Private Equity is classified as an “alternative investment,” meaning it has distinct features from the typical investment diet of stocks and bonds. Some go so far as to define all companies not trading on public exchanges as private equity.

As the name suggests, “private” equity by nature is a bit more amorphous relative to “public” equity, which has more disclosure regulations and is arguably more transparent. But private equity on average has had higher returns than public equity -- thus the allure, but with greater risk. And I think it is fair to say that some segments of private equity have a reputation for being shrewd financial engineers and operators known for aggressive takeovers and restructurings of businesses.

The lack of more stringent reporting makes tracking its performance more difficult and less perfect. Private Equity funds may also use different valuation methods to determine the return on investment, which further complicates the performance calculation.

However, databases exist to track performance as well as surrogate methodologies which, for instance, track state pension investments in private equity which are itemized annually to back out a rough private equity performance number. Please note that a state pension analysis of private equity performance would include selection bias and weighting bias vs. just a database of all private equity funds.

For the period 2000-2023, the best estimates of Private Equity performance suggest an annualized performance rate of 10-11%, which includes a notable decline in performance in 2023. From 1999-2023 the S&P 500 posted annualized gains of 7.18%. This roughly 300+ bps premium is often included in the mandates of Private Equity funds as a performance goal and is a compelling selling point.

Microcap stocks swim in the same waters of private equity, dealing with higher-risk small companies with potentially outsized growth potential. And these companies are typically in the venture capital or growth equity stages that private equity favors. Venture stage companies are early-stage companies in start-up mode, sometimes even pre-revenue, with the business case still in flux. Growth equity focuses on companies that have proven out a business model, but need additional funding to expand and scale.

From 2005 to mid-2021, Microcaps were keeping up with Private Equity returns with a near 9% annual return, as demonstrated below by the performance of the Russell Microcap index, which launched in June of 2005.


Zacks Investment Research
Image Source: Zacks Investment Research

However, as we’ve documented in a previous article, Microcaps have struggled the last few years with the rise in interest rates. As the graph below depicts, the annualized return for microcaps has now dipped to 6.26%. Our recent commentary also suggests that a consistent rate lowering environment may benefit microcaps and enable them to close this performance gap.


Zacks Investment Research
Image Source: Zacks Investment Research

Before we address the question of whether microcaps are a reasonable proxy for private equity, it is important to note their distinct differences, the discussion of which usually begins with “liquidity” and “valuation.”

Private Equity has a longer time horizon, usually 7-10 years, and is often predicated upon the hope of a major take-out event at a later date at a significant premium, as in either a sale or IPO. Because of this longer arc strategy, seed funding from investors is often “locked-up” from anywhere between 3-10 years. Thus, this is not an ideal investment vehicle for investors requiring quick liquidity optionality. Microcaps, on the other hand, offer daily liquidity, though sometimes more limited, as they trade on public exchanges.

In terms of valuation, private equity is more of a black box given that financials aren’t readily available like public stocks, and the valuation often is only revealed at the time of the IPO or sale. So, Microcaps have the advantage of real-time valuation transparency.

Another key difference is investor accessibility. The higher-performing private equity funds often require a substantial minimum investment, which makes them prohibitive for the average investor. Additionally, there is also a network effect in play that prioritizes deals for certain investors, namely accredited investors meeting certain criteria. And private equity typically utilizes leverage more aggressively, so interest rates are an important risk factor for the asset class.

So why not just invest in a private equity ETF? Because the devil is in the details. Private Equity ETFs typically invest in publicly traded private equity firms like a KKR or a Blackrock. These firms then make the investments in the private companies. So, in essence, this is a derivative play on private companies, not a “pure-play” on private equity, with limited information on the private companies.

Additionally, the larger publicly traded private equity firms invest heavily abroad, with typically less than 50% of their investments in the US. The private equity firms may also be investing more heavily in particular industries leading to concentration risk or companies with high debt levels. Or the private equity firm itself may use debt in combination with equity to fund investments. Investors may have specific opinions on economic conditions outside the US, certain industries, or debt and interest rates which may influence their decision-making process regarding private equity vs microcaps.

In conclusion, microcaps are a reasonable proxy for gaining exposure to the types of companies that private equity transacts in. Additionally, microcaps offer some distinct advantages over private equity, especially for the average investor. With the exception of the last three years, microcaps had been generating returns similar to private equity.

There may be an opportunity for microcaps to catch up in this recent underperformance if interest rates begin a steady path downwards, which we’ve previously commented on here. Investors should be reminded that microcaps are inherently more volatile and should be part of a balanced portfolio for risk optimization.

Below we highlight 3 microcap stocks for consideration with an Outperform rating which offer a flavor of private equity, though more of the growth equity variety vs. venture capital, as these are more established businesses.  

TAYD (Taylor Devices, Inc.) is a designer and manufacturer of shock absorption, rate control, and energy storage devices utilized in machinery, equipment, and structures. Backlog increased 8.8% YOY to $30.2 m. Taylor Devices, Inc. is benefitting from a successful expansion in the aerospace/defense vertical with an 88% YOY increase. We’ve previously cited the defense sector as potentially having new macro tailwinds here.

MCEM (The Monarch Cement Co.) is a manufacturer of portland cement and sells primarily in the Midwest to concrete mixer plants, building material dealers, and government agencies. The company is debt-free with $45.8 m in cash ($12.38/share) and owns raw material reserves of 50+ years. The Monarch Cement Co. should continue to benefit from Federal infrastructure spending, a macro theme previously highlighted here.

VLGEA (Village Supermarket Inc.) owns and operates a chain of 34 supermarkets serving NY, NJ, MD, and PA. The chain has been experiencing low single-digits same-store growth buoyed by growing digital sales and store renovations. Village Supermarket Inc. has net cash of nearly $50 m with a dividend yield of nearly 4%, which may appeal to income investors. Lastly, grocery stores typically can weather inflation better than other retailers due to less price elasticity with food items: they can more easily increase prices.

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