Over the past decade or so, investors — particularly institutional investors — have focused more and more on private equity as a way to get exposure to small, potentially high-growth companies. But in a recent research paper, O’Shaughnessy Asset Management’s Chris Meredith and Patrick O’Shaughnessy explain why microcap equities in many cases are a more attractive alternative to private equity.
Meredith and O’Shaughnessy note that private equity investments offers several advantages, including access to smaller companies, diversification, and better total return. But, they say, “Microcap equities provide similar advantages but without the baggage of illiquidity, highly uneven returns, and higher, complicated fees.” They note that while institutional investors’ allocations to private equity on average have jumped over the past decade, the increase has been driven by the largest institutions. “For many investors, illiquidity means private equity is often too restrictive,” they say. “For example, many endowments have been unable or unwilling to build their allocation to the asset class.” They look at a couple different portfolio scenarios that show how much more quickly microcap investments can be liquidated than private equity investments, if need be. “The vast majority of these portfolios could be liquidated in a week — a far cry from the multiyear lockup required by many private equity funds,” they say.
Meredith and O’Shaughnessy also note that historically, the range of private equity fund returns has been significantly greater than that of microcap fund returns. Looking at the five-year period that ran from 2006 through 2010, they show that the top quartile of private equity funds produced a return of 14.6%, while the bottom quartile was just 5.0%. In contrast, the top quartile of microcap funds for the five-year period ending in March 2014 returned 34.0%; the bottom quartile return 27%.
Meredith and O’Shaughnessy also talk about how microcap fees are lower and less complex than private equity fees. And they look at how investing in attractively valued, fundamentally sound microcaps can offer even better returns than investing in the average microcap.