With their distinctive debt lever, private equity funds promise significant returns. This made them particularly attractive during the era of zero interest rates. Yet times have changed, and factors such as extremely lengthy capital commitments become problematic as interest rates rise. While exchange-traded micro caps now offer investors similar potential, they also boast greater transparency and liquidity, making them preferable to private equity in the new interest rate environment.
Under the umbrella term of private equity, the ‘expansion stage’ is a phase of corporate development that private equity (PE) funds often target. These products carry less risk than venture capital but offer greater potential than buyouts. Yet such high-growth companies also exist in the public equity market, particularly in the micro-cap segment. Although you could say they are twins, they are anything but identical. One thing both have in common is the potential to generate higher returns than large-cap equities. Both also require investors to have a high degree of specialisation and experience in order to achieve success.
During the zero interest rate years, private equity experienced a huge influx of investors who expected interest rates to remain non-existent for a very long time. This situation was turned completely on its head in the fourth quarter of 2022. Even the recent market stress surrounding Silicon Valley Bank and Credit Suisse is unlikely to change much for the time being. Instead, rising interest rates are weighing heavily on the expected returns of PE vehicles and prompting investors to turn their attention to alternatives.
Interest rates are critical for PE funds because they finance the purchase of their portfolio companies with high degrees of leverage and sometimes charge them the cost of borrowing. With the ECB key rate dropping below one percent back in June 2012, interest rates have been virtually irrelevant to PE funds for more than a decade. Now that money has a price once again, the high degree of leverage means this weighs heavily on PE fund returns as the interest burden of their portfolio companies rises.
The turning point in the PE cycle has begun
The earnings expectations for private equity investments are ambitious. According to the McKinsey Global Private Markets Review 2023, funds issued between 2009 and 2019 generated average returns of 20.1 percent, although there was a spread of 18 percentage points between the top and bottom quartiles. And then came the turning point. According to McKinsey, the average PE growth fund lost 7.3 percent in 2022 up to September. The Bain & Company Global Private Equity Report 2023 provides the outlook for the sector: “The move to raise interest rates led to a dramatic decline in deals, exits and fundraising in the second half of the year (2022), almost certainly signalling a turning point in the cycle.”
Nevertheless, the best PE funds will continue to generate good returns for investors. The only thing that is limited is access to originators with access to the best corporate deals, with very few investors able to participate in such funds. The vast remainder are still second-class providers with second-class company portfolios.
Micro caps and the corresponding funds are a different story, as any investor can access these on any given trading day. Around 1,500 micro caps with a market capitalisation of EUR 50 to 300 million are traded on Europe’s stock exchanges. If you expand this universe to include small caps worth up to EUR 1.5 billion, this adds another 1,000 stocks. The universe contains numerous companies who have sufficient liquidity on the stock exchange (albeit lower than large caps), who have experienced rapid growth in some case, and who largely operate off the radar of most analysts. This means the wider market is still completely unaware of their considerable potential. The early bird catches the worm, as they say.
The proof of the pudding is in the eating
PE funds often take a long and winding road to achieving their investment goals. As majority shareholders, they can influence the strategy and personnel of a portfolio company by serving on its supervisory board to ensure that the company develops in their preferred direction – and enhance its appeal for an eventual IPO or sale. The current trend is to be content with minority shareholdings and limited influence. By contrast, the fundamental stock picker operates differently. They can implement investment ideas from a large investable universe in which companies are subjected to deep and detailed analysis. As well as examining the annual and quarterly reports that listed companies are required to publish, they also maintain an intense dialogue with company management. This gives them the opportunity to invest directly in good growth stocks.
Micro caps offer greater transparency when it comes to valuation. Daily price determination enables investors to manage risk in a market-oriented way. Private equity, on the other hand, can spring unwelcome surprises about a company’s valuation in the next round of financing or, at the latest, when selling the company. The same rule applies here as in the kitchen: the proof of the pudding is in the eating. While micro-cap investors can part with a stock quickly in the event of unfavourable developments in the business, PE investments usually involve significant capital commitments over what is typically a period of seven or eight years. The outcome of such investments is uncertain. On the other hand, micro caps’ proximity to the market means they can always cause pain in the form of high volatility and pronounced drawdowns. Experience shows that micro caps are afflicted by marked losses even in risk-off phases – although they often go on to recover just as quickly. We saw this over the last year, as heavy losses caused micro-cap valuations to fall to considerably lower levels. This provided long-term investors with a good entry opportunity. The low frequency of valuations for PE funds means they did not really experience the same setbacks. Here, falling valuations and associated impairments and write-downs are still pending in some cases – with corresponding potential for negative surprises.
The question is whether high-growth micro caps can generate returns that can match those of private equity investments. If you add up the long-term market returns for small and mid caps and the alpha potential that comes with limited market transparency and active management, a concentrated portfolio of high-growth micro caps and smaller small caps can generate an above-average target return of more than ten percent. This allows investors to get very close to the target returns of the average PE fund without having to accept downsides such as lengthy capital commitments. As well as an intact growth story, it is important for target companies to have healthy balance sheet ratios, low net debt and solid earnings figures, in addition to softer factors such as the proportion of shares personally held by management (known as having “skin in the game”).
Going direct to the stock exchange is best
That leads me to a fundamental quality argument, namely that an IPO is usually the most lucrative exit for founders and early-stage investors. Companies with convincing products and business models that do not shy away from transparent communication readily accept the reporting obligations imposed by the stock exchanges. Companies who are not yet able to meet these requirements, however, are unable to make the leap to listing and continue to seek financing via PE capital before pursuing an IPO at a later date.
Finally, minimum investments in PE funds involve extremely high sums that have to be parked – safely and thus at low rates of interest – for years before they can be withdrawn from the fund when the company is sold. In the case of micro-cap funds, however, any amount can be invested directly into the target market. This is another reason why I believe these funds represent an adequate alternative to private equity, not only for institutional investors but also for private investors who still have considerable difficulties investing in the best PE funds. By contrast, micro-cap funds can be accessed easily from any local bank – or even more easily via online banking.