May 2023 Commentary

Over the past decade, there has been an increasing
demand for private equity fund investment as investors
have looked to diversify their portfolios and seek higher
risk-adjusted returns. The demand has created a multitude
of private equity funds – so much so that these funds are
now competing and bidding up the prices of potential
takeover targets. The preference of investors for private
equity funds over traditional small cap investing is puzzling.
While some private equity transactions can be large – the
Onex Corp $5 billion purchase of WestJet, for example –
most of the transactions tend to be smaller companies in
the early stages of development or undergoing a significant
transformation. More importantly, acquisitions tend to use
an LBO strategy (“leveraged buy-out”) which is an efficient
method of acquisition without investing much capital. The
book Barbarians at the Gate documents the LBO battle
between KKR, RJR management, and Shearson Lehman
Hutton for control of the company, leaving the eventual
company mired in debt. This type of investment introduces
exposure in the face of economic turmoil, evident during
the financial crisis of 2008. That leads to a higher degree of
uncertainty around the future prospects of the investment.
Private equity firms typically charge a management fee and
a carried interest, a share of the profits earned by the fund.
This can create a misalignment of incentives between the
private equity firm and its investors, as the firm may
prioritize its own interests over those of the investors. The
private equity firm may also have relationships with the
companies in which they invest, such as providing
consulting services or sitting on the board of directors,
which can cause conflicts of interest if the private equity
firm’s interests are not aligned with those of their
investors. The transparency of publicly listed small cap
companies avoids this disclosure issue.

Despite the frequent use of debt and recurrent
involvement with early-stage companies, private equity
funds are frequently referred to as less volatile than
traditional public market small cap investments. Yet,
private equity funds do not reflect ‘general market
conditions’ in their underlying investments – like the effect
of 2022 market conditions on public market equities – and
are typically calculated gross of performance fees
(including carried interest charges noted below).

Private equity funds have a long investment horizon up to
7-10 years and, during that time, investors’ capital is tied
up in the fund. Unlike publicly traded small cap securities,
which can be bought and sold on an exchange, private
equity investments are not easily tradable. Investors may
not be able to access their capital when they need it, which
can be particularly problematic during times of market
volatility or economic uncertainty. Which makes private
equity investing more suited to institutional investors with
long term liability structures but less so for individuals.
In conclusion, while private equity investing may provide
investors with the potential for high returns, it also comes
with its own set of risks. These risks include illiquidity, high
levels of leverage, conflicts of interest, and transparency.
We contend that institutional investors should place more
emphasis on the traditional small cap investment class,
which avoids many of these issues.

Small cap investing focuses on certainty – strong
management teams and competitive advantage, combined
with proven cash flow generation – to maximize the
potential investment opportunity. Investors typically
target companies with attractive free cash flow generation
to eliminate corporate debt over time, and charge
transparent management fees, typically a fraction of those
charged by private equity funds. Finally, with public market
liquidity, the investor can reduce their exposure when
markets become over-valued, as they did in 2021, or
increase exposure as markets begin to exit the trough, as
they are doing currently. By these measures, as a new
market cycle unfolds, investors should give more credence
to small cap investing.

Smaller companies will be key core equity investments
through the next market cycle. But more on that later.