Why Private Equity Is Making Small-Cap Investing Harder

Core Insights - Small-cap stocks are losing performance compared to large-cap stocks due to private equity and venture capital firms acquiring promising small companies that would have otherwise gone public [2] - A widening gap in quality between large-cap and small-cap stocks has been observed, with small-cap stocks showing weaker fundamentals in terms of returns on assets, returns on equity, net margin, and debt-to-capital ratios [2] - The trend indicates that many potential future large-cap stocks are remaining private, limiting opportunities for public investors [3] Performance Analysis - From 1991 to 2024, the US Small Cap Index lagged the US Large Cap Index by an average of 0.49% per year, resulting in a cumulative lag of 400% [3] - Small-cap stocks outperformed large-caps from the mid-1990s until around 2014, after which the growth of the small-cap index began to decline [3] Active Management Opportunities - A recent whitepaper suggests that it may be a time for active small-cap managers to demonstrate their value, although they face challenges due to limited access to high-growth potential small-cap stocks that remain in private markets [4] - Despite the challenges, small-cap managers have shown a median alpha of approximately 57% compared to their benchmarks from 1994 to 2024, while mid-cap and large-cap managers had negative alpha of about 15% each [5] Market Inefficiency - The small-cap market is characterized by inefficiency, with an average of only six analysts per small-cap stock, compared to 17 for mid-cap and 30 for large-cap stocks [5] - Over the past decade, a higher percentage of small-cap managers have outperformed their benchmarks compared to large-cap managers [5]