About the author: Patrick McDonough is a managing director and portfolio manager for PGIM Quantitative Solutions, an affiliate of PGIM, the global asset management business of Prudential Financial.
Smaller companies, often just getting off the ground, running with limited earnings but brimming with new and innovative ideas and seemingly unlimited upside potential, are the highlights of a typical private equity sales pitch. However, microcap stocks, particularly in the U.S., are an often-overlooked segment of the market that give exposure to companies with that same incredible growth potential. In fact, the return profiles for microcaps and private equity have essentially mirrored one another for more than a decade, with an important recent exception.
Today there are three critical factors that set microcaps apart from, and, in our opinion, above investing in private equity: valuations, opportunity, and liquidity.
Valuations
Private equity has dominated the market for startups over the past decade. Until recently, near-zero interest rates supported an easy-money environment that led to huge inflows into the asset class. With a seemingly endless amount of cheap credit, private equity deals surged, and so did valuations in that space. But the economic backdrop of the last two years has changed the landscape. Inflation surged to its highest level in over four decades, and the Federal Reserve aggressively raised interest rate hikes. It’s not clear when the Fed might begin to lower rates. Those shifts have led to sharply higher borrowing rates for private equity. At the same time, dealmaking has slowed, leaving PE firms holding a record $2.59 trillion in cash reserves as they struggle to sell out of previous deals, according to S&P Global Market Intelligence. All of which points to an important question: Where might the better return potential lie between the two asset classes?
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Here’s how we see it: The correction in the equity market due to recession fears in 2021-2022 led to a similar downward adjustment in microcap valuations. But the same can’t be said for private equity, which leads to a few observations. Most interesting is the question of whether the growth potential for microcaps is now cheap. As of mid-April, investors are willing to pay huge multiples for mega-cap growth but are ignoring opportunities in microcap growth. In addition, the Fed has not started rate cuts and U.S. consumers are holding up, meaning the most likely, worst-case scenario is a slowing U.S. economy, which implies near-term growth will be at a premium. Investors in search of emerging companies at early stages of development with high-growth potential are likely to have better success in microcaps, where valuations have generally rebalanced, than in private equity, where valuations remain sky-high.
Opportunity
How might that potential upside play out? One option is in the health care sector, specifically biotech companies, which are a large component of microcap indices. Reporting from Bloomberg suggests higher rates have impacted available funding for biotechs. At the same time, the cash balances of large, established Big Pharma companies are at near-record levels.
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Over the past decade, huge capital infusions into health care startups resulted in an immense amount of early-stage research available for established pharmaceutical companies. Buying cheaper, smaller and publicly available names provides a great starting point for spending some of the built-up capital Big Pharma is sitting on. Given that big fish like to eat small fish, there’s huge potential for mergers and acquisition activity, even amid an overall deal slowdown. All this to say that microcaps are likely to benefit given that stock prices of acquisition targets generally rise. We suspect companies that are already public, with information readily available and listed share prices, are likely to be a priority over the onerous paperwork needed to buy multistage, private startups. It’s easier, cheaper to implement—and remember, already at a revalued price.
Additional industries are poised to benefit as well. Think food products, for example, or other names across the consumer staples sector, where companies are looking for more exposure to consumers’ wallets. Additionally, if core inflation, especially consumer inflation, falls as quickly as markets expect, consumer-focused companies should see strong performance.
Liquidity
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When it comes to liquidity, microcaps outshine private equity as well. With a protracted lock-up period, usually between seven to 10 years, and capital calls and return of profits entirely determined by private equity managers, PE devours liquidity. Particularly for plan sponsors and other institutional investors, the ability to access daily liquidity is often a necessity, which public markets provide. Daily liquidity has soared since 2019, specifically for microcaps, and remains at high levels, clearing a path for institutional investors to invest in emerging companies at early stages of development.
Here’s the deal, in a nutshell: With interest in exposure to emerging companies with substantial growth potential rising, the microcap space looks to be an attractive area for institutional investors, especially given the high valuations and high current cash reserves of PE. Microcaps have historically offered a similar return profile to private equity, but with far greater liquidity. The current market landscape could lead to substantial upside opportunities for microcaps, which, when combined with their attractive valuations, leads us to believe that now is the time to consider an allocation to the asset class.
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