Back when I was a lad, liquidity – and its corollary, price discovery – were prized investment features. Active trading with real-time marks-to-market were generally valued by investors.
Since the global financial crisis, however, heads have been turned by eye-popping returns generated in private equity. Underpinned by the belief that the real money is made before a company goes public – the proverbial everyman has been clamouring for access to private alternatives –, the US Department of Labor paved the way for inclusion of alternatives in retirement.
While it’s tempting to attribute lucrative returns to sponsor acumen and/or to the private vehicle structure itself, most of the kudos should go to the zero interest rates that prevailed when these investments were made.
The ample capital readily available in the years following the global financial crisis and resulting low hurdle rates enabled private equity sponsors to acquire young and/or broken businesses and monetise their investments through sale to a strategic or financial buyer or to the public through initial public offerings.
Since the interest rate environment shifted higher in 2022, the cost of acquiring and building businesses has increased, as have the financing costs and return targets for subsequent buyers.
The private-equity model comes at a cost
While a long lockup period has been characteristic of private investment vehicles, the fundamental qualities of an investment ultimately underpin its returns.
Moreover, illiquidity can convey a false sense of security. The 2025 bankruptcies of Tricolor Holdings and First Brands Group surprised bankers and syndicated loan investors alike. A similar unravelling was seen at Renovo Home Partners. While these occurrences have been characterised as idiosyncratic, more systemic risk may become apparent over time.
Vintage matters. We would be surprised if the returns realised on private investments entered into today kept pace with those made between the global financial crisis and rate tightening in 2022, and expect the lure of private and illiquid assets to ease within the general investing populace.
Should private equity sponsors eventually be laden with investments they can’t monetise, redemption gates likely will go down, leaving investors barred from the exits. As the pendulum swings from one extreme to the other, liquidity may reemerge as the old, and more desirable, new thing.
Fundamentals remain our lodestar
As fundamental investors, we continue to believe that underappreciated earnings potential is the true holy grail and has historically been rewarded in the marketplace. For the past three years, small-cap earnings have been overshadowed by those generated by S&P 500 companies – especially the Magnificent Seven – which also were able to sidestep such small-cap challenges as access to capital and management depth. But there are signs that a recovery in small-cap earnings may at last be underway.
Among the most compelling potential earnings drivers are:
Technology-driven growth. Outsourced software and servicing may provide resources that enable small companies to scale their operations, improve efficiency and facilitate the conversion of some costs from fixed to variable, easing the need for working capital.
More specifically, artificial intelligence (AI) may benefit small-cap companies over a very long cycle. Pick-and-shovel suppliers to infrastructure and data centre construction, for instance, can expand their customer base without triggering incremental spending on research and development (R&D), thus supporting margin expansion. In addition to reduced spending on R&D and selling, general and administrative expenses (SG&A), AI may also enhance the development of superior products to drive pricing power.
Supportive trade and monetary policy. Prospective policy developments and lower interest rates could also bolster small-cap earnings. Although the domestic orientation of many smaller companies has provided some insulation against tariffs, additional relief on this front may come from the Supreme Court as it considers president Trump’s ability to impose tariffs under the International Emergency Economic Powers Act.
A resurgent IPO market. We anticipate the initial public offering (IPO) market to continue reopening, to the potential benefit of small-cap companies. With free money a thing of the past and meaningful hurdle rates, private equity sponsors are incentivised to monetise their investments through the public market, even if they are unable to realise previously hoped-for returns.
The past decade has generally favoured larger stocks
The 39.3% rally in the Russell 2000 index from its post-Liberation Day swoon through the end of November outpaced the S&P 500 index by nearly 300 basis points, and reminded us that the small-cap beast still has claws. Despite this recent show of strength, longer-term performance trends remain skewed toward large names. The relative performance of small-caps remains near previous cyclical troughs. Respecting the tendency for reversion to the mean, our confidence in eventual strong sustained returns from small caps – driven by fundamentals – remains firm.
Bill Hench is portfolio manager at First Eagle Investment Management. The views expressed above should not be taken as investment advice.