Microcaps seen as a new proxy for private equity

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Thomson Horstmann & Bryant (THB), an American microcap and small-cap manager, has set aside some of its precious capacity for Australian investors.

During his first trip to Australia, THB portfolio manager Christopher Cuesta, said last week that a lot of investors were starting to look at the microcap market as a proxy for private equity, but with better liquidity.

Microcap companies tend to behave differently to their big-cap counterparts. For instance, 60 per cent of the 1500 companies in the Russell Microcap Index universe in the US have no debt. When they do borrow, it will tend to be a revolving loan from a bank and be used for tactical purposes, such as a takeover, rather than for ongoing operations.

THB, which has been in business since the early 1980s, remains privately owned by about half of its 15 staff. Of the three founders, only William W. Bryant Jnr is still working at the firm. It has about US$1.7 billion under management, of which US$1 billion is in microcaps and the rest small caps. The company believes it has sufficient capacity to open up its microcap strategy to Australian investors through its third-party marketer Brookvine.

Microcaps in the US are more like Australia’s small caps. The Russell index includes companies with market caps of $50 million to $1 billion. TBH tends to focus on the smaller end, usually less than $500 million.

There is a paucity of microcap managers in Australia, even though the Australian share market has a much higher proportion of smaller companies than the markets of most other advanced countries. Acorn and Contango have the bulk of the tiny professional market.

The problem for the managers is working out how to make a microcap business pay its way. Capacity issues will usually limit a strategy to about $200-300 million in Australia. With an average fee of, say, 100bps, the firm will have maximum revenue of $2-3 million a year with which to employ in-house research, because microcaps are not widely researched by brokers, and other staff, with very little prospect for revenue growth unless the firm has performance fees. THB charges a flat 125bps with no performance fee.

So, the US market offers much more opportunity for Australian investors wanting to take advantage of microcap characteristics. And the returns possibilities are tantalizing. THB has outperformed the Russell index by more than 100 per cent since the current fund was launched in 1998 – 17.0 per cent a year versus the index’s 8.3 per cent, itself a very healthy number.

An interesting aspect of microcaps is their propensity to get taken over. They accounted for nearly 60 per cent of all M&A activity in the US over the past 20 years. Cuesta said 21 THB portfolio companies had been acquired since January 2011, at an average premium of 43 per cent and delivering an average return of 59 per cent.

He said that a rebound in M&A activity generally, from depressed levels of the past few years, could benefit the asset class and active management.

Something which managers need to be aware of with microcaps is the extra need for diversification. Microcap companies tend to have just a single line of business, whereas a large-cap company might have four or more massive divisions producing different goods and services.

But they also tend to have greater shareholder ownership by the board and management, typically second-generation founders, which means a better alignment of interests than a typical large company chief executive who will be a paid a higher salary and be rewarded, also, by options for which he or she may not have paid much, or anything, to purchase.

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