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Private equity funds typically invest in companies valued between $100 million and $2 billion, though some venture beyond this range. This valuation band often overlaps with microcap and small cap publicly traded stocks. Financial advisors or consultants may pitch private equity as a distinct “asset class” that enhances portfolio diversification through uncorrelated returns. Yet, when the underlying companies resemble publicly traded firms with comparable valuations, this argument loses steam.

In our view, wrapping a company in a fund—whether private equity, hedge fund, mutual fund, ETF, or whatever is the latest trend—merely changes its packaging. The core issue remains: understanding the risks and opportunities of the underlying businesses. All these vehicles ultimately invest in businesses, each carrying inherent business risks.

Smaller businesses, whether public or private, often offer higher potential returns to compensate for their greater risks. Investing in them through small or microcap stocks provides distinct advantages: greater liquidity if you need access to your capital, freedom from the often steep fees charged by funds, and the ability to control how much leverage, if any, you take on, rather than leaving it to a fund manager’s discretion.

Private equity funds often tout superior returns and low correlation to the markets, but we believe this is largely an accounting mirage.

First, their preferred metric, internal rate of return (IRR), is highly sensitive to the timing of capital calls. Private equity funds typically require investors to commit far more capital than they initially draw, charging management fees on the entire committed amount—even the unused portion. This capital, tied up and unavailable for other uses, creates a performance drag that IRR calculations conveniently ignore. In contrast, publicly traded securities rely on compounded returns, which account for the full capital committed to a strategy.

Second, since private equity portfolio companies aren’t publicly traded, their values are estimated by the fund’s management and adjusted only periodically. This creates the illusion of low volatility and market independence. In reality, if these companies were valued daily, their price swings would likely mirror the market’s. Infrequent updates don’t erase true volatility, they merely obscure it.

Beyond accounting tactics, private equity funds often boost returns by piling on debt. While the underlying business returns may be similar whether public or private, leverage can amplify gains. But this comes with skewed risks: if a company buckles under heavy debt and goes bankrupt, investors lose everything, while the fund management company still collected management fees in the meantime. Conversely, if leverage magnifies success, the fund’s performance fees eat into investors’ profits.

In our perspective, returns driven by debt don’t reflect genuine value creation.

Finally, private equity funds lack liquidity and your capital may be locked up for a long time. This especially hurts during economic downturns, when you may have the greatest need for liquidity or you might have the opportunity to buy attractive distressed assets but lack the liquidity to pay for them.

The lack of liquidity is an issue on the fund side as well. In a portfolio of publicly traded stocks, if industry trends, technology, regulations, or a myriad of things change in an unfavorable way, you can easily sell your stock. But selling a private company in the face of negative trends can be quite a challenge.

So why consider investing in a private equity fund when: 1) their reported returns may be inflated, 2) those returns aren’t directly comparable to publicly traded securities, 3) they don’t provide true diversification, 4) they charge hefty management and performance fees, 5) their gains often stem from leverage rather than skill, and 6) they lack liquidity?

A compelling private equity fund delivers value in ways a passive investor can’t replicate. It might uncover companies in industries absent from public markets, actively build businesses through synergistic acquisitions, or leverage a network of seasoned executives to turn around underperformers or scale thriving companies.

For example, one advantage private equity funds have that passive investors do not have is control. If management is underperforming, the fund can simply replace management. That is much more difficult, and often impossible, for investors in publicly traded stocks to do.

This ability to add value through control and active management is the key criteria to seek when evaluating a private equity fund. True skill is rare, but exceptional managers do exist, creating real value. Whether or not you find the right fit in the private markets, the public markets, including small and microcap stocks, offer abundant opportunities for the discerning investor.

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