3 Ways Private Companies Are Reshaping Public Markets

Key Takeaways

• The growth of private capital is forcing a rethink of the small-cap investment case.
• High-growth-potential companies are remaining private rather than entering the public market as small-cap stocks, if at all.
• Public firms are increasingly being taken private, and at higher prices.
• Private firms are competing more aggressively with public firms for business, shifting the competitive landscape in some industries. Small companies are most vulnerable to increasing competition.

Private markets are fundamentally transforming public markets in the United States. A surge in private capital flows is keeping some high-growth-potential companies private for longer, intensifying business competition among public and private firms, and causing more public companies to be taken private. This is shifting the investment landscape, but the effect is most acute on small-cap stocks because smaller companies have weaker fundamentals and fewer competitive advantages compared with larger firms.

Small-cap stocks have underperformed large-cap stocks in recent years. In fact, the Morningstar US Small Cap Index lagged the Morningstar US Large Cap Index by 49 basis points annualized, or 401% cumulatively, from 1992 through August 2025. That underperformance gap has widened to 6.2% annualized over the past 10 years. The small-cap index was much more volatile during both periods. This goes against the long-held belief that riskier small-caps should compensate investors with higher returns.

One argument suggests that the growth of private markets has dented the upside of small caps. If true, a core thesis of small-cap investing, that “tomorrow’s big stocks are today’s small stocks,” will be moot. Increasingly, tomorrow’s huge stocks are already big. And tomorrow’s big stocks may never exist as a small-cap public company.

There are nuances to consider, though. Small-cap performance has historically gone in and out of favor, so it’s unclear if the recent past was just another drought or a more meaningful shift.

New Morningstar research examines the evolving landscape, small-cap underperformance, and if investors should rethink their allocations to small-cap stocks and funds.

How Private Markets Are Transforming Public Markets

The growth of private capital is forcing a rethink of the small-cap investment case. There are three primary ways in which private markets are reshaping small-cap investing:

• Venture capital funding is keeping high-growth-potential companies private, allowing a meaningful portion of their growth to accrue outside the reach of most investors.
• Small-cap stocks are increasingly being taken out of public markets by private equity firms.
• Record venture capital and private equity funding is causing private firms to compete aggressively with public firms, shifting the competitive landscape in some industries.

President Donald Trump’s August 2025 Executive Order, aimed at broadening access to private markets, could accelerate these effects, too.

The result is a reduction in the number of public companies eligible for small-cap stock indexes, and a deterioration of the aggregate growth potential and relative quality of those companies. As shown below, the fundamental metrics of the Morningstar US Small Cap Index have deteriorated rapidly relative to the large-cap index based on a composite quality score. This contributes to bleaker sentiment among the small-cap cohort and likely to some of the underperformance observed earlier.

Are Promising Companies Staying Private?

Anecdotally, it’s clear that venture capital funding keeps promising companies private for longer and at high valuations. Some of the most consequential companies today have never traded in public markets but are larger than most public companies. According to PitchBook data, OpenAI was a $300 billion company as of its March 31, 2025, valuation. SpaceX was a $400 billion company as of Aug. 13. Anthropic was a $183 billion company as of Sept. 2. The list goes on. If publicly traded, any of these firms would be top holdings in the Morningstar US Large Cap Index.

The data is starting to turn, but it doesn’t completely support the idea that promising companies aren’t going public. PitchBook reported that 167 US companies went public between 2022 and 2024, and 2021 saw a record 313 initial public offerings from venture capital- or private equity-backed firms. And already in 2025, there have been several notable IPOs, including Figma FIG and Circle CRCL, both of which surged on debut. The chart below shows these trends since 2006.

What these anecdotes miss, however, is that most of the IPO activity remains further down the market-cap ladder. Big IPOs get the headlines, but dozens of small-cap companies still go public every year, refuting the idea that the IPO market has dried up completely. The challenge for small-cap investors is that the highest-growth-potential IPOs may never exist as a small-cap company. Figma and Circle both traded at market caps above $50 billion on their first day being public, for example. And if any of the top holdings in the Morningstar PitchBook Unicorn 30 Index went public, few or none would debut in small-cap territory.

Public Companies Taken Private

Another area where private capital is distorting the small-cap investment landscape is the emerging trend of small-cap stocks being plucked out of public markets by private equity firms. The chart below shows the number of public companies taken private and their median post valuation since 2006.

Public companies rarely go private, but it’s happening more often than it used to, and the companies taken private are larger than they used to be. The effect on the small-cap investment universe is minor for now, but as private equity balance sheets expand, it’s likely that small-cap private companies will increasingly be the targets of leveraged buyouts. And once bought out, the cash infusion may intensify competition with public competitors, stealing business away from those with fewer competitive advantages.

Recent US policy changes could be a tailwind. According to the Investment Company Institute, Americans held $8.7 trillion in 401(k) plans as of March 31, 2025. This is an enormous and untapped market for private equity companies. Even a slight uptick in private equity adoption in 401(k)s would represent a windfall for private equity funding, which is already large and growing. The White House’s Aug. 7 Executive Order could spur more deals and potentially lead to more public company buyouts by private equity firms needing to deploy new funds.

A Note on Private Market Returns

If private markets are holding small-cap stock returns back, it’s unclear if that translates to private market outperformance. If it does, then those private market returns are likely out of reach for most.

Research finds great variability in private equity and venture capital returns, so even if “average” returns look decent, achieving the average return is likely impossible. Steven Kaplan, Robert Harris, Steven Neil, and Tim Jenkinson found in their 2015 paper, How Do Private Equity Investments Perform Compared to Public Equity?, that private equity did outperform the S&P 500 on average, but the returns had a heavy positive skew, meaning a select few outperformed by a wide margin. Fund and security selection is even more important in private equity and venture capital than it is in public markets because of the skewed distribution of outcomes.

How to Position Your Portfolio in the Evolving Landscape

As private capital continues to encroach on public capital, investors should be prudent. Small-cap valuations remain low on average, and there are still opportunities in that market, but investors should be deliberate in their selection of small-cap stocks and small-cap funds.

Higher-quality small-cap stocks have extended their lead and should continue to outperform lower-quality small-cap stocks, since profitable businesses are likely better equipped to weather intensifying competition. Many active small-cap fund managers are focusing on higher-quality companies, identifying take-private targets, and evaluating the public and private competitive landscape of each industry they invest in. Small-cap index fund investors should prefer larger (by average market cap) and higher-quality strategies. The Morningstar Medalist Rating for funds rewards index funds like these with Silver or Gold ratings. These types of small-cap index funds hold stocks that are the least likely to be adversely affected by the shifting landscape. At least not yet.

Get the full report: How Private Companies Are Reshaping Public Markets.