Even though the private equity craze has settled down recently, there's been more than $3.5 trillion worth of merger activity this year. And there are still a few weeks left!

Despite the drying up of the cheap credit that private equity firms largely used to purchase companies over the past few years, the market continues to see industry consolidation activity. Witness IBM (NYSE:IBM) acquiring Cognos (NASDAQ:COGN) this week and SAP (NYSE:SAP) picking up Business Objects (NASDAQ:BOBJ) last month.  

In addition, other megacap companies, like General Electric (NYSE:GE) and Oracle (NASDAQ:ORCL), are sitting on piles of cash that they could use to purchase attractively priced smaller companies.

Shareholders of an acquired company typically receive some nice premiums, especially for this year's buyouts. For instance, Wild Oats shareholders enjoyed a 20% premium on their shares from the Whole Foods acquisition. Hilton shareholders saw a 26% jump on the next trading day, right after the Blackstone offer hit the newswires after-hours on July 3.

Sounds great, right?
Hey, no one's going to complain about a quick double-digit gain, but for small-cap investors, there may be a dark cloud over many of these deals.

Because small caps have huge growth potential, a public or private buyout may cut off what could have been a portfolio- (and perhaps life-) changing stock.

What if Intuitive Surgical (NASDAQ:ISRG) and Core Laboratories -- both of which were small caps in 2002 -- were acquired in November 2002 for a small premium? What may have been a good deal at the time would have stripped investors of the subsequent 1,871% and 1,267% returns that these companies have posted.

Chuck Royce, manager of the Royce Premier Fund (RYPRX), summed up this sentiment nicely in a recent interview:

If a company is taken private at a 15% to 20% premium, it looks like a great short-term benefit. But it gives pause to small-cap investors like us, who employ a fundamentally driven, business-buyer's approach and often own companies for five to 10 years, if not longer.

Wise words from the man who has steered the Royce Premier Fund to 13% annualized returns over the past decade.

Between a rock and a hard place
Private equity buyouts and mergers are an integral part of small-cap investing. And let's face it, the next small-cap buyout is coming soon -- big money is finding a ton of value in small companies. But that doesn't mean you should go out and try to pick the next buyout.

As a small-cap investor, you should continue to look for financially stable, well-run companies. If you can find value in promising small caps, a buyout would simply prove your thesis right. As for where to look, follow Royce's three precepts:

  1. Focus on small companies.
  2. Employ a fundamentals-driven, business-buyer's approach to small-cap investing.
  3. Plan on holding for five to 10 years, if not longer.

And mix those maxims with three teachings from Motley Fool Hidden Gems, where eight companies from Tom Gardner and Bill Mann's picks have since been acquired:

  1. Hunt for cash-rich balance sheets.
  2. Look for top-flight managers (who preferably have an ownership stake in the company).
  3. Buy businesses with a wide market opportunity or a valuable product roster.

We've employed these principles at Motley Fool Hidden Gems, with good results thus far. Our picks are beating the market by 32 percentage points since our inception four years ago. If you'd like to see the companies we've selected for subscribers, follow this link to a free 30-day trial.

This article was originally published June 12, 2007. It has been updated.

Fool contributor Todd Wenning is firmly convinced that Guitar Hero is the greatest video game ever made. He owns shares of Core Labs. Royce Premier is a Champion Funds selection. Whole Foods is a Stock Advisor recommendation. Intuitive Surgical is a Rule Breakers choice. The Fool's disclosure policy is never for sale.