There was $4.38 trillion of global merger activity last year, and while that number may decline in 2008, the deals will undoubtedly keep on coming. One needs to look no further than CME Group's (NYSE: CME) recent offer for NYMEX Holdings (NYSE: NMX) for proof of this trend.

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 International Paper (NYSE: IP) acquiring Weyerhaeuser's (NYSE: WY) packaging business.

In addition, other megacap companies, such as UnitedHealth Group and Intel, are sitting on piles of cash that they could use to purchase attractively priced smaller companies.

Shareholders of the acquired company typically receive some nice premiums, and this has been particularly true of this year's buyouts. For instance, Wild Oats shareholders received a 20% premium on their shares from the Whole Foods (Nasdaq: WFMI) acquisition. Hilton shareholders saw a 26% jump on the next trading day 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 26% 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.

Consider: What if Frontier Oil (NYSE: FTO) or American Tower (NYSE: AMT) -- both of which were small caps in 2003 -- were plucked by private equity or a blue-chip firm back in March 2003 for a small premium? What may have been a good deal at the time would have stripped investors of the subsequent 623% and 697% returns, respectively, that these companies have since posted.

Chuck Royce, manager of the Royce Premier Fund (RYPRX), summed up this sentiment nicely in a June 2007 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 12% 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, all you can do is continue to look for financially stable, well-run companies. If you can find value in promising small caps, a buyout would just prove your thesis right. As for where to look, follow Chuck Royce's three precepts:

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

And mix those with three more from Motley Fool Hidden Gems, where Tom Gardner and Bill Mann have had eight companies from their scorecard 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 employ these principles at Hidden Gems with good results thus far: Our picks are beating the market by 19 percentage points since our July 2003 inception. If you'd like to see the companies we've selected for subscribers, a trial is free for 30 days.

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 does not own shares of any company mentioned. UnitedHealth and Intel are Motley Fool Inside Value picks. UnitedHealth and Whole Foods are Stock Advisor picks. Royce Premier is a Champion Funds selection. The Fool's disclosure policy is never for sale.