In light of recent debates here on Seeking Alpha regarding Keating Capital (KIPO), we had the opportunity to speak with Tim Keating, the company's CEO, to receive his view of the company, as well as answer a variety of questions regarding the company's equity, portfolio, and investment philosophy. Based on our conversation with Mr. Keating, we believe that the market has misunderstood Keating Capital. With a discount to net asset value of over 20%, and with several catalysts set to materialize in the 2nd half, we believe that there is potential for double digit upside in the remainder of 2013 and 2014. Unless otherwise noted, financial statistics and managerial commentary will be sourced from Keating Capital's Q2 2013 earnings release, its Q2 2013 earnings call, its Q2 2013 earnings presentation, its latest 10-Q, or its 2012 10-K, as well as our conversation with Mr. Keating.
How is Keating Capital Different from Other Pre-IPO Investors?
Keating Capital is far from the only publicly traded pre-IPO investment company. There are several others, including GSV Capital (GSVC) and Firsthand Technology Value Fund (SVVC). Hercules Technology Growth Capital (HTGC) is also a pre-IPO fund, but with the bulk of its assets (over 92%) invested into loans to and debt of private companies, as opposed to their equity, the company's investment philosophy is different than that of these other pre-IPO funds. Unlike GSV Capital and Firsthand, Keating Capital, as a matter of policy, always purchases equity directly from portfolio companies, never from secondary markets such as SharesPost or SecondMarket. Mr. Keating outlined that this is due to the company's requirement that it be given access to all relevant financial data and managerial projections of its portfolio companies at all times, something that Mr. Keating believes is essential to being able to make informed investor decisions. We note that shares of Facebook (FB) and Twitter are conspicuously absent from Keating Capital's portfolio; the co! mpany declined to purchase shares of either company due to an inability to acquire direct financial information regarding these companies. In addition, Keating Capital has a stated goal of investing in the most senior equity securities available at each portfolio company.
Insiders & Institutions: Addressing Confidence & Perception
The first part of our conversation with Mr. Keating covered Keating Capital's insider and institutional ownership, both of which can be seen as issues of perception. Keating Capital's 10 largest (and perhaps only) institutional investors control just 3.21% of the company's outstanding shares. To some, this is seen as an issue of confidence. If investment professionals, who supposedly have far better access to research, advice, and information than ordinary investors are not putting up meaningful amounts of money into Keating Capital, why should ordinary investors? I asked Mr. Keating about this issue, and he responded that the company is taking steps to remedy the situation. Keating Capital's ability to communicate with institutional investors has been limited due to the presence of a registration statement with the Securities and Exchange Commission, which put the company into a quiet period. However, the company's registration statement was withdrawn in May 2013, freeing the company from this SEC restriction. Beginning in September, Keating Capital is planning to ramp up its communications with institutional investors, and plans to dramatically increase its participation in financial services conferences to expand awareness and broaden its potential shareholder base. Since listing on the NASDAQ in December 2011, Keating Capital's conference participation has been somewhat limited, an issue that the company will begin to rectify in September.
InvestmentNews' 2012 Alternative Investments Conference, October 23, 2012Security Research Associates' 8th Annual Fall Growth Stock Conference, October 30, 2012FBR's 2012 Fall Investor Conference, November 27, 2012! LD Micro'! s 5th Annual Conference, December 5, 2012Needham's 15th Annual Growth Conference, January 16, 201325th Annual Roth Conference, March 20, 2013JMP Securities' 12th Annual Research Conference, May 13, 201314th Annual B. Riley & Co. Investor Conference, May 20, 2013Since listing on the NASDAQ, Keating Capital has presented at just eight investor conferences, the first being almost a year after its listing. And for a company of Keating Capital's size, active investor outreach is a necessary activity. With a market capitalization of less than $58 million, and coverage from just two sell-side firms (Ascendiant Capital Markets & SeeThruEquity), Keating Capital is unlikely to be on the radar of many institutional investors, and we believe that many have simply not heard of the company, let alone passed judgment on its quality. The company's investor relations and communications campaign, once started, will also likely boost Keating Capital's daily trading volume (average daily volume over the last three months has been below 20,000 shares), enhancing the company's liquidity as well as its appeal to institutional investors. For some investors, Keating Capital's insider ownership may also present cause for concern. Per the company's 2013 proxy statement, the company's various directors and officers own a total of 167,970 shares, or 1.87% of the company's total outstanding shares. We pressed Mr. Keating on this issue, questioning the CEO if he believed that the company's insider ownership was too low, and perhaps more importantly, why company insiders have not been aggressively buying shares, given the discount they trade at to net asset value. Mr. Keating responded by noting that the company has been repurchasing shares at a fairly active pace, under its repurchase program that was launched in May 2012, authorizing the company to repurchase up to $5 million in shares. In 2013 alone, Keating Capital has repurchased over 200,000 shares of its common stock, for a total of more than $1.3 million. Mr. Keatin! g noted t! hat as a matter of policy, the company places heavy restrictions on the trading activity of its insiders (both purchases and sales) while buybacks are underway. SEC records largely confirm that this is the case, with most activity coming to a standstill. Since the company's buyback program was launched in May 2012, there have been a grand total of seven Form 4 filings at Keating Capital, often with months in-between each one, and we note that several of these are formalities, with no underlying transactions taking place. We note these 7 Form 4 filings below.
Purchase of 6,000 shares on August 1, 2013 by Director Taylor SimontonNotice of 25,123 share stake by former director Andrew Miller on June 10, 2013Notice of no stake by former CFO and Treasurer Stephen Hills on February 20, 2013Purchase of 2,000 shares on November 6, 2012 by Director Taylor SimontonPurchase of 3,500 shares on November 5 & 6, 2013 by COO, CCO, and Secretary Frederic SchweigerPurchase of 15,000 shares on August 17, 20, and 21, 2012 by COO, CCO, and Secretary Frederic SchweigerPurchase of 2,000 shares on August 17, 2012 by Director Taylor SimontonMr. Keating stated that the company's own worries about the issue of optics led the company to impose restrictions on insider activity, in order to prevent any appearance of conflicts of interest or impropriety. We also note that Keating Capital is not lavishing its executives with stock options that they simply turn around and cash in the very next day; with the commencement of its repurchase program, it is clear that almost all insider activity has ground to a halt, and it will almost certainly remain this way until at least November 8, 2013, when the company's repurchase program expires (although it may very well be extended, given that the company still has room to repurchase shares under it).
Valuation Methodology: Defending the Process
Keating Capital, like all other pre-IPO investment firms, cannot rely on the equity markets to ascribe a value to the privately hel! d compani! es within its portfolio, and must therefore categorize its investments as Level 3 assets. We do not believe that it is proper to question Keating Capital for merely using Level 3 valuation methodologies when its business model by definition requires it to do so. What can, and should be questioned is how rigorous and accurate the company's methods are. And in this regard, we believe that Mr. Keating has shown that the company's process is solid, both through a description of the process, as well as through historical financial statistics. The company's valuation process, as described in full detail in its latest 10-K, begins with Keating Capital holding a conference call with the management teams of its portfolio companies, alongside the provision of each company's most current financial statements, as well as management's financial projections. Each company is then compared to existing publicly traded peers, alongside various other metrics, and a discount is then applied for lack of marketability (as of the end of Q2 2013, the weighted average discount was 35% for preferred stock, and 23% for common stock). The company's valuation committee consists entirely of independent directors, and Keating Capital, as outlined in its 10-K, also enlists third-party valuation firms to review its process and results.
By their very definition, the process of valuing Level 3 assets is more art than science. Can investors ever truly be sure that the assets on Keating Capital's balance sheet are worth what the company says they are? The answer is that they cannot. However, that is something that applies to all such publicly traded investment firms. And we believe that to date, Keating Capital has shown that its valuation methodologies are fair, as evidenced in figures embedded within its current 10-Q. Through the end of Q2 2013, Keating Capital has had a total of 5 exits or IPOs of its portfolio companies, and with the exception of one company (which we will address below), each of Keating Capital's exits have been! done at ! valuations above where the company was valuing them in the quarter prior to the exit.
Keating Capital Exit Event Valuations
Company | Initial Cost | Value at Quarter Prior to Exit (IPO/Sale) | Value at Exit Event (IPO/Sale) | Prior Quarter Value as a % of Exit Event Value |
NeoPhotonics (IPO) | $1,000,000 | $1,550,000 | $1,760,000 | 88.07% |
Solazyme (IPO) | $999,991 | $999,991 | $2,032,686 | 49.2% |
LifeLock | $5,000,000 | $6,800,000 | $8,500,617 | 79.99% |
Corsair Components (SALE) | $4,000,080 | $4,992,000 | $4,675,397 | 106.77% |
Tremor Video (IPO) | $4,000,001 | $3,860,000 | $5,999,980 | 64.33% |
Each of the companies in Keating Capital's portfolio that have conducted IPOs have done so at valuations above the valuations ascribed to them in the quarter prior to their IPO. This track record implies that to date, Keating Capital's valuation methods have been sound. Why? The reason is due to the fact that the price at which these companies go public is beyond the control of Keating Capital. The offering price is determined by the portfolio company in conjunction with their bankers, who examine its financials, future growth rates, and the multiples ascribed to comparable publicly traded companies. If their valuation ends up being below the levels at which Keating Capital was holding the company's equity on its balance sheet, then this would be a strong implication that there are flaws in Keating Capital's valuation process. However, to date, this has not been the ! case, wit! h the exception of Corsair, which we believe is a special situation. Corsair was set to go public in May 2012, cancelled its IPO at the last minute on May 24, 2012, citing "weak equity market conditions." In reality, the cancellation of the IPO was due to the Facebook IPO debacle, which had essentially frozen the IPO market. In May 2013, Keating Capital disposed of its stake in Corsair after the sale of a majority stake by the company to private equity firm Francisco Partners. Had Corsair completed its IPO, we believe that the prior quarter value of the stake would have been lower on a percentage basis, and believe that Corsair should not be interpreted as a commentary on the overall rigor of Keating Capital's methodology, given that Corsair happened to attempt an IPO just days after that of Facebook.
The Portfolio: Another Win After the Quarter's Close
On August 15, Millennial Media (MM) announced the $225 million takeover of Jumptap, one of Keating Capital's portfolio companies, which the company invested $5 million into. As part of the takeover, Keating Capital will receive $8.75 million of Millennial Media equity (equivalent to a return of 1.75x), and we note that this is based not on Millennial Media's closing price at the time of the takeover announcement, but on its price at the closing of the deal. The exact number of shares Keating Capital will receive depends on the average closing price of Millennial Media in the 5 days prior to closing. Therefore, should shares of Millennial Media fall between now and October, when Mr. Keating estimates that the deal will close (officially, the transaction is expected to close in Q4 2013). 33% of the shares Keating Capital will receive will be eligible for resale 90 days after the takeover closes, with the remaining 66% eligible after 180 days. In addition, 10% of the shares will be held in escrow for 1 year as "partial security for potential stockholder indemnification obligations." Jumptap is Keating Capital's 6th portfolio ! exit (def! ined as either a sale or IPO). We note that in keeping with Keating Capital's valuation track record, the company's Jumptap stake was valued at $5.38 million as of the end of Q2 2013, or 61.49% of its exit value. With the removal of Jumptap from its portfolio, Keating Capital is left with a portfolio of 15 private companies, the largest of which is a $6.68 million position in SilkRoad, a provider of human resource software and services. Keating Capital invested a further $1 million into SilkRoad on August 22, 2013.
We note that Keating Capital's co-investors in many of its portfolio companies are not simply other venture capital or existing investors, but strategic investors as well. Examples include Agilyx, where Waste Management (WM) is a co-investor, BrightSource, where Chevron (CVX) and BP (BP) are co-investors, Kabam, where Google (GOOG) and Intel (INTC) are co-investors, or Tremor Video (TRMR), where Time Warner (TWX) is a co-investor. As of the end of Q2 2013, 9 (excluding Jumptap) of Keating Capital's portfolio companies had unrealized gains, with an average gain of 25.6% (again excluding Jumptap, which had unrealized gains of 8% as of the end of Q2 2013). The remaining 6 companies had an average loss of 44.46%. However, on an overall basis, Keating Capital's portfolio currently has an average unrealized gain of 2.15%. While this is not a large gain, we note that the bulk of Keating Capital's profits are realized upon exiting an investment in conjunction with the portfolio company's IPO or sale. Furthermore, portions of Keating Capital's portfolio are defended by structurally protected appreciation clauses that the company has struck with its portfolio companies, clauses that are not reflected on its balance sheet. These clauses, which are negotiated between Keating Capital and its portfolio companies, allow the company to receive shares in the portfolio company's IPO at a discount, or grant it warrants to purchase additional shares in an IPO for a nominal price. Since inception, Keating C! apital ha! s negotiated structurally protected appreciation clauses in 11 of the 20 companies it has invested in. As of the end of Q2 2013, 6 of Keating Capital's 15 portfolio companies were protected by structurally protected appreciation clauses, representing $22 million in total capital (almost 43% of the company's invested capital), thereby entitling Keating Capital to a weighted-average aggregate value of 1.9x its investment at the time of an IPO.
With $18.5 million in cash on its balance sheet, Keating Capital is poised to expand its portfolio. Our conversation with Mr. Keating covered the company's planned course of action, and he stated that Keating Capital plans to make between one and three new investments by the end of the year (exclusive of the SilkRoad investment on August 22, which was announced prior to our conversation), with the bulk of the company's existing capital going towards new companies. On a long-term basis, Mr. Keating wants the company's portfolio to be equal weighted, with a 5% allocation to 20 different companies, in contrast with the approach taken by other pre-IPO investment firms such as GSV Capital and Firsthand, where Twitter alone accounts for 15.14% and 10.5% of assets respectively.
Investment Fees: Merely Average
Much has been made over Keating Capital's fee structure, and suggestions that company executives are using it as a "personal ATM" to funnel shareholder money to Keating Investments, Keating Capital's investment adviser (Keating Capital is an externally managed business development company). However, Keating's fees are not exorbitant, at least in comparison to the industry average. Per data sourced from Triangle Capital (TCAP), the average externally managed BDC has a management fee of 1.75%-2% of gross assets, and an incentive fee of 20%. Keating Capital's fee structure includes a 2% management fee, and a 20% incentive fee, in line with the industry average. The formula below represents Keating Capital's incentive fee:
(click to enlar! ge)
We note that to date, no incentive fees have actually been paid out to Keating Investments, Keating Capital's investment manager. As the company states in its latest 10-Q,
"As of June 30, 2013, no incentive fees related to our cumulative net realized gains of $4,682,381 would be payable to the investment adviser since the total unrealized depreciation (or write-downs) of $6,893,325 exceeds our cumulative net realized gains. Accordingly, our investment adviser will not be paid an incentive fee, despite the accrual of incentive fees in our financial statements under generally accepted accounting principles, until our cumulative net realized gains exceed our total unrealized depreciation (or write-downs) and, in such case, the incentive fee would only be paid on the amount of the cumulative net realized gains in excess of our total unrealized depreciation (or write-downs)."
Per the terms of the Investment Advisory and Administrative Services Agreement signed by Keating Capital and Keating Investments, Keating Investments will not actually receive any of the incentive fees that have accrued on Keating Capital's balance sheet (a total of $1,212,038 as of June 30, 2013) until the company's net realized gains exceed its total unrealized depreciation. And we note that Keating Capital's net asset value per share of $7.79 (the company currently trades at a 22.68% discount to NAV, based on its August 29 closing price of $6.35) already accounts for accrued inventive fees, as this accrued liability is taken into account when calculating net assets. We also note that Keating Capital does not record an expense for incentive fees in every quarter. For example, in Q2 2012, Keating Capital recorded an incentive fee benefit of $9,709 on its income statement due to the fact that net unrealized appreciation decreased by $319,247 during the quarter, and net realized capital gains came in at $270,701. M! athematic! ally, 20% of the spread between those two figures is $9,709. And during Q2 2013, Keating Capital booked $266,924 in incentive fees, due to the following: a $3,065,557 decrease in net unrealized appreciation, offset by an increase in cumulative net realized gains of $4,400,178. The spread between these two figures is $1,334,621, 20% of which is $266,924, equal to the incentive fee expenditure recognized by the company in its latest quarter. Keating Capital's fee structure is not, in our view, materially different than that of many other externally managed BDCs, and we reiterate that to date, no incentive fees have "gone out the door" to Keating Investments.
Conclusions
We believe that Keating Capital is misunderstood, and that there is double digit upside potential embedded in shares of Keating Capital as its discount to net asset value begins to close. The fact that Keating Capital fell 0.3% after the takeover of Jumptap was announced speaks volumes. The company stands to make a profit of 75% on the sale of Jumptap and yet the company's shares did not react to this development. Keating Capital is under-followed in the sell-side community, and as Keating Capital begins its outreach campaign in September, the liquidity and trading volume of its common stock will likely increase. That, alongside the outreach campaign itself, will likely lead to increased institutional awareness of the company and its strategy. With one exception (the nuances of which were highly specific), Keating Capital has demonstrated the soundness of its valuation methodology, as every single portfolio company that has completed an IPO has done so at a valuation above where Keating Capital had been valuing it in the prior quarter. The company's fee structure is in line with that of the broader BDC sector, and the company has been actively repurchasing its shares. And Keating Capital's portfolio is stronger than it appears, thanks to the presence of structurally protected appreciation clauses in 6 of the company's! 15 portf! olio companies (as of the end of Q2 2013). In our view, Keating Capital is undervalued at present levels, and for risk tolerant investors, we believe that shares are worthy of consideration heading into what we believe will be a material rest of 2013 and 2014.
Disclosure: I am long KIPO, GSVC, SVVC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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