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I was drawn to look at Keating Capital (KIPO) after my review of GSV Capital (NASDAQ:GSVC) as an investment here.

Both are registered as business development companies and can be considered closed-end equity funds that invest in private companies. Both are trading at a significant discount to NAV, which is favorable considering that the IPO market, a source of investment exit for these companies, has been doing decently of late. Yet, it is also during the course of performing due diligence on Keating Capital that I realized how different these two companies are. Note also that I have had the chance to speak with Keating Capital's CEO on a call, and some of the following points were inferred from the conversation.

Background

GSV Capital has roughly 2.5 times the market capitalization of Keating Capital, and taking Yahoo! Finance's 3 months average volume, the former is 15.6 times more liquid than the latter. Basically, this shows Keating Capital to be a more undiscovered stock, which makes perfect sense.

On the GSVC side, you have a growth guru with portfolio holdings of Twitter, Facebook (NASDAQ:FB), Dropbox, GILT Groupe and other well-known names (regardless of how they perform as investments). On the other hand, you have a company trying to capture the liquidity premium that exists before a private company goes public, and whose better-known names include LifeLock (NYSE:LOCK) and Solazyme (NASDAQ:SZYM) (I had personally never heard of ANY of their portfolio companies before I began researching). It just goes to show that growth is sexy, and arbitrage? Bleh!

Nevertheless, throughout the course of due diligence, I have been impressed with KIPO management's disciplined and focused attitude toward their investment mandate. I believe they are more risk-averse than GSV Capital, and hence, manage their exposure much better. In fact, instead of thinking of them as an entity that invests in private companies like GSVC does, I would look at them as a single strategy fund not so different from a merger arbitrage fund or special situations group. Each company is in the portfolio because there is a perceived catalyst that will occur within the next one to two years; that catalyst is the IPO.

The strategy is, in my words, liquidity arbitrage. According to KIPO,

We specialize in making pre-IPO investments in innovative, emerging growth companies that are committed to and capable of becoming public. We provide investors with the ability to participate in a unique fund that allows our stockholders to share in the potential value accretion that we believe typically occurs once a company transforms from private to public status.

Together with a tagline of "buy privately, sell publicly, capture the difference", I believe it is clear what they do. I will highlight the pertinent points that separate Keating Capital from GSV Capital.

Clear Investment Mandate

Keating Capital does one thing, and one thing only; they find solid companies that are capable and committed to go public in the next one to two years, determine how much they might be worth on the public markets and how stable the revenue generation is, and acquire a stake at a 50% discount to that perceived value (Keating's CEO was adamant that this margin of safety be present in prospective investment opportunities due to the unseasoned nature of these private companies). They then advise and work with the companies to go public, generally targeting to exit their position within 3 years.

The requirements that a potential investment candidate should possess are also pretty stringent. Taken from their website, these include:

  • Revenue: $10 million+ in trailing 12-month period
  • IPO Timing: Within 18 months (from their investment date)
  • Return Potential: Expectation of 2x return over an anticipated 3-year holding period. If investment horizon is less than 3 years, targeted returns may be correspondingly reduced.

Mr Keating notes that KIPO invests strictly in companies with enterprise values between $100 million to $1 billion. Companies below that range probably present too much risk, and companies valued greater than that (like Twitter and Facebook before IPO) have a tendency to already be fully valued in the private marketplace and would therefore be difficult to acquire at a 50% discount to intrinsic value, which is absolutely critical to securing a margin of safety and limiting down-side losses. Since the type of growth companies Keating Capital invests in would likely be valued at 3-10x revenue as public companies, this implies that a company with a $100 million private enterprise value would generally be required to have minimum revenue of $10million ($100 EV/10x EV/Rev = $10).

I would like to contrast that with GSV Capital. Although GSVC seem to imply that it is targeting the same segment of private companies (EV between $100M ~ $1B), it holds companies that exceed that spectrum both above (Twitter, their largest holding, is an obvious example here) and below (It is my belief that they provide seed capital to a few of their smallest holdings). They do not require the companies be generating revenue at the point of investment, and this means that, although the company could have a good product or idea, they may have no route to monetize them. This was pointed out by meridian6 in my previous article:

I don't get why so many companies get funded with no business of being there. There are too many start-ups with a cute product, but that doesn't make a business.

The contrast is stark also in terms of position sizing. Keating Capital, as an arbitrage-focused fund, aims to hold no more than 20 positions with each position constituting less than 5% of assets, spreading risk evenly. In contrast, GSVC currently has 47 positions, even though its top 10 positions comprise more than 70% of its portfolio.

Due Diligence Process

I start off this section by noting that I do not know what GSV Capital's due diligence process is like, and so, certain assumptions may be totally false.

I realize over the course of researching KIPO that they strongly emphasized their access to portfolio company's financial information (quarterly and annual statements). As Keating Capital generally acquires preferred stocks directly from the target company, they are able to negotiate within these investor rights agreements the right to have access to financial reports, both at the time of the investment and on an ongoing basis. This implies also that common stock holders of private companies are usually not privy to such financial information, as is evidenced when Keating Capital's preferred stock in Livescribe was converted to common shares and they lost access to the right to receive the same level of information of that holding. I did not know this, and had previously assumed that private companies are required to at least provide their investors with financial information.

Looking back at GSVC, it became pretty evident that some of their investments might have been made without full access to the company's financial data. Their website attests to this as well, stating that their

strategy is to utilize the private marketplaces like SharesPost and SecondMarket to acquire shares in companies.

Therefore, although a majority of their investments are preferred shares, those might not have been acquired directly from the company with contractual obligations of financial disclosure. In the case of Zynga (NASDAQ:ZNGA), they did not even start with holding shares of the company. They entered into a swap deal with a third-party fund that synthetically creates embedded options on Zynga's share price.

This is quite a revelation, because it is my belief that any investment should only be made after proper due diligence has been carried out. Furthermore, a company may be poised for growth due to macro trends, but without knowing the financial information, it is hard to ascertain whether one is overpaying for the notion of growth. Keating Capital seems clearly more concerned about not overpaying than GSV Capital. This leads to my final point: risk-reward profiles of investment.

Risk Management

Keating Capital

believes that investing in an issuer's most senior equity securities or negotiating investment terms that are expected to provide an enhanced return upon an IPO event is one important way to mitigate the otherwise high risks associated with pre-IPO investing.

They currently hold the most senior equity securities in all but 5 of their investments and have negotiated investment terms, also know as structural protections, in 8 of the companies. As noted in their 2012 10-K filing,

Examples of such structural protections include conversion rights which would result in our receiving shares of common stock at a discount to the IPO price upon conversion at the time of the IPO, or warrants that would result in our receiving additional shares for a nominal exercise price at the time of an IPO. In some circumstances, these structural protections will apply only if the IPO price is below stated levels.

Structural protection helps to lower the cost basis per share of the investment upon IPO, and from a value investing standpoint, mitigates risk. After all, the cheaper you got a stock for, the more leeway you have when the stock becomes volatile. I will go into more of this below.

Keating Capital's track record has not been fantastic, with Livescribe written off and two of their earliest IPOs, NeoPhotonics (NYSE:NPTN) and Solazyme (SZYM), resulting in realized and unrealized losses (although they have exited 30% of their Solazyme position at a realized gain representing a 1.7x return multiple). Yet, if we look at each investment carefully, we can get a sense of management's conservative approach regarding investment decisions.

Livescribe: In fairness, this can hardly be deemed an outsized loss, since the total investment amounts to just over $600,000, less than 1% of KIPO's asset base. Nevertheless, because it is being marked as worthless at fair value, and this reflects management's stock-picking skills, I will try to address it. The position in Livescribe was first initiated in July 2010, when the company still looked to have promising prospects and a legit opportunity to marry physical note taking with electronic mobility.

However, its subsequent product offering failed to gain traction, and the company required greater investments to continue operations. Keating Capital obliged in the Series C-1 and Series C-2 convertible preferred stock offering, putting up over $100,000 in these two rounds of financing, because the business proposition still looked to be intact and they wanted to retain preferred stock status within the company.

However, in the latest round of convertible note financing, KIPO abstained from investing because of their "belief that an IPO by Livescribe was not likely in the foreseeable future." Accordingly, their preferred stocks were converted into common shares, and the fair value of those shares were marked to zero because they "believe that the common stock has no value…since any value will be attributed to preferred securities." Livescribe is still a going entity and personally, I would be interested in their products. While the outcome is not desirable, Keating Capital has, in my opinion, shown great investment discipline not to throw good money after bad when the portfolio company stops demonstrating the capability to go public. In a single-strategy special situation fund, it is absolutely critical to stop the bleed when the only catalyst seems doubtful.

NeoPhotonics was the first portfolio company to go public at $11 per share. With a cost basis of $6.25 per share at the point of IPO, that represented an unrealized 1.8x gain for Keating Capital. Quickly, it shot up to as high as $20.55 before an announcement that it would miss its revenue and earnings guidance caused the stock to plunge. It never recovered. Keating Capital disposed of the shares at an average price of $5.49, recognizing a 12% loss on investment.

Ultimately, this investment did not turn out as planned, but I would draw readers to the fact that the risk/reward was actually compelling. Using Keating Capital's per share cost price, and taking the historic high ($20.55) and low ($3.75) prices of the stock for comparisons, the potential gains and losses are 228% and 40% respectively. Given that KIPO does not use leverage - it can only lose 100% on any investment - and that it is always targeting for the share price to double or more, the upside/downside consideration should generally look rather similar to NeoPhotonics'.

Solazyme is a renewable oils and green bioproducts company. KIPO made the initial investment in July 2010, and the company went public in May 2011 at $18 per share. The cost basis of Solazyme shares at IPO was $8.86 per share, which means that the unrealized appreciation in share price met the targeted 2.0x. Like NeoPhotonics, it spiked up in the following month to reach a historic high of $27.03 before an overall selloff in cleantech companies cause Solazyme to plunged to $8.34 by October 2011. (This selloff was attributed to the bankruptcy filing by solar panel manufacturer Solyndra which had previously received a substantial U.S. government loan guarantee, the global uncertainty about continued government subsidies to support these emerging technologies and the continued challenges to find cost effective cleantech solutions)

Keating Capital, believing that the stock was undervalued, bought additional stakes at $11 and $10.50 during this move downwards, eventually taking profit for part of the combined stake at $15.06 (representing a 1.7x return multiple). The stock is now back in the region of $7.78, with an unrealized depreciation of roughly $350,000 on the remaining shares (combined cost basis of $10.178). Note that a realized gain of $403,631 was recognized in 1Q 2012 when the company sold off a stake. Overall, this investment is still net positive, and Keating Capital has not disposed the entirety of their stake (as of end-2012).

Even when investments go wrong, as they occasionally do, Keating Capital is able to weather these with relatively minor losses because of their low cost basis. GSV Capital, on the other hand, suffered greater than 40% losses on 7 of their holdings, some of which were rather large positions (GILT Groupe, Groupon, Zynga and Silver Springs being notable).

Conclusion

It might seem that Keating Capital, or GSV Capital for that matter, has nothing going on in the pipelines, with none of their portfolio companies having publicly filed offering documents. However, the passing of the JOBS Act last year allowed "emerging growth companies" to confidentially file offering documents with regulators and then make them public 21 days before they start their IPO roadshows. This obscures the visibility in the markets, but makes it easier for private companies to test the waters before they actually leapt. What I suggest is that the pipelines may not be so dry for both companies after all.

Keating Capital has much to prove, but I am more willing to discount past performance because the management of losing positions has been highly disciplined. After all, if you don't lose a lot of money, the alternatives aren't half bad. I am also in agreement with management's value approach to investing, which recognize that buying low and instituting contractual obligations to that end ultimately mitigates risk. They may take hits of 10~25% in individual investments, but given the targeted returns of 100%+, there is certainly a compelling risk/reward here. Their thesis regarding the private-public liquidity arbitrage (which I doubted initially) has also been somewhat proven to hold water, with IPO prices for LifeLock, Solazyme and NeoPhotonics ranging between 1.7x to 2.0x of their cost price. The key is simply to get portfolio companies to go public.

In the end, I do not see another fund that is doing the exact same thing as Keating Capital, even if many are operating in the same crowded private equity space. If you believe in their mandate and want to place a part of your portfolio betting on the strength of the IPO market, this company could be one of the purest plays. The discount to NAV and management's desire to close that discount (they instituted a share buyback, unlike GSV Capital) are simply bonuses.

KIPO is scheduled to host an earnings call on Monday, 29th April. We will know more then.

Source: Keating Capital: Liquidity Arbitrage In The IPO Market