Keating Capital Inc. (KIPO) Q4 2013 Earnings Conference Call February 24, 2014 4:00 PM ET
Margie Blackwell - Director, IR
Tim Keating - President and CEO
Edward Woo - Ascendiant Capital Markets
Sam Roboski - SER Asset Management
Good afternoon and welcome to Keating Capital’s Quarterly Earnings Call being held on February 24, 2014. This call will discuss Keating Capital’s results for the Quarter And Year Ended December 31, 2013. As a reminder, this call is being recorded and will available for replay until our next quarterly conference call, which is currently scheduled for April 28, 2014.
I’m Margie Blackwell, the Investor Relations Director for Keating Capital. Let me remind you of the two points. First, we issued a detailed financial results Press Release that includes all of the important financial information and metrics for the quarter and year ended December 31, 2013; and second, the slides to be presented during this call, which themselves contain comprehensive and detailed financial information, are posted on the Investor Relations sections of our website at keatingcapital.com.
Now let me begin by reading our disclaimer about forward looking statements. Before we begin, we would like to remind you that various statements that we may make during this afternoon’s call will include forward-looking statements as defined under applicable securities laws. Management’s assumptions, expectations and opinions reflected in those segments are subject to risks and uncertainties that may cause actual results and/or performance to differ materially from any future results, performance or achievements discussed in or implied by such forward-looking statements and the Company can give no assurance that they will prove to be correct. Those risks and uncertainties are described in the Company’s earnings release and in its filings with the Securities and Exchange Commission.
And with that, I’ll turn it over to CEO, Tim Keating.
Good afternoon. Because of the extensive discloser in both our earnings press release as well as our 2013 letter to stockholders, in my prepared remarks I’m going to highlight three items that deserve special attention. First, I’ll explain the new quarterly distribution policy adopted by our Board last week. Second, and in response to a very frequently asked question, I will discuss how our fair value marked each quarter compared to exit prices of our portfolio companies that had completed an IPO or sale at the time of their IPO or sale. And third, I will provide a high level overview of our expectation for upcoming IPO or sale and merger activity for our portfolio of companies.
Now that we’ve run through the highlights; let’s circle back and fill in some detail starting with our new quarterly distribution policy. In 2013 we paid $0.49 per share in dividends to our stockholders, which reflected 100% of the approximately $4.4 million of our realized gains for the year and which are characterized as long-term capital gains for tax purposes on the Form 1099-DIV that were mailed each stockholder in late January. All of these dividends were paid in cash.
On February 20, 2014, Keating Capital’s Board of Directors adopted a regular quarterly distribution policy, effective Q1 2014 which provides for the following. First, that we intend to pay regular quarterly distributions to our stockholders based on estimated net capital gains for a given calendar year. Second, that the distribution will be payable in cash or shares of Keating Capital common stock at the election of stockholders, subject to a limitation that no more than 25% of the aggregate distribution will be paid in cash, with the remainder paid in shares of common stock. Under the quarterly distribution policy, we seek to maintain a consistent distribution level that may be paid in part or in full from net capital gains or a return of capital, or a combination thereof.
If our actual net capital gains are less than the total amount of our regular quarterly distributions for the year, the difference will be distributed from our capital and will constitute a return of capital to stockholders. Alternatively, if our actual net capital gains exceed the total amount of our regular quarterly distributions for a given year, our Board of Directors currently intends to adjust or make an additional distribution in December of each year so that the total distributions for any given year represent 100% of Keating Capital’s actual net capital gains in that year. A return of capital is generally not taxable and, instead, reduces a stockholder’s tax basis in his shares of Keating Capital.
The quarterly distribution policy reflects our commitment to stockholders to provide a predictable, but not assured, level of quarterly distributions based on the estimated amount of net capital gains we project to realize during the year. However, due to the uncertainty of portfolio companies achieving a liquidity event either through an IPO or sale or merger, and our ability to sell our positions at a gain following a liquidity event, we can give no assurance that we will be able to realize net capital gains during the year equal to the amount of our regular quarterly distributions. In addition, we can give no assurance that we will be able to realize any net capital gains from the sale of our portfolio company investments.
Consistent with our new quarterly distribution policy, and based on our estimated net capital gains for the year, our Board has declared a regular quarterly distribution for the first, second and third quarters of 2014 up $0.10 per share per quarter. Each of these quarterly distributions will be paid in cash or common stock at the election of stock holders. The record and payment dates for these distributions can be found on our website at keatingcapital.com.
Our Board also determined it intends to pay regular quarterly distribution in cash or shares of Keating Capital's common stock at the election of stock holders, subject to a limitation that no more than 25% of the aggregate distribution will be paid in cash, with the remainder paid in shares of common stock. Why? Our Board believes there are a number of benefits from paying stock distributions and caning cash for additional portfolio company investments, including increased cash resources would allow us to make investments in a greater number of portfolio companies at potentially larger investment amounts.
An increased capital base would have the effect of reducing our operating expenses as a percentage of net assets and a higher market capitalization and potentially greater liquidity may make our common stock more attractive to investors and help reduce or eliminate our stock price discount to NAV overtime. The Company will be providing additional information to stockholders, regarding the administrative details about cash and stock collections for the Q1 2014 distribution on or about March 7, 2014.
Now let’s turn to our valuation analysis of portfolio companies completing an IPO or sale. Of the 43 publicly traded business development companies, four BDCs including Keating Capital have investment objectives that are focused on capital appreciation rather than yield. Frequently, members of this peer group trade at discounts to NAV. By contrast as of December 27, 2013, the median BDC traded at a price equal to 100% of NAV and 22 BDCs out of the 43 had a yearend price either at parity or above NAV.
So why is it that the capital appreciation focused BDCs so frequently trade at discounts at NAV? We believe there’re two reasons. First, unlike the yield oriented peers, BDCs focus on capital appreciation do not have a history of generating consistent realized gains and paying corresponding dividends. Although Keating Capital began generating real life gains and distributing these gains in the form of dividends to our stock holders in 2012 and 2013, these dividend payments have been episodic, irregular and unpredictable.
Second, the determination of the fair value of our private portfolio of companies involves subjective judgments and estimates that is subject to inherent uncertainty. Therefore because most of the capital appreciation focused BDCs, including Keating Capital invest in the equity of privately owned companies, it is extremely difficult for someone that doesn’t have access to the financial statements of these companies to verify on a quarter-to-quarter basis, whether the fair values are reasonable.
However, once a private company completes an IPO or merger, the price at the time of the IPO or sale/merger can be then be compared retroactively to the fair value marks we made since our initial investment up to the last quarter before the IPO or sale or merger. But this would actually require a lot of work for a third party to compile this information. So we have done it for you.
Please look at the chart now shown on the screen, which is also contained on page 80 of our 10-K, which was filed this morning with the SEC. We have presented in this chart a valuation trend line analysis for the four portfolio companies that have completed an IPO and Millennial Media, whose common stock we received in connection with its merger with JumpTap. The valuation trend line analysis includes those portfolio companies that have either completed an IPO or have merged into a public company. Accordingly our investment in Corsair, which was sold in a private transaction, is not included in the chart.
The valuation trend line analysis shows our reported fair value for each of these companies as determined by our board while they were private, or shows how these companies compare to the eventual IPO or merger value. The comparison is measured from our initial investment through the date the company becomes public through the IPO or merger. Following an IPO, we value our public portfolio of companies based on the market price of these companies subject to a 10% discount for lack of marketability to positions where we’re still subject to a customary 180 lack of provision.
It is important to note that this analysis does not reflect the increase or decrease in the value of our equity interest in these portfolio of companies following the IPO or merger since the fair value of this positions post IPO or merger are derived principally or solely from changes in the portfolio company’s market price.
By looking at the chart, it should be evident that of the five transactions where one of our portfolio companies had either completed an IPO or merger with a public company thus far in all five cases or 100% of the time, our fair value marks trended up in the time leading up to the exit event and the fair value in the final quarter before the exit event was lower than the exit price. We believe that this analysis validates the reasonableness of our fair values for these five companies.
Now let’s turn to a high level of our overview of our expectation for upcoming IPO or sale of merger activities for our portfolio companies. Since our first investment in January 2010, through December 31, 2013, we have invested about $68 million in a total of 21 portfolio companies and we were the lead investor in seven of those transactions. Of those 21 investments, four companies have successfully priced IPOs, one portfolio company publicly filed a registration statement for an IPO but was sold to a private equity firm and one portfolio company was acquired in a merger with a publicly traded company.
We believe a number of our other portfolio companies are achieving key operating millstones as they progress toward an expected IPO and we believe that several of these companies may complete an IPO in the second or third quarter of this year.
Further, we expect a majority of our private portfolio of companies to complete an IPO or strategic sale or merger over the course of the next four to eight quarters. However the timing of the completion of IPO or strategic sale of merger by any of our private portfolio of companies is highly uncertain and could be affected by a number of factors, including the portfolio company’s performance, equity market trends, market volatility, recent IPO performance and sectors that maybe in or out of favor of IPO investors. Accordingly there can be no assurance as that any of these private portfolio companies will complete an IPO or strategic sale or merger.
Now let me provide a brief update on the IPO market. In a word the, IPO market in 2013 was perfect. The 222 companies that went public in 2013 eclipsed the 217 IPOs that priced in 2004 and was the most since 2000. For a more recent comparison, there were 128 IPOs priced in 2012 and 125 in 2011. We have at long last broken the post 2000 bubble period IPO record. Please see the blog section on our website for a comprehensive review of the highlights of the 2013 IPO market.
Finally, let me conclude with an important reminder of our investment strategy. We believe that because investors place a premium on liquidity, public companies typically trade at higher valuations to private companies with similar financial attributes. We further believe that there is a private-to-public valuation arbitrage opportunity that can be exploited by providing growth capital to private companies seeking to go public and then benefiting from the transformation and value associated with becoming public as they complete IPOs. Finally we believe that when steps are taken to mitigate the risk associated with pre-IPO investments, there is a potential for both higher absolute returns and attractive risk adjusted returns.
Accordingly our investment strategy is focused on making investments in emerging growth companies that are committed to and capable of becoming public. Effectively, we have an IPO event driven strategy and we attempt to generate returns by accepting the risk of owning illiquid securities of typically later stage venture capital backed private companies.
Naturally the process of transforming from private to public ownership is subject to the uncertainties of the IPO process. If this process happened quickly and with certainty, we believe there would be less of an illiquidity discount and hence less return potential available to us when we invest. Instead the process takes time and is subject to market conditions and we therefore incorporate an expected four year average holding period for each portfolio company into our model.
In closing, I want to remind you how we seek to create long term value for stockholders. We believe that the prospects for the IPO market in 2014 remains strong; indeed as of February 21, 2014 there have already been 35 IPOs and $6.8 billion in gross proceeds raised, which are 75% and 24% increases compared to this time last year respectively. And remember, 2013 was the best year for IPOs since 2000. We have already bought privately. Now we simply wait to sell publicly and capture the difference.
With that I will turn it back to Margie.
We will now open the call to Q&A. As a reminder we are accepting verbal questions and we ask that you follow the operator’s instructions if you would like to ask a question. Operator do we have any questions?
Ladies and gentlemen we will be accepting questions from over the phones today. [Operator Instructions] And the first question comes from the line of Edward Woo, research analyst. Please go ahead.
Edward Woo - Ascendiant Capital Markets
I wanted to ask a little bit more about the IPO markets. Obviously 2013 was a very strong year. What’s your outlook for 2014 and do you see any possibility of any major changes in the outlook?
Ed, we basically see 2014 as a continuation of a very strong 2013. There really are a few technical points that I wanted to mention. Number one, volatility was extremely low in 2013 and that is probably the most important technical indicator for the IPO market. And of course we had the tailwinds of an incredibly strong IPO market and a very, very strong equity market that closed at or just about at its 52 week high. So that’s basically a trifecta of perfect conditions. In 2014 we had a little bit of volatility, but through the first six weeks of the year, we are actually up year-on-year in terms of the number of IPO bases, in fact quite substantially 75% and I recognize that it’s early on. But I think that the key thing that we see here is the JOBS Act, which allows companies, emerging growth companies to file confidentially is really having a major, major impact in Silicon Valley. It is making it safe for companies to file without worry that their competitors see any financial information and other trade secrets. And this has really been a game changer for the IPO market.
And again the JOBS Act was passed in April of 2012 and it was designed to stimulate the IPO market and we believe that it’s doing just that. The other benefit of the JOBS Act is that emerging growth companies, which are those companies with a under a $1 billion in revenue do not have to comply with the requirement to audit internal controls -- that’s Section 404(b) of Sarbanes-Oxley -- for a period of up to five years. That’s a very, very significant benefit as well. So the ability to file confidentially and the ability to avoid the monstrosity that is known as SOX 404(b) has really encouraged the venture capital community to jump back into the IPO market in a major way. So I think you can mark us down as extremely bullish.
Edward Woo - Ascendiant Capital Markets
And if I could another question, I was just curious what your opinions were on Facebook's whooping purchase of WhatsApp for $19 billion. Do you think that that’s going to affect you at all, either on exits or even invest in private companies?
Ed that’s a great question and I perpetually look foolish when I try to understand some of the valuations with some of these earlier stage companies. I still haven’t quite figured out what some of these companies are all about to be quite honest with you. $19 billion for WhatsApp is staggering. And I think probably the best way to understand this market is really to bifurcate it into two pieces. And what you really have in one category are some highly publicized private companies and then the rest of the market. I'm not even sure that WhatsApp would make it into the category of highly publicized private company, but certainly companies like -- obviously Twitter from last year, but Box, Dropbox, Uber The Taxi Service, LendingClub; these are examples of highly publicized private companies and generally I think the litmus test is when those companies soar above a $1 billion of enterprise value in the private markets, they've generally reached a category where they are trading in their own orbit. Companies that have $19 billion that have little or no revenue are very difficult for ordinary people to value and they probably make more sense to strategic investors.
So I think the short answer to your question is that there is a small corner of the private company marketplace of private companies with values in excess of a $1 billion and I will put that number right now at about 50 companies. We will not generally be investing in those companies and therefore we do not think we will be negatively impacted by some of those very high valuations. For the rest of the market, those thousands of companies that have private valuations below a $1 billion, it’s pretty much business as usual. So, it is a concern that we have to worry about to make sure that there isn’t valuation inflation sticking into the bulk of the market but obviously we’re pretty vigilant about that. And so I think this corner of $1 billion plus enterprise highly publicized private companies is not a territory that you’re going to see us involved in.
The next question is from line of Sam Roboski, SER Asset Management. Please go ahead.
Sam Roboski - SER Asset Management
I'm looking over your balance sheet and you showed $13.5 million at December 31, and you’ve got cash from the sale of 400,000 shares of Millennial, which is about another $3 million. What have you invested of the $16 million at this point?
The last investment we made was in September of last year. It was $3 million in the company called Deem and I think at this point Sam we feel confident that we have plenty of cash to make new investment opportunities and I believe that the comfort of changing our distribution policy coupled, as you correctly note with the roughly $3 million that we’ve generated from the sale of about 400,000 shares of Millennial gives us plenty of cash to make some new investments. So I think you can expect to see us active in the very near future.
Sam Roboski - SER Asset Management
Was there any rationale for not making investments; that you wanted to keep a certain amount of cash, or was the investments that you were shown not good enough was there some kind of…?
Yes, it’s a great question. The general policy, we seek to maintain cash reserves of about $10 million at any given time and to -- we actually were looking at one or two companies and so when we were thinking of -- if you think back to the $13 million, we had circled $3 million for a next investment. And the reason why we keep $10 million in reserve is that some of our companies do have a subsequent round of financing and we want to be able to participate in those, both opportunistically and defensively, because in certain cases the subsequent financing rounds have penal provisions, which are pay-to-play and basically underpaid a pay-to-play provision, if you don’t participate in the financing round, you run the risk of having your preferred stock converted to common stock. So we believe that $10 million is the correct cash buffer, but as you pointed out, with the $13.5 million we had at year-end plus the $3 million of gross proceeds that we’ve generated from the 400,000 shares of Millennial, we’ve got plenty of dry powder to make some new investments.
Sam Roboski - SER Asset Management
And as now some of the companies you said you expect -- two or so in the second or third quarter IPOs, that some of them qualified under the JOBS Act or has something been done or filed relative to these two or three that your situations has been…
Yes, by the way I think just to be a weasel, I think our official word that we’re using is several. So what you -- you're in the right -- I think all of our companies in our portfolio today would qualify or do qualify as emerging growth companies under the JOBS Act. And so as and when these companies do make their filings for IPOs, they will at this point more than likely do it confidentially. I don’t have the statistic at my fingertips but I believe that something on the order of about 80% of companies that qualified as emerging growth companies did avail themselves of the ability to file confidentially in 2013 and that’s an increasing trend. So I think you’re going to see a very, very high percentage of emerging growth companies avail themselves of the ability to file confidentially. So as always, we’re stuck in a position of having information that we’re not able to share and all we can say is that all of our companies would qualify as emerging growth companies and we would expect at this point all of them to file confidentially and therefore us not being able to report that until 21 days before they intend to launch their road show, which is what have to make their last filing.
Sam Roboski - SER Asset Management
So would it appear that if you’re saying in the second and third quarter, several; so the point would be if it hasn’t happened yet, because it needs 21 days, but it will happen, that’s what your expectations, they will initially file quietly until the 21 days are up I guess?
Yes, that’s correct.
Sam Roboski - SER Asset Management
Okay. Now the one situation that you have a fairly big loss, Stoke could you address; that what the chances of that company succeeding or what the -- how you handle this type of situations?
What I can tell you about Stoke is they focus on a very, very narrow segment of customers. Specifically they are focusing on telecom network carriers, that there is really only about a dozen major carriers in the world. They had a very significant relationship with a Japanese company called Docomo and continue to have that. And there has been some variability in their revenue and under our fair value accounting requirements we have to mark the positions to accurately reflect the variability of that revenue.
I would say notwithstanding the significant write down in Stoke, it’s a very promising company. It has venture capital backing both from Sequoia Capital and Kleiner Perkins. It is quite unusual to see those two VCs paired up together. So I think we remain very committed to our Stoke investment and I know it’s difficult for us to write these down but I think with several of the companies that had been written down, I think you might expect to see some write-ups in the quarters to come. That’s common. It is not specific to Stoke, but that does apply to some of the write-downs generally.
Sam Roboski - SER Asset Management
And one other question relative to Stoke. Would they need to raise additional funds, and that would be an opportunity to you to come in on a cheaper valuation on this one?
I think conceptually without commenting specifically on Stoke, but yes generally if there is a write down and the company raises additional capital, typically we might have an opportunity to participate in another round at a lower valuation. So again that’s a general comment, and not specific to Stoke.
Thank you Sam. Do we have other questions?
The next question is from the line of Mike Felger [ph] at [indiscernible]. Please go ahead.
I have just a question regarding the recent stock offering. Can you elaborate on like what was your -- did you gain anything by that? Do you feel like that was successful? I assume that’s where a good portion of the cash that's on balance sheet came from, but could you elaborate a little bit on that?
Yes. So we conducted a rights offering in December 2013. We wanted to go back to our existing stockholders because our stock was trading at a discount to NAV. So we did an offering where we were able to issue up to 3 million shares of common stock that had a variable pricing formula which was either the higher of $6 or 92.5% of the five day volume weighted average price leading up into the expiration period for the rights offering. $6 ended up being the accrual subscription price and we raised approximately $4.1 million in gross proceeds. So to answer your first -- the point of your first numerical questions; of the $13.5 million cash on the balance sheet as of year-end, about $4.1 million of gross proceeds, which translated to about $3.8 million roughly -- $3.9 million in the proceeds. So $3.9 million or of $13.5 million was attributable to the rights offering.
The reason we did the rights offering was following. The IPO market is white-hot. The pre-IPO investment opportunities are white-hot. Because of our desire to maintain a $10 million cash cushion, we wanted to get some additional capital. By going to our existing stockholders, any stockholder who participated in the rights offering was not diluted as a result of that. So we thought was the right thing to do.
Were we disappointed by the gross proceeds? Yes. So relative to our target of $18 million, we did not meet our expectations. And I think the step that we take in this quarter, which is to pay our dividends, part in stock, part in cash depending on the election of stockholders, we believe and board believes is a better solution to shore up our cash balances. And both in our 10-K and in our earnings release, and I didn’t say this, and I should have, we have stated categorically -- repeat, we’ve stated categorically that we will not go back to the equity markets to seek to raise additional capital, unless and until our stock prices at or above NAV. One of the complaints that we've had and we've heard the complaint is with the prospect of an equity offering hanging out there; it serves as a wet blanket on the stock price. We hear that complaint. We agree. And that’s why we've taken it off the table. So there will be no equity offerings in 2014; repeat none unless and until the stock prices above NAV. So no rights offering, no anything else. Basically generate gains, distribute dividends and retain approximately three quarters of the cash to gross assets and make new investments. Is that responsive to your question, Mike?
Yes, it is, I guess, I was just frustrated the way it was trended at 7. The rights offering brought it right down to 6. At any rate, [indiscernible] right offering was minimum price for the rights offering…
I’m sorry, if I just can make just a closing comment on the rights offering. The nature of a rights offering is fundamentally different from a typical -- a book building exercise in IPO or following offering. In a book building exercise, an issuer goes out, talks to investors, gets indications of interest and ultimately determines the amount and price at which you can do a deal and the issuer always has the option of just saying the price isn’t right, we can pull it back.
A rights offering does not work that way. Once you let the genie out of the bottle, you have no idea -- an issuer has no idea what’s going to come through the rights offering. So although we were disappointed with the results, we think it was the right thing to do, given the market opportunities, given the IRRs that we posted on our exits, the validation of the model. So hindsight is obviously always easy but I think given the fact pattern and the set of data front of us, we still would have proceeded with the rights offering.
Did I miss somewhere in this presentation -- is the book offer, the book value still at about $7.95?
The NAV is $7.65 per share.
Remember that we paid $0.49 per share in dividends and so the dividends, because we’ve always paid them cash are a reduction of net asset value. So for those of you who are following on the screen right now, we’ve got one slide with a lot of important financial data. I should add just by way of commercial notice that we are working from our Q4 2013 Investor Presentation. So this presentation has been posted to our website, along with an updated one page factsheet and executive summary. So everything that we’re using here today, all the data all the information is posted in and available on our website.
Okay and one final question just regarding the, is the 25% cap that can be paid out in cash. So what is that, a first time first serve? Is it pro-rated I assume or?
Yes, Mike, the way it’s going to work and I’m glad you asked it. So first of all, we will be sending out a very detailed separate communication along with an election form. But basically there are two choices. A stockholder either elects to receive his dividend 100% in cash or 100% in shares of commons stock. So there is only two choices; cash or stock.
What we then do is total up all of the elections and if the aggregate amount of elections exceeds 25%, then what will happen is investors who have elected to receive all stock will of course get their stock and then what will happen is investors will – there are different scenarios, but basically the simple way to it is people will get at least 25% in cash.
So really what -- we cannot determine how much cash will actually be paid out or what percentage will be paid out until we have all elections. But the way it works is that we’ve capped the aggregate at 25%. And again, there will be a separate letter that will be posted to our website and mailed to all stockholders and that will be going out in the next week or so, March 7, 2014.
Operator, do we have other questions?
The next question is from Jay Li, Principals [ph]. Please go ahead.
I think we’ve been talking around this and in some ways that you’ve already addressed it. I really appreciate the recent changes and adjustments, particularly in light of the fact that really for the last two years the stock price is down 30%. So what would be some talking points? I’m an advisor and I have to go back to my clients that are in this and talk with them that you succinctly rolled in so much detail that's overwhelming for regular retail clients. Two or three bullet point highlights, that I could help them to hang in there and not sell out early.
I’ll see if I can stand on one leg and do it to keep it as short as possible. Here are the bullet points; 8% dividend yield in 2013, currently about a 25% discount to NAV, several portfolio company IPOs expected in the second or third quarter of 2014, a majority of the portfolio expected to complete IPOs or sales or mergers over the course of the next four to eight quarters. I’d say those are the four bullet points. And I’m now standing on two legs again.
There are no other questions at the moment.
Okay. That will conclude our call for today. And we want to thank everyone for joining us. Our next conference call has been tentatively scheduled for April 28, 2014 following the filing of our Q1-2014 results. We look forward to your continued interest in Keating Capital.
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