Several columns ago, I touched on the improving health of the initial public offering (IPO) market, but noted that there were few ways for individual investors to participate early on. One of those ways would be to participate in a pre-IPO fund. I recently had an opportunity to speak with Tim Keating, founder of Keating Capital, a business development company that makes pre-IPO investments and offers individuals the opportunity to participate in those investments.
Q: Tim, how does Keating Capital compare with most other funds consumers can invest in?
A: We know of three domestic funds that provide an opportunity for individual investors to participate in the aftermarket of companies that have just completed their initial public offerings, but we believe that Keating Capital is the only fund in the country exclusively dedicated to making pre-IPO investments.
This is an important distinction. As a pre-IPO fund, Keating Capital is designed to take advantage of the significant increase in value that typically takes place when a company goes public. Studies show that the resulting liquidity associated with the transformation from private to public ownership typically doubles a company’s value.
Q: What kinds of companies does the fund look to invest in, and what kinds of investors are best suited for the fund?
A: The Keating Capital Investment Committee meets weekly and carefully reviews the hundreds of investment opportunities that come before us. We invest only in companies that meet the following criteria:
• Later stage, with $10 million to $200 million in revenue (our average portfolio company has about $50 million in revenue).
• Seeking growth capital.
• At or near EBITDA (earnings before interest tax, depreciation and amortization) profitability.
• Accelerating earnings growth.
• Exchange qualified, with a public listing expected within 18 months.
We favor companies with innovative technology, and our early investments have especially favored clean technology. For example, our portfolio currently includes companies with the technology to convert algae to oil, designers of computerized “smart” pens and a company that is developing renewable energy from organic waste.
We seek to make each investment at a price that represents up to a 50 percent discount to where we anticipate the company will be priced once it is publicly traded. The large discount provides a margin of safety and creates the potential for a high return once a company goes public. While private equity investments are typically available only to the very wealthy, we deliberately opened investment in Keating Capital to the individual investor with a minimum investment of $5,000.
Q: Most funds, such as a typical long-only mutual fund, generate positive returns as their investments rise. How does the Keating Capital fund generate returns on invested capital?
A: A typical long-only mutual fund is generally capable of only matching a market return over time — what Wall Street calls “beta” — or exposure to the stock market. “Alpha” is outperformance, or excess return above the market return. Countless studies demonstrate conclusively that most actively managed, long-only mutual funds consistently fail to deliver alpha over extended periods of time. Because of fees and transaction costs, most investors seeking exposure to the market — or beta — would be far better off with a low-cost, index-tracking fund.
Keating Capital is entirely about generating alpha, not beta. The alpha is generated by buying privately, selling publicly and then capturing the difference. In other words, there is a wide pricing anomaly, or valuation arbitrage, that can be exploited. Unlike most actively managed, long-only mutual funds, the hedge fund and private equity industries — in aggregate — have been able to deliver steady amounts of alpha over time. Keating Capital runs a niche strategy that has such potential.
Q: The fund has been open since 1997. What’s the track record over that period compared with the S&P 500?
A: Keating Investments, a Securities and Exchange Commission-registered investment adviser, was founded in 1997, but Keating Capital Inc., our closed-end fund that is structured as a business development corporation, is new.
We made our first investment in 2010 in a company called NeoPhotonics, a leading developer and vertically integrated manufacturer of photonic-integrated-circuit-based components, modules and subsystems for use in telecommunications networks. That company just went public in February. A second portfolio company, Solazyme, this month announced plans to go public.
Given that the fund is brand new, the best measure of our track record is the previous pre-IPO fund we ran. This fund generated a net annual return of 35.6 percent over its four-year existence, from 2004 to 2007. For the same period, the Russell MicroCap index, our benchmark, generated a net annual return of 5.5 percent.
Q: For investors, how do they keep track of their investments in the fund and what kind of liquidity do they have?
A: Keating Capital will list its shares on the Nasdaq Capital Market in December. At that time, shares of Keating Capital will be continuously traded in the secondary market, just like any other stock or exchange-traded fund (ETF). Once Keating Capital is listed, in addition to continuous trading throughout the day, there will be a daily closing price. Once the fund begins trading, an investor can track it on any investor portal, such as Yahoo Finance. Information about Keating Capital can be found on the SEC’s website.
Q: How should individual investors think on Keating when contemplating their own investment strategies?
A: Morningstar recommends that all individual investors should have between 3 percent and 10 percent of their portfolios invested in private equity strategies:
“A range around this 2.6 percent market-neutral allocation — varying from 0 percent to 10 percent — seems appropriate for most investors, according to the optimizations. For investors with average risk tolerances, an allocation below 2.6 percent could be regarded as underweight in private equity. Allocations to private equity above 10 percent should be entered into with great caution and are only appropriate for very aggressive, knowledgeable investors with access to top-quartile managers.”
Keating Capital is a unique vehicle that gives individual investors at all levels of wealth access to such a strategy.
• Chris Versace, the Thematic Investor, is director of research at Think 20/20, an independent equity-research and corporate-access firm in the Washington, D.C., area. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned; however, positions can change.
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