Keating Capital’s President Timothy Keating was interviewed by OneMedRadio where he describes the liquidity premium that gives public companies 3x valuation over private company peers and the dramatic decline in IPOs and increase in size that is debilitating economic growth.
Click to hear audio and see below for a full transcript.
Brett Johnson: Good day, this is Brett Johnson of OneMed Radio in New York City. Today, we are with Tim Keating founder and CEO of Keating Capital, a Colorado investment firm that recently raised $86 million in an initial public offering for the purposes of investing in pre-IPO companies. Keating expects to be listed as KIPO on the NASDAQ in December of this year. Tim, thanks for joining us.
Tim Keating: Thank you, Brett. I appreciate you having me.
Brett Johnson: So, can you tell us a little bit about the concept of Keating Capital or KIPO as it will be listed and where you came from and what your business is?
Tim Keating: Absolutely. Keating Capital was formed two years ago and the idea was to create an access vehicle for investors to participate in pre-IPO investments. At the time that we formed the fund, there was no other pre-IPO vehicle in the marketplace like Keating Capital. There were a couple of similar funds a decade ago back in the bubble years and I’m sure we’ll get around to talking about those, but there was nothing like Keating Capital. And really there’s a couple of reasons for that and I think the main one is that for five of the past ten years, namely ’01 to ’03 and ’08 to ’09, there was very, very bad IPO market so it wasn’t an obvious opportunity to create a pre-IPO fund.
Brett Johnson: So what’s your sense about where the business will be and what you’re going to accomplish with this?
Tim Keating: Well, I think there’s been a dramatic change in the IPO market. And just to rewind, about 15 years ago, if you look back in the mid ’90s, the average market cap of a company going public was about $100 million and a typical company was raising $10, $20, $30 million. If you fast forward to today, the average market cap of a company going public is over a billion dollars so that’s over a ten times increase in a little over a decade and the average company is raising anywhere from $200 to $300 million in the IPO market. So what’s happened now is the size of the companies has grown dramatically larger and many of these late-stage private companies are doing a final round of financing that is typically restricted to a very narrow universe of potential investors.So the idea behind the vehicle was to create access for an ordinary or average individual investor to be able to participate in these pre-IPO investment opportunities.
Brett Johnson: What changed?
Tim Keating: There were a couple of things that changed. The main one — well one of the main ones was back in the ’90s, there were four firms that were very active in taking emerging growth companies public and they were referred to as the four horsemen and they were, in no particular order, Hambrecht & Quist, Robbie Stephens, Montgomery, and Alex Brown. And what happened over the course of the last 15 years, is that there has been tremendous consolidation in the investment banking underwriting industry and gone are the four horsemen, gone are people like Beary Sterns, Lehman Brothers and a host of other firms.
Now in today’s market, there are four firms, which we actually refer to as the final four and those are Goldman Sachs, Morgan Stanley, JP Morgan, and Merrill Lynch and those four firms account for the vast majority, 2/3 or more typically, of all IPOs. And if you look at the size of those firms, really what’s happened is a lot of the smaller firms have disappeared, merged, consolidated, what have you, and what you’re left with is four investment banking behemoths who really control the IPO market and from their perspective, it doesn’t really make sense to do small IPO deals. So they’ve got a minimum deal size. So with a consolidation of those firms, the size of the remaining four firms has really ratcheted up the size of an IPO transaction that makes sense to price for those underwriters.
Brett Johnson: So you effectively are stepping into that void left by these smaller firms who were doing these earlier underwritings and I guess there’s other companies that have followed into this business. Global Silicon Valley Capital [NASDAQ: GSVC] recently did a $50 million raise and is out now doing $100 million raise to also invest in these sort of late-stage companies, private companies, venture-backed companies. Do you envision other companies like GSVC to be following into this void? And can you comment about how these capital markets will change and whether firms like yours will fill this gap?
Tim Keating: Yes. And we are familiar with GSV Capital and its founder Michael Moe who’s written a great book, “Finding the Next Starbucks.” We have great respect and admiration for Michael Moe and have known him for a number of years. Specifically, I think both we and GSVC identified that there’s a very broken capital formation process, the five barren years for the IPO market over the last decade and the consolidation that has occurred, which has caused the size of the transactions to increase.
Another factor that’s very important is that there is a venture capital industry that has literally thousands and thousands and thousands of companies, many late stage. And the reason there’s so many late stage companies is a that a decade ago, the average time from funding to an IPO exit was a little over three years. Now, that average time is probably somewhere between 10 and 12 years. So, you have many older, much more mature, very late stage companies that are looking for an exit and because the underwriters oftentimes require these late-stage private companies to do a final round of financing for purposes of window dressing the balance sheet or giving them some strength in terms of coming to the market, the size of these final rounds of financing has grown larger and larger. I think there’s clearly opportunity for Keating Capital, for GSVC and perhaps others.
And I think the other phenomenon that’s worth mentioning is the development of the secondary market in places like SharesPost and Second Market, which have emerged as really a mechanism to create secondary markets in some of these private companies that in a different era or decade would have been normally prime candidates for doing IPOs.
Brett Johnson: So to go back to the boom around the 2000, there were a couple of very high flying stories, Internet Capital Group and CMGI who saw their stocks go from very little to $200 and $40 or $60 billion valuations. So there’s been some history of public enterprises entering the business of getting into buying, acquiring securities and private companies and trading. Can you compare and contrast, you know, the Internet Capital Groups and the CMGIs of the 2000 timeframe with what you and GSVC are doing?
Tim Keating: Absolutely. And I think it’s a great question, Brett. Thanks for asking. I think the common approach to Internet Capital and CMGI 15 years ago compared to Keating Capital and GSVC today is a recognition that there is a significant valuation differential that exists between private companies and public companies that are of comparable size and growth and profitability. And the reason that valuation differential exists can be described in two words and those two words are ”liquidity premium” And what that means in plain English is that investors are always willing to pay more for a dollar of earnings when a company is publicly traded. Why? Because when a company is publicly traded, the investor has the option to sell instantly, has the option to have instant liquidity. And what’s remarkable is the size of that valuation differential. We’ve studied transactions for the last 10+ years and there’s a constant valuation differential. Typically, a public company is valued two to three times higher than a similar private company.
So now to circle back to your question, Internet Capital and CMGI, I believe, were founded on the concept of investing in these private companies with the expectation that when the private companies became public, there would be a significant step up in valuation. And that indeed is exactly the premise of Keating Capital. Where the strategies depart is as follows. CMGI and Internet Capital became very active in investing in concepts and stories and companies that had business plans but no revenue, no customers, no earnings.
And if you fast forward to today, Keating Capital for example is investing in some very substantial late-stage private companies. These are companies that have been around anywhere from 5 to 10 years on average. They often have very significant revenue, and in many cases, very significant positive cash flow or earnings. So if you go back to Internet Capital and CMGI, they invested in these concept stocks, which got sky high valuations when the companies went public but just as in musical chairs, when the music stopped, there were no underpinning earnings to support the valuations of the portfolio companies of Internet Capital and CMGI. The stock prices of those companies collapsed and the stocks of Internet Capital and CMGI also collapsed corresponding with the decline of prices of their underlying portfolio companies.
The difference with Keating Capital is that we are investing in companies with revenues and we’re doing it with a valuation discipline. So specifically, we’re looking at where a private company will trade when it goes public and attempting to invest at a 50% discount to that valuation. Now, obviously, we’re going to make mistakes, we’re not going to be right in all cases, but at least there is a value discipline framework that underpins all of Keating Capital’s investing activities.
Brett Johnson: Could you give us sort of an example of some of the companies or one of the companies you’ve invested in recently and how you valued them and where they are today?
Tim Keating: Sure. I’ll give an example of perhaps one of the easier companies to look at. It’s a company that we invested in a year ago called Solazyme. Solazyme is a very exciting company that is in the business of converting ordinary algae to different types of oils that can be used in fuels, chemicals, cosmetics and nutritional products – so an absolutely extraordinary company in every respect. Clearly a clean tech biofuel company. When we looked at Solazyme, we looked at where we thought it would be traded if it were public and there was a relatively small set of comparable public companies. But there were some and many of those companies were valued on a discounted cash flow technique based on an expectation of their revenue and earnings over time. But we had a number of good reference points to compare Solazyme to other publicly traded companies.
We made an investment in Solazyme in their final preferred stock round at a price of $8.86 per share. The company ended up going public in May of this year at about $18 a share, has generally traded up north of $20 a share, and has held there pretty consistently. It’s been a surprisingly unvolatile stock. When I say surprisingly, just because almost all IPO stocks are much more volatile than normal. But that’s an example of a company, a clean tech company doing some very exciting things that had some real revenue. They had about $37 million of revenue in their previous fiscal year so it wasn’t just a concept; it was a well executed science base with some real revenue. Solazyme today is trading at a valuation similar to its peers, but it’s a very exciting growth company that’s tackling a big problem in a very innovative way. But there was a basis for us determining a value to invest privately and in this case so far it’s worked out nicely for us.
Brett Johnson: Terrific. So can you sort of give us what sort of the optimal company would be revenues in the $20 or $30 million range like a Solazyme or what’s the range of companies that you’ll look at?
Tim Keating: We’re really looking for three things. The minimum revenue is absolutely $10 million. We simply won’t look at a company with less than $10 million in trailing 12-month revenue. Again, that might not seem like a very high bar, but if you compare that to Internet Capital and CMGI, that might have knocked out 95% of their portfolio companies. I think the average company in our portfolio right now is somewhere between $60 to $70 million in revenue. They range from $10 up to about $300 million in revenue and are equally divided between companies that are already profitable and those that are expected to turn profitable in the next four to eight quarters, which is another important thing.
So revenue is one criteria, a minimum of $10 million in revenue. Second is an expectation of going public within the next 18 months, and third is Keating Capital wants to invest at a valuation that affords us the opportunity to achieve a doubling of our money at the time of the IPO. So, a 50% discount is equivalent to 100% return and our typical holding period is going to be anywhere from two to three years. Therefore we are targeting a 25% gross rate of return on each of our investments. If we’re able to achieve 100% return on each company, and hold for an average of three years, that would work out to be roughly a 25% internal rate of return. Obviously we’re in a high risk, high return business so some will work out better, some will work out worse, but that’s the average of what we’re looking to achieve across the portfolio.
Brett Johnson: How many companies do you have in your portfolio now and how many do you expect to add in the coming 12 months?
Tim Keating: A mature portfolio for us will consist of 20 companies each roughly equally weighted at about 5%. So 20 positions of 5% each. As of the date of this interview, we have nine companies in the portfolio. We expect to add two or three by the end of the third quarter of 2011, and we’d expect to be somewhere between 12 to 15 companies by the end of the year. We believe that by the end of the first half of 2012, the portfolio will be close to 20 positions and at that point, we’ll be relatively fully invested.
Brett Johnson: So would that mean the $86 million that you recently raised will then sort of be pretty much all distributed among your portfolio?
Tim Keating: Yes.
Brett Johnson: And would you expect to go back to the capital markets to do an additional raise like GSVC is doing right now?
Tim Keating: It’s possible. I think the gating factor for us is that we want to ensure that we achieve a couple of milestones before we consider going back to the capital markets. Number one, we want to make sure that we’re substantially invested. Number two,, we would expect a significant number of our companies to have completed IPOs. We would want to have a number of full exits. In addition to the companies completing their IPOs, we would want to have realized capital gains on a number of those positions. And then of course, we’d expect our net asset value to increase over time. So when a number of those milestones had been hit, and if we still had as many opportunities aswe are seeing today, then yes, we would absolutely consider going back to the capital markets for additional capital.
Brett Johnson: Well, it sounds like a very exciting strategy and a very exciting time for your company, Tim. Thanks for joining us today.
Tim Keating: Brett, thank you very much for the opportunity to share the Keating Capital story with you and your listeners.
Brett Johnson: Sure. That was Tim Keating who is the founder and CEO of Keating Capital, a Colorado investment firm that will be traded on the NASDAQ, under the ticker symbol, KIPO later this year, expected around December. Thanks for joining us. Brett Johnson in New York City for OneMed Place and OneMed Radio.
End of Interview