Transcript The Holy Grail of Alpha March 19, 2009 Agenda 1. The Loser’s Game of Active Money Management 2.

The Holy Grail of Alpha
March 19, 2009
Agenda
1. The Loser’s Game of Active Money Management
2. Alternative Investment Case Studies
 Venture Capital
 Private Equity
 The Harvard Endowment
3. True Alpha: Keating Capital Case Study
4. Seeking Alpha in the Business of Investment Management
and in Life
2
Keating Investments Overview
 Keating Investments, LLC: Denver-based SEC
registered investment adviser focused on micro-cap
public companies since 1997
 Keating Capital, Inc.: Publicly reporting, closedend investment fund managed by Keating
Investments, LLC that makes minority, noncontrolling investments in rapidly growing private
companies and advises them on how to maximize
shareholder value by going public through an
alternative to an IPO
3
The Loser’s Game of Active
Management
Median Ten-Year Annual Compound Total
Returns from Historic P/E Deciles 1926 to 2008
16.92%
15.99%
15.20%
14.48%
13.86%
11.55%
Return (%)
9.32%
8.01%
5.69%
3.27%
Stocks Cheap
Stocks Expensive
5
Costs and Net Returns
All General Equity Funds
1994-2008
Annual Total Return
Total Expense
Ratio
Portfolio Turnover
Low Cost Quartile
7.24%
0.71%
25.5%
Quartile 2
6.51%
1.09%
54.5%
Quartile 3
5.87%
1.33%
80.8%
High Cost Quartile
4.65%
1.80%
146.7%
Quartile
Source: Lipper
6
6
Index Funds Are the
Perfect Low-Cost Vehicles
Percent of Large-Cap Equity Funds
Outperformed by S&P 500 for Periods Ending 12/31/2008
Period
1 Year
Index Outperformance
61%
3 Years
64%
5 Years
62%
10 Years
54%
20 Years
68%
Source: Lipper and The Vanguard Group
7
Index Funds Have Outperformed
Benchmark
20 years to 12/31/2008
S&P 500 Index
8.43%
Average Equity Fund
7.50%
S&P 500 Advantage
0.93%
Source: Lipper & The Vanguard Group
8
8
The Odds of Success:
Returns of Surviving Funds
Mutual Funds 1970-2008 Compared with S&P 500 Returns
9
9
Potential Advantages of
Core-Satellite Approach
Core portfolio (indexed investments)
Low costs vs. active management
Lower risk budget vs. active management
Diversification (broad indices)
Close tracking of benchmark performance
Satellite
1
Satellite
2
Satellite portfolio (active investments)
Take “bets” to enhance returns (add alpha)
Higher costs versus indexed management
Decorrelation
Requires strong selection skills
Can use illiquid assets
Index core
Satellite
3
10
10
Do Not Try to Time the Market
Flows to Equity Funds Related to Global Stock Price Performance
Source: Investment Company Institute
11
Dispersion of Returns:
1st, Median and 3rd Quintiles
10 years ending June 30, 2005
38
Alternative Investment Case Studies
David Swensen on Liquidity
David Swensen
Success matters, not liquidity. If private, illiquid investments
succeed, liquidity follows as investors clamor for shares of the hot
initial public offering. In public markets, as once-illiquid stocks
produce strong results, liquidity increases as Wall Street
recognizes progress. In contrast, if public, liquid investments fail,
illiquidity follows as investor interest wanes. Portfolio managers
should fear failure, not liquidity.
-- David F. Swensen, Pioneering Portfolio Management, 2009
14
IPO Market Facts
Number of Total U.S. IPOs
Withdrawn IPO Filings 1985-2000
9% Eventually priced
# of IPOs filed: 7,442
# withdrawn: 1,473
# withdrawn and return for IPO: 138 ≈ 9%
91%
Never priced
Source: Hoover’s IPO Central.
Source: Wall Street Journal; Dealogic; Journal of Financial Economics.
VC-Backed Companies
Traditional IPO: Ever Rising Bar
Average IPO size:
1997: $70 MM
2007: $230 MM
Source: Hoover’s IPO Central.
Source: Dow Jones VentureOne.
15
Venture Capital

Median return for all funds raised in 2000 is -1% (as of 9/30/08) vs. S&P 500
return of +0.4% (Source: Cambridge Associates)

VC industry is now managing $257 billion, up from $64 billion in 1997

It has been 11 years since the VC industry has returned more cash than it
plowed into investments

Median return of top quartile of 1,252 venture funds going back to 1976 was
28% (Josh Lerner, Harvard Business School)

Median return of all funds was just under 5%, worse than Treasury bonds

$36 billion raised in 2007 = $720 million in annual management fees…even
if there are no gains

“Lottery slogans with Ivy League veneer”

5,400 private portfolio companies at beginning of 2006 (a good year)

Only 1% exited via IPO during 2006

7% exited via M&A, but at only $52 MM median valuation

12 years of inventory remaining at 2006 exit rates
16
VC: Coming Up Short with No Exits
17
Emerging Growth
Underwriters: R.I.P.
18
Private Equity Fact and Fiction

Allegation: PE firms are quick flip artists.
– Between 1970 and 2007, nearly 60% of 21,400 companies acquired by PE
investors remained under PE ownership for 5+ years (Josh Lerner, Harvard
Business School).

Allegation: PE firms load up companies they buy with massive amounts of debt.
– 1987 to 1990: 87.3%
– 1992 to 2000: 71.6%
– 2001 to 2007: 63.7%
Source: www.privateequitycouncil.org
19
Private Equity Fact and Fiction

Stephen Kaplan (University of Chicago) study:
– In 2005, initially reported that the average PE firm’s annual return was no
better than the S&P 500
– Subsequently reported that PE firms’ returns were inflated
– Example: Blackstone Group
• 2002 to 2006: 26% vs. 6% for S&P 500
• 2003 to 2006: 26% vs. 20% for S&P 500

Ludovic Phalippou and Oliver Gottschlag study:
– PE returns are dramatically overstated because they include estimated value
of deals before the investments are actually realized through a sale
– When the data is cleaned up: PE underperforms S&P 500 by 3% a year
after fees
Source: CondeNast Portfolio (March 2009)
20
Final Words on PE Performance
John Maynard Keynes
David Bonderman
Some bursars will buy without a
tremor unquoted and unmarketable
investments in real estate which, if
they had a selling quotation for
TPG boss David Bonderman told a
conference in Hong Kong this month
that, unlike hedge funds, which allow
investors to get their money out in as
little as 45 days, "private equity all has
long-term lockups. So you may like
our performance, you may not like our
performance, but you're my partner for
the next 12 years." Mr. Bonderman
then made a loud smooching sound,
sending the audience into hysterics.
immediate cash available at each audit,
would turn their hair grey. The fact that you
do not know how much its ready money
quotation fluctuates does not, as is
commonly supposed, make an investment a
safe one.
--John Maynard Keynes, “Memo for
the Estates Committee, King’s
College, Cambridge” May 8, 1938
-- Wall Street Journal,
November 24, 2008
21
The Harvard Endowment Fund

$36.9 billion endowment designed to generate $1.4 billion in annual earnings

Designed to fund 1/3 of $3.5 billion operating budget

$7.2 billion in derivative exposure to commodities and foreign stocks

Margin calls…but no cash

Had 105% exposure to risky assets

Tried to sell illiquid PE portfolio, but there were no buyers

Had to sell $2.9 billion stock portfolio in a falling market

Subsequently had to raise $2.5 billion by issuing bonds

Assumption is that endowment will have fallen 30% for year ending 6/30/09

In 15 years through June ‘08, endowment had generated 15.7% annual return
vs. 9.2% for S&P 500
Source: “When Genius Failed”, Forbes (March 16, 2009)
22
Keating Capital Case Study
Keating Capital Overview
Alternative investment strategy focused on publicly-traded private equity

Makes minority, non-controlling, growth equity investments

Invests in rapidly-growing companies at a 50% discount to comparable public
companies

Takes portfolio companies public via simple “self-filing” process as alternative to an
IPO

Exits positions through open market sales after 2-3 years of earnings and P/E growth
by portfolio companies
24
Keating Capital Differentiation
25
Public Companies Have Higher
Valuations
Benefit #1: Raise growth capital at a premium to private valuations
Benefit #2: Increase enterprise value significantly by going public
Source: Pratt’s Stats® at BVMarketData.com, Public Stats™ at BVMarketData.com as of March 5, 2009 for transactions between January 1, 2004 and December 31, 2008. Used with permission from Business Valuation Resources, LLC.
+Valuation data based on 5,000+ private and public company transactions under $100 MM.
*Keating Investments, LLC calculations based on those companies having positive net income; valuation data based on private and public company transactions under $100 MM.
*Keating Investments, LLC calculations based on those companies having positive net income; valuation data based on private and public company transactions under $100 MM.
26
Top Performing Stocks
Start as Micro-caps
27
Why Can’t I Do an IPO?
Number of IPOs Raising Less Than $25 Million
“A structurally compromised IPO market leaves a lot of shareholder return, economic growth and job formation
on the table… Big corporations are eating our young as they starve for capital before they
have the opportunity to reach adulthood. Their true potential will never be known.” David Weild and Edward Kim
“Why are IPOs in the ICU” (Grant Thornton, 2008).
28
Investment Process
29
Investment Criteria
30
Keating Capital Value Proposition
31
Seeking Alpha in the Business of
Investment Management and in Life
Careers in Finance: Decision Tree
 MBA vs. CFA
 Investment banking
 Wealth management/financial advisory
 Active management
 Alternative investment management
 Searching for the Holy Grail
33
Seeking Alpha in the Business of
Investment Management
Alpha

What is mispriced and why?

Can you articulate why the pricing anomaly has not been arbitraged away?
Possible Sources of Alpha

Small

Undiscovered

Illiquid
Meaningful

Is leverage required to make the strategy financially viable?

What impact do transaction costs have on the strategy?
Sustainable

Will the alpha persist over time?
Scalable

Can you build a sizable strategy around the alpha?
34
Personal Traits for Success
Jim Cramer’s 4 Key Traits
+
Tim Keating’s 6 Building Blocks
 Tenacity
 Accounting/Valuation
 Rigor
 Sales & Marketing
 Honesty
 Psychology/Behavioral Finance
The Holy Grail
 Loyalty
 Reading
 Mental Models
 Execution
35
Seeking Alpha in Life
Theodore Roosevelt
It is not the critic who counts: not the man who points out how the strong
man stumbles or where the doer of deeds could have done better. The
credit belongs to the man who is actually in the arena, whose face is marred
by dust and sweat and blood, who strives valiantly, who errs and comes up
short again and again, because there is no effort without error or
shortcoming, but who knows the great enthusiasms, the great devotions,
who spends himself for a worthy cause; who, at the best, knows, in the end,
the triumph of high achievement, and who, at the worst, if he fails, at least
he fails while daring greatly, so that his place shall never be with those cold
and timid souls who knew neither victory nor defeat.
"Citizenship in a Republic,"
Speech at the Sorbonne, Paris, April 23, 1910
36