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The Holy Grail of Alpha March 19, 2009. Agenda. The Loser’s Game of Active Money Management Alternative Investment Case Studies  Venture Capital  Private Equity  The Harvard Endowment True Alpha: Keating Capital Case Study

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Agenda l.jpg

  • The Loser’s Game of Active Money Management

  • Alternative Investment Case Studies

    •  Venture Capital

    •  Private Equity

    •  The Harvard Endowment

  • True Alpha: Keating Capital Case Study

  • Seeking Alpha in the Business of Investment Management

  • and in Life



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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, closed-end investment fund managed by Keating Investments, LLC that makes minority, non-controlling investments in rapidly growing private companies and advises them on how to maximize shareholder value by going public through an alternative to an IPO


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Median Ten-Year Annual Compound Total

Returns from Historic P/E Deciles 1926 to 2008








Return (%)




Stocks Cheap

Stocks Expensive


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Costs and Net Returns

All General Equity Funds

Source: Lipper



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IndexFunds Are thePerfectLow-Cost Vehicles

Percent of Large-Cap Equity Funds

Outperformed by S&P 500 for Periods Ending 12/31/2008

Period Index Outperformance

1 Year 61%

3 Years 64%

5 Years 62%

10 Years 54%

20 Years 68%

Source: Lipper and The Vanguard Group


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Index Funds Have Outperformed

Source: Lipper & The Vanguard Group



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The Odds of Success: Returns of Surviving Funds

Mutual Funds 1970-2008 Compared with S&P 500 Returns



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Satellite 1

Satellite 2

Index core

Satellite 3

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 portfolio (active investments)

Take “bets” to enhance returns (add alpha)

Higher costs versus indexed management


Requires strong selection skills

Can use illiquid assets



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Do Not Try to Time the Market

Flows to Equity Funds Related to Global Stock Price Performance

Source: Investment Company Institute


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Dispersion of Returns:

1st, Median and 3rd Quintiles

10 years ending June 30, 2005


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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







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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%


Never priced

Source: Wall Street Journal; Dealogic; Journal of Financial Economics.

Source: Hoover’s IPO Central.

Traditional IPO: Ever Rising Bar

VC-Backed Companies

Average IPO size:

1997: $70 MM

2007: $230 MM

Source: Dow Jones VentureOne.

Source: Hoover’s IPO Central.



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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






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Emerging Growth Underwriters: R.I.P.


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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%



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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)


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Final Words on PE Performance

John Maynard Keynes

Some bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for 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

David Bonderman

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.

-- Wall Street Journal,

November 24, 2008


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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)







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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


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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, Public Stats™ at 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.


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Top Performing Stocks Start as Micro-caps


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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).


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Careers in Finance: Decision Tree in Life

  • MBA vs. CFA

  • Investment banking

  • Wealth management/financial advisory

  • Active management

  • Alternative investment management

  • Searching for the Holy Grail







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Seeking Alpha in the Business of Investment Management in Life


 What is mispriced and why?

 Can you articulate why the pricing anomaly has not been arbitraged away?

Possible Sources of Alpha

 Small

 Undiscovered

 Illiquid


 Is leverage required to make the strategy financially viable?

 What impact do transaction costs have on the strategy?


 Will the alpha persist over time?


 Can you build a sizable strategy around the alpha?







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Personal Traits for Success in Life


Jim Cramer’s 4 Key Traits

 Tenacity

 Rigor

 Honesty

 Loyalty

Tim Keating’s 6 Building Blocks

 Accounting/Valuation

  • Sales & Marketing

  • Psychology/Behavioral Finance

     Reading

     Mental Models

     Execution

The Holy Grail







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Seeking Alpha in Life in Life

Theodore Roosevelt

It is not the critic who counts: not the man who points out howthe 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