Keating Capital Inc.: A Smart Way to Play the IPO Boom!
www.keatingcapital.com
Buy Privately, Sell Publicly, Capture the Difference™
Closed-end fund Keating Capital's portfolio is bursting with 15 private investments groomed to go public. Their focus is on private, venture capital-backed pre-IPO technology companies planning to go public within two years and attempting to capture the private to public price difference. IPOs are back but for years not just for a little while.
Stock Symbol:
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KIPO
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Balance Sheet as of September 30, 2013
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Recent Price:
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$6.15
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Net Assets+:
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$74.1 million
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52-Week Range:
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$8.05 - 5.65
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Long-Term Debt
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None
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Shares Outstanding+:
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9.5 million
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Net Asset Value Per Share++:
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$7.60
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Market Capitalization:
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$59 million
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2013 Realized Capital Gains
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$4.4 million
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Avg. Daily Share Vol. (3m):
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24,989
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2013 Dividends per Share
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$0.49
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+ After the Dec. 2013 rights offering of 713,562 shares that raised $4.1 million in proceeds after dealer-manager fees.
++ $7.93 before being reduced to $7.76 to reflect the rights offering (-$0.17), and then $7.60 after also being adjusted for the KIPO portfolio price changes in Q4 2013 of Millennial Media (MM) and Tremor Video (TRMR) public shares (-$0.06) and Keating estimated quarterly operating expenses (-$0.10).
By Robert J. Flaherty and Arnaldo Arroyo
Buy Recommendation
In 2013 America has finally edged past the 2007 post Dot Com new issue high of 217 with a total of 222 IPOs, but the party is just beginning. In 2013 only six IPOs doubled on their first day of trading. In 2000 84 of 406 IPOs doubled the first day. So our hot IPO market should continue to be robust for several years. It must. America needs the economic growth and resulting jobs which come from new enterprises.
America is in a jam! Unemployment is unacceptable and the restless middle class complains it is getting too little of the pie. We don't have enough jobs to make our people feel secure and prosperous. Merely cutting government spending can't solve the problem. Former Harvard University President Larry Summers stresses that we need real economic growth. We need lots more new expanding companies which can hire and give raises. We need to cut regulatory red tape. Then we will grow our way out of today's stagnation just as we grew our way out of yesterday's.
Over the last decade America's job creation machine has been broken. More friendly regulation like the JOBS Act which was signed into law in 2012 is reviving the Initial Public Offering. It is exactly these new enterprises which are essential to creating more jobs. So while 2013 has been a very good year for IPOs there is an entire lost decade to catch up. We must have an explosion of new public companies to strengthen our economic base. Interest rates are low. We need more new companies to borrow, make profits and grow the economy.
That is where Keating Capital, Inc. (Nasdaq: KIPO) will play its role. Technology successes have triggered most of the recent enormous new wealth gains. If you want a diversified strategy to pick IPOs successfully and ride the resurgent boom in new issues consider this closed end fund. KIPO's shares yield about 8% and recently sold at a 20% discount to our estimated updated underlying fund net asset value.
This closed-end fund operates as a business development company. It specializes in making pre-IPO investments of $3 million to $5 million in emerging growth companies that are committed to and capable of becoming public within two years. Keating Capital typically invests alongside top tier venture capital firms such as Kleiner Perkins and made its first investment in January 2010. While trying to limit risk, management seeks bargain prices so invested capital will have a return of two times over a four-year period. Doing a real IPO where the company raises money to grow is a must. Reverse mergers where no new money is raised to help the underlying company grow need not apply. Neither should start-ups seeking a quick merger and not growth capital from an IPO.
With the IPO market warming up Keating is poised to prosper as new enterprises in its portfolio of private investments go public. Led by founder Tim Keating, who graduated cum laude in Economics at Harvard exactly 30 years after Editor Bob Flaherty, Keating leads a tight, experienced, smart group of venture capital pros.
To avoid the large losses which come from concept companies with zero revenues which fail to perform Keating refuses to invest until a private company generates repeatable sales. The necessary minimum for trailing 12 months revenue was recently upped to at least $20 million. That way Keating knows the prospect is real. It knows the prospect is not just hype but has substance. Keating also prefers prospects be in venture capital-backed technology companies because that is a source of many of today's biggest stock market gainers. The elite venture companies attract the best deals. From the ones which move from concepts into revenue producers emerge the best private companies worthy of becoming an IPO.
To further protect itself, Keating seeks to negotiate "structural protections" as a feature of its convertible preferred stock investments. These are typically in the form of conversion rights. They provide for the conversion of preferred stock into common stock at a discount to the IPO at the time of the IPO. Alternatively protection could come from warrants that would result in Keating receiving additional shares for a nominal exercise price at the time of an IPO. For example, the right to convert at a 50% discount to the IPO price would enable Keating to have a cost basis of $5 for a $10 IPO. This would ensure unrealized appreciation of 100% at the time of the IPO. Of course, Keating is always subject to a 180-day lockup post IPO during which it cannot sell or hedge its position. But where it has this additional structural protection Keating has a great start toward a bigger profit.
Technology is the area Tim Keating's team understands. All new investments should have a potential return of at least two times Keating Capital's investment over an anticipated four-year holding period. The structural protections are complicated and may be hard to understand. But they have and we are sure will make KIPO returns even better in the future.
With a modest total stock market cap of $59 million Keating generated its first realized capital gains and paid its first dividend of $0.03 per share in 2012. Picking up speed in 2013, the fund generated $4.4 million in realized capital gains and declared three dividends totaling $0.49 for a yield of 8%. Many promising portfolio companies are now primed to go public. KIPO offers a diversified way to participate in the continuing IPO boom at a moment when the fund is building momentum to break out itself.
Because Keating focuses on the neglected micro- and small- cap pre-IPOs management tries to invest at a steep discount to what it believes will be the public valuation. So far in 21 investments management has succeeded in negotiating built-in downside safeguards in just under half of its new portfolio company investments. In those KIPO has the prospect for a higher return when the private investment becomes a new issue. Look at how having structural protection in LifeLock enhanced KIPO's return dramatically.
LifeLock Case Study
On March 14, 2012, Keating Capital purchased 634,711 shares of LifeLock's Series E convertible preferred stock for approximately $7.88 per share, for a total investment of $5 million. The Series E round raised over $100 million from Keating Capital and other co-investors, including Bessemer Venture Partners, Goldman, Sachs & Co., Kleiner Perkins Caufield & Byers and Symantec Corporation. Also, the Series E had a special conversion right that provided for a 1.7x return as of the IPO date.
On October 2, 2012, LifeLock completed an IPO of 15,700,000 shares of common stock at a price to the public of $9.00 per share. Goldman, Sachs & Co., BofA Merrill Lynch and Deutsche Bank Securities Inc. were the bookrunners.
Based on the special Series E conversion rights upon an IPO, Keating Capital received 944,443 shares of common stock which, based on the $9.00 IPO price, had a value of approximately $8.5 million. This represented 1.7x the initial investment cost. Effectively, the cost basis reset from $7.88 per share to $5.29 per share.
In May 2013, Keating Capital received total proceeds of $8.7 million from the sale of its LifeLock position, compared to a cost of $5.0 million.
Keating Capital's sale of its LifeLock position represented a return multiple of 1.74x its investment cost over a holding period of 1.1 years. This represents an internal rate of return on this investment of approximately 66% per year before any of the fund's operating expenses.
We think our contrarian pick for this issue is the right stock in the right place at the right time. Keating Capital specializes in buying at bargain prices minority positions in private companies which plan to go public within two years and then capturing the gains when these companies have gone public through IPOs and following the expiration of the customary 180-day lockup periods.
A Smart management! Many Keating executives graduated on the dean's list or with honors. Always bet on good management. People are what make the difference.
We end this newsletter with the favorite advice of our late guru Sir John Templeton to remember that your U.S. dollar will always buy less in December than it did in January. But Keating's smart team has already followed several of Sir John's other dictums. The fund started up at the worst possible time as the Great Financial Crisis was just beginning to unfold in 2008. The team turned that negative into a positive. When they made their first investment in January 2010 they set up their approach to only invest in private pre-IPO companies enjoying real, repeatable revenues. Currently Keating requires at least $20 million in trailing 12-month revenue so they can be sure their portfolio companies are real.
In the best bargain-hunting tradition of John Templeton, Keating focuses on the smaller (i.e., under $1 billion market cap), less popular private companies. Here you can find more reasonable valuations and far less downside risk. Remember your profit or loss when you sell will be determined by the price you pay when you invest!
Best of all, bargains galore exist among the micro-caps and small-caps. The huge banks have grown too large to care about small companies or small accounts. So many micro- and small-cap companies are capital starved. They are in desperate need for the pre-IPO seed capital to thrive and grow. This is America's greatest current unfilled economic need. Keating can help and also invest at bargain prices. Its IPO winners will help provide those missing new jobs America needs to become stronger again. Buying the best long run values at the best prices already is producing a stream of winners. (Three out of the first four KIPO investments exited were at a profit.)
The odds are the majority of their next IPOs will be winners and could even include a game changing blockbuster. In New Issue Land you have to wait awhile before you know the winners which have staying power to be keepers. Isn't it wise to put a bet on this closed-end fund with currently 15 pre- IPO contenders in the race than betting on just one IPO which financially could break a leg?
The right company in the right place at the right time, Keating is just picking up momentum! It began generating realized capital gains in 2012 and increased its special capital gains dividend from an initial $0.03 in 2012 to $0.49 in 2013 based on $4.4 million of realized capital gains in 2013. Many of the private companies in Keating Capital's pre-IPO investment portfolio are poised to go public in 2014 and more in 2015. The best is yet to come.
The goal of a Flaherty Special Situation is a gain of 50% to 100% over two years. On December 31, 2013 the stock of closed-end fund Keating Capital closed at $6.15, and was selling at a 20% discount to our updated estimated fund NAV of $7.60 and was yielding 8%. Overlooked is that Keating Capital is picking up momentum. This investor in pre-IPO private companies is poised to have its best year ever in 2014 and potential for even greater upside in 2015 as Keating is able to dispose of portfolio companies that go public in 2014 following post-IPO lockup periods. We believe that investors can achieve our target of a 50% to 100% total return. A few more successful IPOs could switch the current discount from fund NAV to a premium. So astute patient investors should have an excellent chance of landing a really big winner. Smart management! Exciting prospects for 2014 and 2015! We like KIPO. (The trading symbol stands for Keating IPOs.)
Finance
The late great company builder IT&T's Hal Geneen argued that running out of cash was really the only mistake a management couldn't afford to make. Then you are out of business! Everything else is correctable. Founder Tim Keating must have been listening.
On May 30th an error-filled case for a short of the stock claimed the fund followed a doomsday strategy and the stock price plunged. Worse, the company's recent rights offering period which began Nov. 20th and ended on December 16th, brought in a disappointing $4.1 million in proceeds after dealer-manager fees. This was way under a goal of $19 million which was calculated using at an estimated subscription price of $6.51. That price in turn was based on a 7.5% discount to the five-day volume weighted average price of $7.04 in the prospectus. Because shares which were trading about $7.10 on Nov. 20 fell below the minimum subscription offering price of $6.00 per share for much of the time during the subscription period, the rights lost much of their attraction. To have a successful rights offering, the stock price needs to be remain above the rights offering minimum so existing shareholders have a strong incentive to exercise their rights by acquiring new shares at an appetizing discount.
Fortunately, Keating has a policy of avoiding leverage and having no debt. So its pro forma cash position following the December rights offering rose to $13.5 million. To be ultraconservative Keating also maintains a cash reserve of $10 million. That means there is still enough surplus cash to make one new investment of $3 million and possible follow-on investments in existing portfolio companies.
A smart management has done the smart thing. Keeping the $10 million cash reserve ensures that in spite of unforeseeable events or other short attacks, the fund will have the staying power to survive and make the right moves to achieve a bright future.
In the present case, with many of the pre-IPO private holdings in its portfolio aiming for IPOs in 2014 and more in 2015 Keating should have its best year ever in 2014. KIPO should exceed the record $4.4 million of realized capital gains in 2013. With any upside sizable winners at all, Keating should get the opportunity to make more portfolio investments. As it harvests more winners, Keating will also be able to plan new offerings in the future. If capital markets improve such new offerings could be at an even higher price per share.
The fund's existing portfolio public positions in Millennial Media Inc. (NYSE: MM) which acquired Jumptap, a private Keating portfolio company, and new issue Tremor Video, Inc. (NYSE: TRMR) also can be thought of as a type of "secondary liquidity." The lockup period for the TRMR shares expired on Dec. 24th. For MM the lockup period expires in two parts: 33% of their position in Feb. 2014, 67% in May 2014 (however, 11% of Keating's overall position is subject to an indemnity escrow that ends in Nov. 2014). As of September 30, 2013 Keating's investment in Jumptap was marked at $7.2 million, which reflected $2.2 million in unrealized appreciation. The ultimate value of the shares above will depend on the actual trading prices of MM and TRMR when the fund disposes of its shares.
In general Keating has a four-year investment model which naturally is adjusted to the real world since each investment is unique. Keating focuses on investing in venture capital-backed pre-IPO private companies planning to do an IPO within two years. After the expiration of the 180 day lockup period shares are held for up to a year to determine the wisest timing for a sale. When Keating has the visibility to dispose of some of their existing public positions they plan to make additional investments to keep their portfolio vibrant. The opportunity to exit some of their currently losing investments or limited successes should also occur periodically.
As of September 30, 2013, the total fair value of Keating Capital's portfolio company investments was $62.0 million. In addition, the fund also had $10.4 million of cash. Keating's portfolio continued to perform well during the third quarter with the net increase in unrealized appreciation on its investments of $5.1 million. It also paid a capital gains dividend of $0.24 per share in the third quarter and recently declared $0.01 per share in the fourth quarter, which brings its total 2013 dividends to $0.49 per share. Since its initial return of capital distribution in 2011, Keating Capital has now distributed a total of $0.65 per share to stockholders.
In addition, Keating completed the exit of four portfolio company positions to date, with only one portfolio disposition at a loss of $121,000. The overall internal rate of return on the invested capital on these exited positions was 22%, calculated at the portfolio company level, before taking into account the fund's operating expenses.
As of September 30, 2013, the company's NAV was $7.93 per share-an increase of $0.14 per share from the second quarter net asset value of $7.79. Adjusted for the increased number of shares from the December rights offering, price changes during the fourth quarter in the public shares of Tremor Video and Millennial Media and quarterly management costs we estimate year end NAV will be in the ballpark of $7.60.
At a December 31st closing price of $6.15, Keating Capital's shares yield 8% and sell at a discount of 20% from our estimated year end NAV. With many of its portfolio of private pre-IPOs heading for the queue to go public in 2014 the odds favor higher capital gains above the $4.4 million generated in 2013 and higher corresponding dividends in the next few years.
Overview of Keating's Investment Portfolio
Where tomorrow's IPO action is: The key to Keating future is in the 15 private companies in the fund portfolio which are valued at $65 million. This includes the most recent $3 million investment in Deem, Inc., an e-commerce network that connects a large and diverse ecosystem. Many of these pre-IPO investments are primed to go public in 2014 or 2015.
While the headlines warn of a few Internet concepts with no sales and valuations in the billions, Keating companies are made of sterner stuff. By policy and to reduce risk Keating refuses to invest in zero revenues concept companies. Currently a venture capital-backed technology company needs at least $20 million in trailing 12-month revenues before it can make the cut to be considered by Keating.
Median annual revenues of the companies in the portfolio as of September 30, 2013 were $64 million and five exceed $100 million. Keating has already completed four portfolio dispositions out of 21 portfolio company investments, three of which have generated net realized gains. Two other portfolio companies (Tremor Video and Millennial Media-which acquired Jumptap in November) are publicly traded and pending disposition. All of the fund's previous portfolio IPOs have been underwritten by famous name investment banks. None of Keating's IPOs have become what are called, "orphan stocks" with no research coverage. In terms of analyst coverage of the Keating portfolio investments that are now public Solazyme (SZYM) has 10 analysts, NeoPhotonics (NPTN) 7, LifeLock (LOCK) 6 and Tremor Video (TRMR) 3.
Even one really big new IPO winner could make a huge difference for Keating at this early stage. Judged by unrealized appreciation as of September 30, 2013 a contender could be Xtime, Inc., which is a software and a service provider of Web scheduling and CRM solutions for automotive service departments ($3 million of unrealized appreciation as of September 30th. Others are Silk Road, Inc., which is a global provider of cloud-based social talent management software($2.5 million of unrealized appreciation ) and Zoosk ,Inc., which operates online dating communities ($1.8 million).
Looking promising in the middle of the pack is Harvest Power, Inc., which operates organic waste facilities that convert organic waste, such as food scraps and yard debris, into compost, mulch and renewable energy ($980,000 of unrealized appreciation as of September 30th. So are Metabolon, Inc. which is a molecular diagnostics and services company ($860,000) and Glam Media, Inc., which is an online media and social networking company focused on matching targeted audiences with targeted content through its properties in the lifestyle, entertainment, home, health and wellness, food and parenting categories($750,000).
A bit further down the unrealized appreciation list as of September 30th are TrueCar, which wants to change car buying forever by providing online research and pricing tools to obtain a fair deal on new or used cars ($650,000) and Kabam, Inc., which focuses on Massively Multiplayer Social Games and their traditional gamer video fans ($291,000).
Keating's pre-IPO investment strategy is working according to plan. Their publicly traded stock provides investors the opportunity to participate in a private to public valuation arbitrage transition that is both diversified and executed with discipline.
The Management Team
All investment decisions are made by an investment committee comprised of these three investment professionals.
Timothy J. Keating, 50, is founder, chairman, president and CEO of Keating Capital Inc. He also has served as president, managing member and majority owner of Keating Investments, an investment adviser founded in l997 and registered under the investment Advisers Act of l940. Prior to founding Keating Investments, he was a proprietary arbitrage trader and also head of the European Equity Trading Department at Bear Stearns International Ltd. (London) from l994 to l997. From l990 to l994, he founded and ran the European Equity Derivative Products Department for Nomura International Plc in London. Keating began his career at Kidder, Peabody & Co., Inc. where he was active in the Financial Futures Department both in New York and London. He is a l985 cum laude graduate of Harvard College with an A.B. in economics.
Kyle L. Rogers, 37, has been chief investment officer of Keating Capital since September 2010. Rogers also has served as a member of the Investment Committee of Keating Investments since 2008. Since joining Keating Investments, Rogers has been involved in evaluating, negotiating and structuring investments in micro-and small-cap companies, and assisting them in obtaining public company status. Previously, Rogers was a financial analyst in the private Wealth Management and Fixed Income Currency & Commodities divisions at Goldman Sachs from July l999 to September 2001. He is a Chartered Financial Analyst and a l999 graduate of Dartmouth College with a B.A. degree in government and a minor in environmental studies.
Rick M. Schweiger, 53, is chief financial officer, chief operating officer, chief compliance officer, treasurer, secretary and director of Keating Capital Inc. From l999 to March 2010 Schweiger had been the sole stockholder and president of Garisch Financial, Inc Prior to founding Garisch Financial, Inc., from l993 to l999 he served in various officer positions, including executive vice president, CFO and general counsel, with Old World Industries, Inc., a privately-held automotive products and industrial chemicals manufacturer and marketer. From l991 through l993 he was general counsel and chief acquisition officer for the Boucher Group, Inc., a multi-location automotive dealership group. Schweiger began his career as a corporate and mergers and acquisitions attorney. In l982 he graduated magna cum laude from the University of Notre Dame with a B.B. A. in Accounting. In l982 he graduated magna cum laude with a J.D. degree from Marquette University. He also has a Master of Law in Taxation from New York University.
History
In 2008 Keating Capital was incorporated in the State of Maryland as an externally managed, non-diversified, closed-end fund. Under the Investment Company Act of l940 Keating elected to be regulated as a business development company. As a BDC Keating is required to invest at least 70% of its total assets in "qualifying assets," including securities of private U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less.
Because of the chaotic conditions following the Great Financial Crisis which began to unfold in 2009, Keating took its time getting started. It learned from what it saw in the debacle and put in strict investment criteria to add downside protection, especially seeking companies that had repeatable revenue and were not all concept. Keating commenced its portfolio investment activities in January 2010 and expanded carefully.
In June 2011 Keating completed the capital raising for its pre-IPO fund aimed at investing in a diverse group of smaller companies with expected initial market caps of between $100 million and $1 billion. It also avoids companies aiming for a merger or acquisition rather than an IPO. Since its first investment in January 2010, Keating Capital has invested in 21 portfolio companies.
Competition
Keating Capital is organized as an investment company under SEC rules operating as a Business Development Company. Like Keating, about 36 other mostly much larger publicly traded BDCs are externally managed and pay an investment advisory fee to the investment advisor. Keating's own strategic focus is to invest in the micro- and small-cap venture capital-backed pre-IPO technology sector where there is less competition compared to highly publicized private companies that often command valuations as private companies in excess of $1 billion. This creates the opportunity to invest at bargain prices which can return two times invested capital over an anticipated four-year holding period. Interestingly most of Keating's portfolio IPOs have gone public using a famous name bulge bracket underwriter to lead the offering.
Unlike the broader bulge bracket investment banks, Keating Capital is focused on achieving long-term capital appreciation through investments in equity securities of later stage, typically venture capital-backed, pre-IPO micro and small-cap technology companies that are committed to and capable of becoming public. Because this niche is underserved Keating has a surplus of lucrative opportunities from which to choose.
Risks
In a new issue boom everyone loves to get on the IPO rollercoaster ride and get off just before a downturn. Timing is today's biggest current risk. Is it too late to play? We don't think so. Because America has had a weak IPO market for over a decade a big inventory of capital hungry private companies are thirsting for public money. With minor annual ups and downs investors should enjoy several more thrilling years of plentiful IPOs. The regulatory environment should improve too. That's because America must encourage the financing of more job creating new enterprises to avoid stagnation. If we are right the IPO ride is just beginning.
Keating needs to have more big winners than losers. To Keating's credit, its IPO successes so far are proving that its conservative strategy of only buying private companies with sizable revenues at bargain prices is working. Momentum is building. The Keating portfolio of 15 private company investments contains some with the potential to be blockbuster new issues. To be successful Keating will need those big winners.
As new issue fever gets hotter discipline must be maintained. Inevitable disappointments must be recognized and admitted as early as possible so any laggard's underperformance doesn't drag down overall portfolio performance. Sounds easy, but admitting your own mistakes is never easy.
Finally, Keating Capital suffered from an error-filled case for a short of its stock because it was "A Business Model Doomed to Fail." and KIPO shares plunged. Management vigorously responded by publishing the errors, including going so far as to list the page numbers from its 10-Q that contained the factually correct information. Short attacks can always happen again. Their best defense is good portfolio performance, resulting in higher realized capital gains from new IPOs and the corresponding payment of higher dividends to stockholders.
COMPANY CONTACT INFORMATION
Keating Capital Inc.
www.keatingcapital.com
5251 DTC Parkway, Suite 1100 Greenwood Village, CO 80111 Phone: (720) 889-0139
Investor Relations:
Margie L. Blackwell, IR Director
Phone: (720) 889-0133
Email: [email protected]
For more information please visit www.keatingcapital.com
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