The Hedgeweek Interview: Kevin Pilarski, partner and derivative portfolio manager, Kilkenny Capital Management: Focusing on opportunities in the biomedical sector

Kevin Pilarski outlines the investment process and analysis that underlies the performance of Kilkenny's biomedical-focused range of funds.

HW: What is the background to your company and funds?

KP: Kilkenny Capital Management, founded in May 1995, currently has assets under management of USD200m, and manages the following funds: KCM Biomedical (inception in May 1995), KCM Biomedical II (inception in February 2001), and KCM Biomedical Offshore Fund (inception in April 2000). The portfolio manager on all funds is Michael Walsh, while Vince Aita is a partner and co-portfolio manager, and I am a partner and derivative portfolio manager.

HW: Who are your service providers?

KP: Ernst & Young, Shartis Friese, Fulcrum and Bear Stearns.

HW: What is the profile of your current and targeted client base?

KP: Our client profile comprises a mix of high net worth and institutional investors.

HW: What is the investment process of your funds?

KP: Our investment process is a bottom-up fundamental valuation of biomedical innovation, using a proprietary methodology that has been honed since 1995.

HW: How do you generate ideas for your funds?

KP: KCM has a universe of 250 biomedical companies that it monitors for investment opportunities. A probabilistic model of fair value for the cash flow generating potential of these companies is force ranked using our proprietary methodology that illuminates market mispricings.

HW: What is your approach to managing risk?

KP: Long positions are sized at no more than 5 per cent of cost or market, while shorts are approximately one-third of that size. The portfolio does not use leverage. Typically there are between 25 and 35 long positions, and between 30 and 50 shorts. Derivatives, such as options can be used on a long-only or fully collateralised basis.

HW: Has your performance been as per budget and expectations? Do you expect your performance or style to change going forward?

KP: Performance has been in line with expectations. Our compounded rate of return since inception is 22 per cent. With the increased liquidity in derivatives on individual equities we expect to utilise the asymmetric return benefits of these instruments more actively in the future.

HW: What opportunities are you looking at right now?

KP: We are constantly evaluating the landscape of biomedical product development to identify product opportunities within companies that are significantly mispriced relative to their time-discounted, probability-adjusted potential to generate cash flow. We are looking for cheap call or put options on innovation as represented by the stock price of a company relative to their appropriate fair value.

HW: What events do you expect to see in your sector in the year ahead?

KP: As in any given year, two significant perennial themes in our sector are cycles in investor appetite for speculative risk, and continued consolidation in the sector via corporate M&A activity.

HW: How will these trends impact on your own portfolio?

KP: With our uncompromising focus on valuation, we tend to benefit from corporate M&A activity and often see several of the companies in our long portfolio acquired in any given year. We have already seen three such events this year in the acquisitions of Serono, TriPath Imaging and KOS Pharmaceuticals.

HW: What differentiates you from other managers in your sector?

KP: Firstly, our 12 year-track record, which is unmatched in this sector. Also, we view the world on a probabilistic basis and do not claim we are smarter than everyone else at determining the right outcome in every situation.

Instead, we focus on identifying asymmetric risk/reward situations where the market is dramatically mispricing a company's innovative potential to generate cash flows, and we believe that over the long term, investments in a large enough sample of these opportunities will consistently yield positive returns with more upside than downside volatility.

HW: Do you have any plans for other product launches in the near future?

KP: A less liquid longer-term fund, a concentrated portfolio fund and a market neutral sector approach are in the works.



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