Private Equity Placement Observations
Board: Value Hounds
The mention a few days ago of PIPE (private placement of public equity) financing in a Chinese-controlled reverse merger raised some thoughts on PIPE’s in general.
We’ll remember that Mark Cuban ran afoul of regulators for selling his stake in Mamma .com after being approached to see if he had any interest in participating in a PIPE of that company. Why is it seemingly axiomatic that just the prospect of a private placement of otherwise public shares is itself ‘inside’ information that would justify a rush to the exits? Are PIPE’s inherently that bad?
Not inherently, maybe, but Cuban was astute in his reading of the warning signs of a PIPE, based on the historical evidence. PIPE’s are typically issued with some sort of incentive – frequently at a discount to the current market price of equivalent publicly traded shares. There have been numerous studies of PIPE discounts over the years – historically in they are in the 25% range (when all incentives are included) vs current market levels. (Recently the nominal discounts have shrunken, for reasons which we’ll get to shortly). For a company to take that kind of equity haircut – diluting existing (public) shareholders with the disproportionately smaller contribution of (private) new money-- smacks of some level of desperation.
I noted that recently PIPE discounts – at least the nominal gap between PIPE price and current market – have shrunken considerably. There are at least two reasons – one, which many overly focus on, is the shortened required holding time for PIPE shares (it used to be two years, then one year-plus, now it’s formula driven). Just as importantly, PIPE’s now are often packaged so they include valuable kickers, such as in-the-money warrants, in lieu of a steeper discount. This makes the apparent discount appear less onerous, but in fact can be just as expensive and at least as dilutive. (Again, more in a minute)
A few years ago – pre-recession in 2007—I did a study of the success rate of PIPE-financed companies, using PIPE transaction for one quarter in 2000, and another quarter in 2004. Of the companies issuing PIPE’s in that quarter in 2000, about 10% were operating profitably in 2007. Of the (more recent) 2004 issuances, 20% were profitable in 2007. Not all failures (and there’s always the chance of a baby in the bathwater, as someone here noted), but not a generally promising outlook for companies who employ PIPE financing. See also the study referenced in the Barron’s article below.
So why do sophisticated investors (unlike Cuban) buy into the private placements of shares of these often desperate public companies-even at a discount? Even at 25% off, it would seem a fair chance that you might not even get that when any restriction period ended.
Let’s look at the history. One of the largest Wall St firms in the PIPE placement market has been Cowen (see the WSJ article reference below). They routinely advise companies looking to obtain PIPE financing. In 2005 their then-managing director was charged with routinely shorting, for Cowen’s benefit, shares of the companies they were helping to raise money.
In fact, while direct and simultaneous shorting (as an offset to a PIPE purchase) is not permissible, there have been rather systematic episodes of PIPE purchasers ‘locking in’ guaranteed profits – the PIPE discount – by shorting the higher-priced publicly common shares – either directly, or through options or privately constructed derivative products, and simultaneously buying the lower-priced PIPE shares. When the PIPE holding period expires, which these days is a shorter time-frame than was permissible in the past, those restricted shares can be unloaded and the short position also closed. Both the ‘buy’ and ‘sell’ prices had effectively been established at the beginning of the transaction. No matter what happened to the company’s shares, a hedged PIPE purchaser made money.
As SEC surveillance capabilities -- such as they might be -- have ‘improved,’ the PIPE ‘discounts’ seem to have shifted into other less-obvious forms than just a lower nominal per-share price. One, as noted earlier, has been the emergence of the inclusion of in-the-money warrants, which presumably could be hedged.
Unfortunately, I can’t speak to other creative financial devices that might be used for establishing a hedge for these products, other than the obvious straight-forward shorting or through options. But it’s not likely – given the overall track record of PIPE-issuing companies, or of the hedge funds buying these—that hedge funds are suddenly seeing straight-up investment opportunities here. Those of us holding soon-to-be-diluted public shares probably should not rest easy with the idea that ‘smart money’ is following us into a company by buying its PIPE’s. The history of PIPE’s suggests overwhelmingly that the deck is stacked against us – both in terms of the underlying company’s prospects, and in the structures of the deals.
Of course some PIPE-issuing companies do survive. But the historical odds haven't been great.
WHY HEDGE FUNDS LOVE PIPES
February 5, 2007
By BILL ALPERT
“THE HISTORIES OF WALL STREET'S scuzzy companies frequently feature PIPEs, or "private investments in public equities." In these financings, a public company sells stock via a discounted private placement to investors—typically hedge funds or investment vehicles…. Public investors in PIPE-issuing companies don't make out very well, say researchers [who] studied more than 5,000 PIPE deals…They found that shares of PIPE issuers underperformed those of similar companies by about 30% in the two years after a PIPE deal, if the private-placement investors were mostly hedge funds….
“The private-placement investors seem to do well, however. Hedge funds got their PIPE shares at an average discount of 14% to the stock's public market price, often also receiving warrants…those warrants boosted the deals' value to the private-placement investors by another 15%...
“….PIPE issuers have complained that…the private-placement investors exploit the discount they receive, by shorting the issuers' stocks……”
Secrets in the Pipeline
Wall Street Journal
By GRETCHEN MORGENSON AND JENNY ANDERSON
Published: August 13, 2006
“WALL STREET, where information is transformed into cold, hard cash, is also a place where secrets have their own special currency. And while trading on inside information, to most people, means buying a stock ahead of news that sends it soaring…..The hot tips at issue in these cases involve an increasingly popular type of security called a ''private investment in public equity.''….
“….Ranked by dollar amount of transactions, the biggest brokerage firms involved in PIPE's during the first half were Cowen & Company, with $744 million in deals; Deutsche Bank Securities, $602 million; and J. P. Morgan Chase, $511 million…..Although the S.E.C. issued new guidance in 2004 to discourage sham transactions -- short sellers trying to mask how they cover their shorts -- regulators say potential problems remain.
“……..A case that the S.E.C. brought in April 2005 against Guillaume Pollet, a managing director of S. G. Cowen & Company, as Cowen was then known, illustrates the problems. Mr. Pollet was in charge of investing S. G. Cowen's funds in PIPE transactions and shorted the stocks of 10 companies that were planning to issue PIPE's. In several instances, S. G. Cowen also advised the PIPE issuer as its investment banker…”