Publication Date: July 25, 2005
Overview: Private Investment in Public Equity (“PIPES”)
A Friedland Capital White Paper
www.friedlandworldwide.com
In recent years management of many public companies have utilized PIPEs (“Private Investment in Public Equity”) as a way to obtain equity capital to finance growth, acquisitions or for working capital. At the same time hundreds of investment funds have been established to invest in PIPEs. And, many investment banking firms are also specializing in placing PIPE transactions for client companies.
A Brief Introduction to PIPEs
In a PIPE transaction, investors typically purchase securities directly from a publicly traded company in a private placement. Depending on the structure of the transaction, this can be done at a premium to, or at a discount from the market price of the company's common stock. Because the sale of the securities is not pre-registered with the Securities and Exchange Commission (SEC), the securities are ‘restricted' and cannot be immediately resold by the investors into the public markets. Accordingly, the company will usually agree as part of the PIPE transaction to register the restricted securities with the SEC. Thus, the PIPE transaction can offer the company the speed and predictability of a private placement, while providing investors with a nearly liquid security.
Who are the PIPE Investors and What Are They Typically Looking For?
Hundreds, if not thousands of private equity funds or hedge funds have been established over the past few years to invest in PIPEs. Some of these are affiliates of major financial services firms such as Merrill Lynch, Goldman Sachs and Citigroup. Others have been established by private money management firms, individual investment advisors, or by “family groups.” There is no regulation in the United States that limits the investment criteria of any of these PIPE fund sponsors. However, many PIPE funds have established their own criteria. For example, some may only be interested in certain industry sectors, such as Energy; Biotech, Medical & Healthcare, Technology or Real Estate. Still others may have a geographical focus, such as Africa, Latin America or China. Others may have specific criteria regarding the subject companies that are appropriate for their investment, such as companies whose shares trade on the OTC Bulletin Board, the New York Stock Exchange, Nasdaq, the American Stock Exchange or foreign stock exchanges. Others may have requirements as to a minimum share price, for example over $2, or companies that are cash flow positive.1 In addition to PIPE funds, specific PIPE investment transactions are marketed and sold to a wide range of investors, largely depending upon the type of PIPE (e.g. pure as opposed to standard, traditional as opposed to structured), the size and industry of the company and the quality of the placement agent, if any, involved in the transaction. Historically, PIPEs were not sold to traditional private equity investors, but rather to sophisticated public market investors who focused not only on the fundamentals of the company but also on the technical aspects of public market investing dynamics, such as trading volume, float and volatility. These investors generally do not seek board seats or special approval rights and, apart from their right to a resale registration, are content to be treated as ‘outside,' passive investors. Recently, a growing number of traditional venture capital firms have made investments in PIPE transactions. Although many of these investments have been structured in a fairly straight-forward
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manner, it is not uncommon for venture capitalists to attempt to transpose to the PIPE arena the fullblown rights and protections that they typically seek with respect to private company preferred stock investments. Often, such ‘venture capital PIPE' investments will raise a host of issues under the federal securities laws, and corporate governance regulations. Many PIPE investors are primarily focused on the liquidity of the company’s stock, e.g. average daily trading volume. While these PIPE investors tend to have a short-term investment horizon, and are not typically long-term investors, they must usually also be comfortable with the company’s business operations and potential for the future. Other PIPE investors are more “traditional” private placement investors and will be looking for a longerterm investment, often two to three years. While not being as concerned with share trading volume or current market liquidity, these investors’ investment decision making process will rely on their own research and due diligence, which will usually focus on an evaluation of the company’s current business operations and the company’s prospects for the future.
Varieties of PIPEs
There are many varieties of PIPEs, which typically differ based on the structure and terms of the transaction, the securities offered, and the investor base to which it is offered or targeted.
Pure PIPEs Compared to Standard PIPEs
In a ‘pure' PIPE, investors agree to purchase the company's securities in a private placement on the condition that a registration statement for the resale of those securities is declared effective by the SEC immediately after the closing of the private placement. The closing of the pure PIPE transaction, therefore, is delayed until the effective date of the registration statement, giving investors the immediate ability to resell the securities purchased in the PIPE. Today, due in large part to legal concerns created by the structure, this type of PIPE transaction is not utilized very often. In contrast, a ‘standard' PIPE transaction is structured so that the private placement of the securities is closed not only prior to the effectiveness of the resale registration statement, but also prior to the filing of such registration statement with the SEC. The company agrees in the PIPE documents to file for the registration of such securities promptly following the closing (typically within ten days of the closing) and to use its best efforts to obtain effectiveness of the registration statement (generally within 30 days of the filing). However, depending on whether or not the SEC opts to review the registration statement, the resale registration process can take several months to complete. Due in large part to this period of illiquidity, investors typically purchase their PIPE securities at a discount to the public market price. Although various types of debt and equity securities, as well as more exotic securities such as derivatives, can be sold and registered with the SEC in a PIPE transaction, most PIPEs involve the issuance by the company of common stock, convertible preferred stock or convertible debt. As an inducement to complete the PIPE financing, investors also may require warrants as a ‘sweetener.' Warrant terms vary widely, but typically include an exercise price set at a premium to the current market price.
Traditional PIPES
The majority of ‘traditional' PIPEs involve the sale of common stock at a fixed price. The traditional PIPE can be priced at a discount from market, a premium to the market, or at the market price of the company’s common stock. However, traditional PIPEs may instead consist of the sale of preferred stock which, at the investor's election, is convertible into common stock at a fixed conversion price. Such preferred stock may entitle the investors to dividends and other rights and in a sale, merger or liquidation of the company, will provide the investor with the right to receive back the purchase price of the preferred stock prior to any distributions to the holders of common stock. These benefits can be argued to off-set the illiquidity discount applicable to traditional common stock PIPEs, and therefore traditional preferred stock PIPEs are often priced at or near the current market price of the company's common stock.
Structured PIPES
In a “Structured' PIPE, the company will sell preferred stock or debt securities which, in either case, are convertible into the company's common stock. The conversion price in a structured PIPE, however, is either variable or contains a re-set mechanism that automatically adjusts the conversion price downwards
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(e.g., allows the investor to acquire more shares) if the market price of the company's common stock falls below the conversion or re-set price fixed at the time of issuance. Structured PIPEs provide price protection to investors but subject the company's common stockholders to the risk of significant dilution. Additionally, a structured PIPE transaction may require shareholder approval prior to the issuance of the PIPE securities. In 2001, according to industry surveys, approximately 23 per cent of all PIPE transactions (representing only ten per cent of dollars raised) were structured PIPEs.
‘Death Spiral' PIPES
If improperly structured, PIPE transactions have the potential for significant shareholder dilution. Such ‘toxic' transactions typically involve a convertible security with a conversion price that is linked, often at a discount, to the market price of the company's common stock at a discount to the current market price, the discount provides a built-in economic gain, which creates the incentive immediately to sell the securities purchased instead of holding them. As the company's stock price drops, the company is required to issue more stock under the terms of the PIPE transaction. These additional issuances cause further downward price pressure, and the price of the common stock often enters a ‘death spiral.' The effect of toxic financings is hastened by their unpopularity with institutional investors. Institutional investors are wary of the extreme dilutive effect on the holders of common stock and the historically inevitable decline of their own investments as a result of toxic transactions. Merely announcing a PIPE transaction that does not sufficiently limit the ultimate dilution suffered by current stockholders can negatively impact the company's stock price as existing investors attempt to sell their positions before the results are manifested. Today, management of very few public companies are willing to commit to a “Death Spiral” PIPE, unless they have desperate capital needs that can’t be achieved otherwise.
The PIPE Transaction Itself
A significant advantage of PIPE transactions compared to traditional public offerings is that they can be completed rapidly - typically two to three weeks from kick-off to closing. In a typical PIPE transaction, due diligence is limited in scope because of the compressed time frame, and generally consists of a review of the company's filings with the SEC and press releases and investigative conference calls with the company's management, counsel and accountants. The documentation for a PIPE financing is relatively minimal: typically consisting of an offering circular summarizing the terms of the financing and containing a description of the business of the company taken directly from the company's filings with the SEC, a purchase agreement, a registration rights agreement, an investor questionnaire, a legal opinion from company counsel and, in the case of a convertible preferred stock offering, a certificate of designations or charter amendment defining the rights and privileges of the preferred stock. After the closing of the financing transaction, the company and its counsel typically prepare and file the registration statement to register for resale by the investors the common stock issued (or issuable on conversion of preferred stock or other securities issued) in the PIPE. Typically, the registration statement is filed within ten days after the closing, and the company is required to use its best efforts to have the SEC declare the registration statement effective within thirty days after the filing. The SEC may elect to review and comment on the registration statement, which could delay the effectiveness past this 30-day commitment. Once the SEC is satisfied with the registration statement, it will declare it effective and resales of the PIPE securities may begin. The company must keep the registration statement up to date during the entire time that PIPE investors are reselling their restricted securities pursuant to the registration statement.
Footnote: 1. Friedland Capital Inc. has been the co-sponsor of a New York City PIPEs Conference which was attended by management of hundreds of PIPEs Funds. Friedland Capital has classified these PIPE investors in its databases based on their investment criteria, including market cap, share price, and industry group or country focus.
Copyright 2005 – All Rights Reserved – Friedland Capital Inc.
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About Friedland Capital
Friedland Capital Inc. is a US based merchant bank with offices in the United States in New York, Dallas and Denver; in Canada in Vancouver; and in China in Beijing and Guangzhou. Among its activities, Friedland Capital provides corporate finance advisory services to enable publicly-traded and privately-held emerging growth companies, as well as sponsors of investment programs worldwide to achieve their short-term capital goals, and to realize their long-term business objectives. Friedland Capital also sponsors its proprietary “Micro IPO®” Program which enables privatelyheld companies worldwide to become publicly-traded in the United States. (www.microipo.com) Friedland Investment Events LLC, an affiliated company, is the world's largest sponsor of financial and investment events, sponsoring over 280 events annually, in 28 US cities and 3 European cities. These events include all-day conferences, breakfasts, luncheons and cocktail receptions. These events include:
• • Events featuring presentations by management of publicly-traded companies for buyside and sell-side members of the financial community. Events featuring presentations by sponsors of investment programs for financial planners, brokers, accountants and investment advisors.
Friedland Corporate Investor Services, which is also an affiliated company, provides financial marketing and investor awareness programs to privately-held and publicly-held companies, as well as sponsors of investment programs and products.
Friedland Capital Contact Information
United States:
Denver: Jeffrey Friedland, Erich Leimgrubler or Nate Nicholson—Tel. 303-355-6566 New York: Dylan Hundley—Tel. 646-435-4069 Dallas: Ben Doherty—Tel. 214-354-9747
China:
Beijing: Kristina Wang or Max Zhao—Tel. 65-10-5869-4791
Web Sites:
Friedland Capital: www.friedlandcapital.com Friedland Investment Events: www.friedlandevents.com Friedland Worldwide: www.friedlandworldwide.com
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