Cash-hungry tech
companies get stuck in the PIPEs
With the
secondary equity markets effectively closed, public
companies are being forced to seek private investments in
a public entity, or PIPEs. Is the money worth the price?
By Stephen Lucey
February 14, 2001
The real innovation these days in technology companies
is happening in the finance department, not in the R&D
labs. Thanks to a continued capital
crunch, the real challenge for many companies today is
locating alternative financing channels.
With the IPO pipeline and secondary markets all but
sealed shut, many technology companies are scrambling to
raise money to keep their doors open. Now public companies
have nowhere to turn except the private markets, through
financing vehicles known as PIPEs (private investments in
a public entity).
In January alone, 54 PIPE offerings were completed for
a total of $681 million, according to
PlacementTracker.com
, the market data division of
DirectPlacement.com
, an online PIPE market exchange. By way of contrast, just
three IPOs and 12 follow-on offerings have been priced so
far this year, down from 34 and 46, respectively, at this
point in time last year, according to
Thomson Financial Securities Data
. And analysts say that these PIPE deals may be just the
tip of the iceberg. The tenuous financial condition of
many of the 351 companies that had IPOs last year -- 147
of which are trading at a 50 percent discount to their
offering price -- suggests another public offering would
be unlikely.
"It doesn't look like things are going to get
better anytime soon," says Brian Overstreet,
president and cofounder of DirectPlacement.com.
"We've already seen a pretty active PIPE market this
year, but it is going to pick up even more into the second
quarter."
TIMES ARE TOUGH
While these deals have provided financing primarily for
small and midsize companies, Mr. Overstreet expects large
technology concerns to follow shortly. A desperate need
for funding has forced companies to reinvent the
relationship between the public and private capital
markets. The same young companies that gladly rushed to
the public markets not long ago are now returning to
venture capital firms, institutional investors, and buyout
firms.
Though the amount of money raised through PIPEs has
risen in recent years -- $54 billion in 2000, compared to
$22 billion in 1999 and just $12 billion in 1998 -- these
deals are clearly not new, but simply one of the last
alternatives in a slowing marketplace (see "Debt
Reckoning").
The sale of private equity stakes to a selected group
of institutions provides a quick channel to capital for
companies. By targeting the offering to a limited number
of investors, the process to complete the deal becomes
much faster than completing a traditional secondary
offering. Since any direct sale of capital stock of more
than 20 percent requires shareholder approval, most PIPE
deals amount to a sale of roughly a 10 percent stake in
the company.
But the speed of the offering combined with the
often-distressed nature of these companies allow issuers
to extort a price for the financing. Among the recent
PIPEs surveyed by Kent Penwell, a managing director in the
equity capital markets group at Banc of America
Securities, companies raising $50 million or more through
common stock offerings accepted a discount of 10 percent
to 12 percent below their stock price. According to Mr.
Penwell, this was double the discount rate of companies
completing traditional offerings in the secondary market
last year.
PUBLIC HUMILIATION
The higher discount rates are in large part a function
of the speed with which a PIPE can be completed. But Mr.
Penwell says that since many of the companies completing
these deals are smaller, potential volatility in the stock
price must be factored into the terms of the deal. With
nowhere else to turn, companies have little bargaining
power. It's becoming a case of take it or leave it.
With the public markets in disarray and the startup
community suffering from the weakness in the broader
market, venture firms and institutional investors are glad
to see these deals coming across their desks. Though
investors at all levels are less inclined to part with
their money than they were a year ago, there is still
capital available in both the public and private markets
to fund these cash infusions. And institutional investors
and VCs are finding some bargains in the public market at
the moment.
"The public market, in days like these, is a very
attractive place to put your money to work," says
Rick Kimball, a general partner at Technology Crossover
Ventures, which invests in both private and public
companies. "The valuations of some public companies
are more attractive than a lot of those in the private
markets. And at the end of the day, if you were wrong,
you've got a better chance at liquidity than if you made a
mistake on the private side."
Unlike the public markets, which open and close based
on market sentiment, the PIPE market is always open. The
only thing that really changes is the terms of a deal. And
while the terms of an investment are the most important
part of any deal, in crunch times like these, many
companies are more concerned about a quick cash infusion
than the terms of the PIPE. In other words, it's a buyer's
market.
SURVIVAL AT ANY PRICE
In the case of the ailing Internet consulting firm
Marchfirst
(Nasdaq :
MRCH
), the need for emergency access to cash forced it to give
up 32 percent of the company and two seats on its board in
exchange for a $150 million investment by Francisco
Partners in December.
Having suffered along with the other Internet
consulting firms following the dot-com fallout in April,
Marchfirst drastically cut its staff and closed offices in
the face of declining revenue and weak demand for Net
consulting services. With such a dramatic shift in the
market and its stock price falling 89 percent between
September 1 and the time of the infusion in mid-December,
Marchfirst had no chance of convincing public investors to
bankroll a restructuring. In many ways, the PIPE deal was
the company's last hope for financing.
This was an extreme case of a company on the ropes, but
it does highlight the tradeoff that many firms are willing
to accept to capture more capital. And while existing
shareholders welcome the additional liquidity these deals
afford, they are forced to contend with the dilutive
effects of the placement. Nowhere is this more apparent
than with the type of PIPEs dubbed "death
spirals."
PINING FOR THE FJORDS
Death-spiral deals allow a company's PIPE investors to
reprice the conversion rate in the face of a declining
stock price and thereby acquire more shares. Although
these deals already have received a large amount of
negative publicity because of the impact on existing
investors, Mr. Overstreet expects their volume to increase
in 2001 as private investors look for downside protection
against companies that are struggling to turn around their
operations.
This was the case for
Log On America
(Nasdaq :
LOAX
), a regional Internet provider and competitive local
exchange carrier (CLEC), after completing a $15 million
convertible preferred stock PIPE offering last February.
Rather than marking the turning point for Log On America,
the stock subsequently fell 89 percent from the negotiated
investment price of $16.31 to close Monday at $1.66.
With the stock well below the conversion price of
$24.615, Marshall Capital Management, HFTP Investments,
Fisher Capital, and Wingate Capital were able to adjust
the number of shares eligible for conversion. The initial
stock price decline could be attributed to any number of
company-specific problems, but Log On America management
alleges the drop was due to market manipulation on the
part of the investors in the deal. As such, the company
filed suit last month against Credit Suisse First Boston,
the parent of Marshall Capital Management, to seek
recovery of $100 million in damages associated with the
PIPE.
In general, the negative stigma attached to
death-spiral offerings emanates from short-selling by
investors that are aware of the dilutive effects of such a
PIPE, according to Mr. Overstreet. The growing trend
toward these alternatives highlights the perils that small
public companies face when shopping for new funding. And
for existing investors, the questionable history of such
transactions shows the dangers of this last-resort
financing.
As more companies encounter the capital crunch, the
complexity and risk of PIPE deals will only escalate.
While risk is associated with any investment, the downside
risk may be deadly to investors.
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