MAY 3, 2004
A Pipeline To
Bargain Deals
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Through
little-known PIPEs, investors buy shares of listed stocks at
favorable terms
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Suppose you're an investor
who could persuade a company to sell you shares of its stock for less than
the last price on NASDAQ or the Big Board. Wouldn't that give you an edge
up on the public investor? Well, that's precisely what a group of hedge
funds did in January with modem maker Novatel Wireless (NVTL). By
negotiating a private transaction with the San Diego company, fund firms
such as Omicron Capital and Vertical Ventures were able to buy shares at
$7 when they were trading for $9 on NASDAQ. Recently shares were $21 -- a
robust 133% gain for the regular investor, but an even sweeter 200% for
the hedge funds that still hold the shares.
Such bargain-price deals -- known as Private Investments in Public Equity
(PIPES) -- are becoming popular among sophisticated investors. Some hedge
funds specialize in these deals, but PIPEs have also attracted buyers such
as Berkshire Hathaway's (BRK) Warren Buffett and mutual-fund manager Bill
Miller of Legg Mason Value Trust. Most of the companies are not household
names. They include SuperGen (SUPG), a biotech firm, American Water Star (AMWS.OB),
which makes flavored-water drinks, and Empire Resorts (NYNY), which
operates a race track in Monticello, N.Y., and hopes to build a casino and
resort nearby.
Broadly speaking, a PIPE is a transaction between a public company and
select investors involving equity or equity-related securities such as
convertible bonds or convertible preferred stock. The buyers negotiate
favorable terms, such as price discounts or warrants to receive additional
shares should the stock hit a target price. In exchange, they agree to
hold the securities for a set time, often one year, after which they can
sell. "Discounts can range as wide as 50% for weak companies to 5%
for strong ones," says Steven Dresner, publisher of the PIPEs
Report, an industry newsletter.
Why would companies sell shares at a discount? Some may be cash-strapped
and unable to borrow from a bank. But even healthy companies make these
deals, because they're often cheaper and faster than issuing new shares. A
typical secondary offering "takes six months to do and costs at least
10% of the deal's value in underwriting fees plus legal costs and road
show expenses," says Andy Reckles, co-manager of the Palisades Equity
Fund in Roswell, Ga., which specializes in PIPEs. "I can turn a PIPE
deal around in two weeks for much less."
HEDGING OPTION
Most of the companies that do these deals are relatively small, which can
make them risky. Still, the PIPE investor can come out ahead of the public
investor if the stock goes down. That's because PIPE funds often hedge
their risks by selling the stock short. A manager who buys a $10 stock for
$8 can short the publicly traded shares and lock in that $2 difference,
ensuring a gain of at least 25%, no matter which way the stock moves.
The average PIPE fund delivered a 12% annualized return for the five years
ending Feb. 29, net of fees, vs. -0.1% for the Standard & Poor's
500-stock index, according to fund tracker Hedge Fund Research. Palisades
Equity, run by HPC Capital Management (CPDM), also in Roswell, has been
one of the best performers. It has delivered a 79.6% annualized return
since its inception in December, 2001, rising 25.1% in 2002 and 143.9%
last year. "The critical component to our performance was the quality
and strength of our PIPE deal flow, not how the stock market
performed," Reckles says. During 2002, Reckles structured most of his
deals so he received convertible bonds that could be swapped into equity
at a fixed price. Such bonds retain their value and pay interest even if
the stock market declines. But in 2003's recovery, Reckles favored
discounted stock PIPE deals with warrant kickers -- options to buy more
shares of a company cheaply if the stock rises above a certain price. That
effectively leveraged his portfolio as the stock market soared.
LOCKED IN
Pipes have their risks. The selling company could go bankrupt or engage in
fraud, in which cases the PIPE investor may be locked in as the shares
plummet. And shorting shares as a hedge may not always be an option: The
shares may be too illiquid to short, or the company may oppose it.
"We will short a stock only if a company gives us permission to hedge
our position beforehand," says Lawrence Goldfarb, general manager of
BayStar Capital, which is in Larkspur, Calif. "If we did otherwise,
we'd never get another deal." If shorting is impossible, the investor
may opt for convertible bonds.
Getting your money into PIPEs isn't easy. First, you must have a net worth
of at least $1 million or an annual income above $200,000 -- what it takes
to buy into any hedge fund. (Fees are similar to those of most hedge
funds: 1% to 2% annual management fee, plus 20% of the profits.) Even
then, PIPE funds are a small and not well-known subset of the hedge fund
world. "Often you have to know somebody who knows somebody to get
into one of these funds," says Brian Overstreet, CEO of Sagient
Research Systems, a firm that tracks PIPE deals. "Unless you have a
lot of money, chances are you won't hear about them." In fact,
because of the increased regulatory scrutiny of hedge funds, several PIPE
funds declined to reveal their performance to BusinessWeek for fear
regulators would interpret it as advertising, a no-no in the hedge fund
business.
A good source for investors is the PIPEs Report's Dresner (516
364-8431). He knows most of the major fund managers and is willing to help
accredited investors find a match for free. (He will charge the hedge fund
a fee if the pairing is successful.) If you want to do your own research,
a subscription to his newsletter is $1,950 a year. Another alternative is
to examine the funds with the highest deal volume in size and quantity at www.sagientresearch.com/pt/.
While volume doesn't ensure great returns, it can drive performance.
"Someone like Larry Goldfarb at BayStar Capital knows everybody in
the business," says Sagient's Overstreet. "He may not have the
best returns in any given year, but he will certainly get the deal
flow." On the free portion of Sagient's Web site, you'll find
listings of the top dealmakers. You can purchase a detailed report on an
individual fund for $225. An annual subscription to Sagient's site costs
$30,000.
All this may seem like a lot of effort and expense to get into an
investment. But given the inherent advantage PIPEs funds have, it may be
worthwhile.
By Lewis Braham
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