Here’s a product that generates alarm and pained cries that institutional investors are running around harming small-cap and mid-cap companies: PIPEs. PIPE stands for private investment in public equity. In a PIPE deal, a public company typically issues unregistered equity-linked securities to a kaffeeklatsch of power investors at a discount to the price of the issuer’s common stock at the time the deal is closed. The issuer commits to registering the securities with the Securities and Exchange Commission so they can be resold to the public, typically within 90-120 days.

Everyone is happy, no? Public companies get a much-needed cash infusion quicker, with less fanfare, and at better terms than they could otherwise score from Wall Street, while investors get a chunk of the company’s securities at a discount to the market price.

PIPEs hit the headlines starting in 2000, when high-growth, small-cap companies in desperate need of financing — typically tech and telecom companies — turned to the PIPEs market. But instead of getting the financing that would save them, the companies tanked. Within a year of their deals closing, dozens of companies with so-called “death-spiral” or “toxic” structured PIPEs had lost 96 percent, 97 percent, 98 percent of their value. The list is a Who’s Who of failed enterprises: MicroStrategy Inc., Quokka Sports, Log On America, Ariad Pharmaceuticals, IFS International Holdings and eToys, just to name a few. Total PIPEs issuance that year was $24.7 billion.

In a typical death-spiral structure, a company issues convertible preferred stock or convertible debentures that convert into common stock; however, instead of being fixed, the conversion price changes based on how the issuer’s common stock performs after the deal is closed or over some predetermined period in the future (or some other trigger). If the price of the common stock falls within that period of time, the conversion price drops according to a set formula, enabling the investor to get more stock for the same amount of principal. The problem with that structure, as issuer after issuer — as well as public investors — discovered, was that PIPE investors had every incentive to pound the price of the common stock down after the deal closed so they could rake in more stock. 

Last year, as of November 1, total PIPEs issuance was $10 billion, on par with issuance volume in 2002 and 2003 (total issuance in each of those years hovered around $12.5 billion). The number of deals in the first 10 months of last year was a high 1,026, approaching 2001’s 1,040 deals. Investors include a broader swath of hedge funds, corporations, mutual funds, pension funds, private equity firms and venture capital funds than was the case a few years ago. 

So is it bad news that the PIPEs market, four years after its Annus Horribilis, is expanding its reach? Not necessarily, although criticisms abound. 

Myriad lawsuits and civil litigations have come and gone, and the PIPEs market has changed. Structured PIPEs — deals that offer investors price protection through conversion prices that are reset or variable — represent a far smaller portion of the overall PIPEs market nowadays. In 2000, structured PIPEs represented 13 percent of the total PIPEs issuance, according to PlacementTracker, an industry research firm; through November 1 of last year, structured PIPEs were 7 percent of the market. 

The current structured deals are also designed differently. They typically include hard or soft floors that prevent “high-level dilution,” thereby reducing the incentives of investors to push the stock down, says Steven Dresner, publisher of “The PIPEs Report” and co-author of “PIPEs: A Guide to Private Investments in Public Equity.” Many PIPE contracts also specify that the investors cannot short-sell or can only short a certain amount of the company’s stock over a period of time. Regarding the death-spiral structures of a few years ago, Dresner says: “It’s so 2000. It’s totally irrelevant.”

What’s behind the change?

First, data. There is an increasing supply of data and research about the PIPEs market. PlacementTracker, a research firm launched in 1999, was the first to publicly report information on transactions, their structures, their investors and the bankers that helped raise the money. PrivateRaise, another research firm, provides data and analysis on PIPEs and Rule 144A placements for the private equity market. More data and understanding of PIPE structures has prompted a broader range of investment banks and investors to test the waters. 

Another reason for the development of the PIPEs market was the 2001-2002 massive market correction after the tech bubble burst. The financing options that once existed for high-growth companies dried up and blew away, and the number of PIPE deals declined. But the PIPEs market didn’t shut down the way the IPO and secondary markets did, says Brian Overstreet, president of Sagient Research Systems, which owns PlacementTracker. “For companies that were already public and needed to raise capital, the only place was the PIPEs market,” he notes. “They realized it wasn’t such a bad alternative, and when the market came back in 2003 those same companies kept coming to PIPEs to access capital. Now bigger companies, bigger investment banks and bigger investors are involved in the marketplace.” Companies with larger market caps that have accessed the PIPEs market in 2004 include Corvis Corp., Allegheny Energy, OMI Corp. and WebMD. 

Still, it’s the appeal of the market to hedge funds that sets many portfolio managers’ teeth on edge. The sharpest criticism is that PIPE investors — primarily hedge funds — are profiting at the expense of an issuer’s existing shareholders. The PIPEs market is seen as secretive and nontransparent. In addition, the issuance of a PIPE, whose unregistered securities can eventually be converted into common stock, dilutes the stock price by increasing the number of shares outstanding.  

In a way, all this is true. Neither institutional investors nor fast money will venture into a market if the risk-reward ratio isn’t beneficial. At the same time, companies issuing PIPEs tend to be distressed and there’s a limited supply of investors ready to pony up the necessary cash. Hedge funds can be seen as last-ditch investors — or, alternatively, as venal speculators. (PIPE investors also face risks: they hold illiquid unregistered securities for a period of time and can’t be certain that the issuer’s stock price won’t capsize while they’re long the securities.) 

For those not in the PIPEs community, there is limited transparency into the market. After a PIPE deal closes, the issuer must file a Form 8-K with the SEC, but the documents are legal, lengthy and complex, and extracting information that may be market-moving is no walk in the park. “If someone’s only contact with the PIPE market is peripheral, and they’re not reading through the filings, I can see why they may feel they don’t know what’s happening and why it would be confusing,” says Sagient’s Overstreet.  

Speaking at an Investment Company Institute conference on mutual funds in September, Harold Bradley, chief investment officer for U.S. growth equity at American Century Investments, said that PIPEs hurt the issuing company’s shareholders and that hedge funds operating in the PIPEs market “move stocks around without transparency.” That “steals performance from my investors and my mutual funds,” he added. He called for “regulatory help right now.” 

The SEC isn’t expected to heed the call. “Our concern is adequate disclosure of information,” says SEC spokesman John Heine. “With regard to public operating companies, it has often been said the SEC is a disclosure regulator and not a merit regulator.” 

Nonetheless, the SEC is always concerned about market manipulation and is reputed to be investigating activity around a number of PIPE transactions. Market participants say that the SEC has been requesting information from broker-dealers about short sales in connection with particular PIPE transactions. In a case that highlighted the Commission’s focus, the SEC in February 2003 sued Rhino Advisors, an unregistered investment adviser, for manipulating the price of Sedona Corp.’s common stock by selling the stock short on behalf of a client that had a stake in a structured PIPE; the SEC further charged Rhino, which knew the client had agreed not to short the stock while the convertible debt was outstanding, with hiding the short sales from Sedona by running them through a series of broker-dealers. Rhino settled the case for $1 million. 

Nowadays, with the PIPEs market maturing, PIPEs are increasingly becoming a more mainstream financing vehicle. The common characteristic of issuers is that they are “mostly high-growth companies not making money in their core business but that need to expand quickly,” says Sagient’s Overstreet.  

For a lot of small companies, the ability to issue $10 million or $20 million of equities at a slight discount is a better option than trying to do a follow-on offering with an investment bank and a road show. To do a public issuance, a company might have to issue $40 million of stock for the deal to be worthwhile to bankers, whereas a small company may need much less. 

The most common types of PIPEs are common-stock PIPEs and convertible securities with fixed conversion prices. As these so-called traditional PIPEs take hold as an “economically rational way to raise capital,” the mix of companies finding it advantageous will also change, notes Susan Chaplinsky, a finance professor at the University of Virginia’s business school. She compares PIPEs to the high-yield market in the late 1970s and early 1980s, when it was seen as controversial; now high-yield debt is part of mainstream finance. 

Dresner, publisher of “The PIPEs Report,” agrees. He adds that the terms of a PIPE deal efficiently reflect the issuer’s need for cash. If a company wants to do a deal fast — if it needs the money bad — that company “might be making concessions to investors to get the money,” he says. “But the investors are going to hedge themselves by selling the stock short.” At the same time, contractual limits

can be set around the timing of the short-selling or the amount of stock that’s sold short. If, on the other hand, the company wants to attract long-term investors that will hold its stock, “that will cost the company in terms of the cost of capital,” adds Dresner. “That investor may require a lot more — a bigger discount, for example — to buy into a piece of stock and hold onto it.” 

Common-stock PIPEs draw a broader mix of investors, including mutual funds, pension funds, asset managers and private equity firms. Many companies that issue common-stock PIPEs “went public too early, four or five years ago,” says UVA’s Chaplinsky. “Since they’ve survived, a number of them may now be at the point, as the economy has begun to turn, where they have weathered the worst of the storm.” This means some of these small-cap, illiquid stocks might be appealing to buy-side firms with a longer timeframe. Through a PIPE, a large mutual fund can get a chunk of stock at a discount to the market price and can buy in size without worrying that its buying pressure will raise the stock price. 

Last year, through November 1, the two largest PIPE investors among mutual funds and pension funds were Wellington Management and Pacific Corporate Group, each with more than $100 million in investments, according to PlacementTracker. Others on the list are more mainstream names. They include Janus Capital Corp. (#6), Fidelity Management & Research Corp. (#7), Neuberger & Berman (#9), Delaware Investments (#16) and T. Rowe Price Associates (#19). 

For Wall Street investment banks, the PIPEs market is also a boon, “particularly with the IPO market rebounding slowly” from the tech market rout, says Sagient’s Overstreet. The deals are far smaller, but they’re still lucrative. In 2003 reported investment banking fees associated with PIPE transactions were $447 million, compared with $248 million the previous year, according to PlacementTracker. 

Even as the market broadens, reset and variable-rate PIPEs maintain their niche in the financing spectrum. However, these are clearly riskier deals. “If a company today must do an extreme, death-spiral-type transaction when other options are open, that means its prospects are probably not very strong, because there are so many people willing to invest money today in the PIPEs market on more company-friendly terms,” says Overstreet. 

This raises another question. If, say, 10 percent or 20 percent of the companies that do structured PIPEs survive because they got money and could turn their businesses around and create shareholder value, is that sufficient to say that this is, from a social point of view, a good thing? asks Chaplinsky. “It’s the ultimate kind of Hail Mary pass,” she observes. “If you’re down to six months of operating cash left, and you don’t get an infusion of money, you’re sure to fail. On the other hand, like a Hail Mary pass in football, how many times is the pass actually completed?” 

From the perspective of a financial economist, she adds, it’s always better for a company to have more options to finance itself since that makes markets more complete. “If I were an existing shareholder in that company, I’d want the CEO to get the funding,” Chaplinsky says. “If, on the other hand, you’re trailing in the fourth quarter by 38 points and you have some cash left that could be distributed to public shareholders, assuming you don’t have a lot of debt-holders, maybe it’s better to liquidate and not throw the pass.” 

“It depends on the situation,” she insists.