Piping Up: Once considered a murky backwater of corporate finance, the so-called PIPE deal is becoming a fresh source of investment ideas.

Financial Planning October 01, 2003

The never-ending search for alternative investments has led financial advisers to pick over a lengthy menu of familiar options. Hedge funds, real estate, precious metals, and futures are among the standard entrees. Meanwhile, a more exotic vehicle is starting to whet the appetite of more adventurous investors-the private investment in public equity, or PIPE.

The bursting of the dotcom bubble contributed to a rise in PIPE issuance, because many firms that went public during the market frenzy remain alive, yet have little or no ability to raise additional capital in traditional equity or debt deals. Through a growing network of venture capital firms, investment banks, and boutique specialists, the market for PIPEs has emerged as a high-risk-but also potentially high-return-alternative channel. Shoreline Pacific LLC, a leading investment banker for PIPEs in Sausalito, Calif., says the market for PIPEs has averaged about $14 billion per year since 1999 (see "A Bigger Pipeline" on page 134).

By definition, PIPEs are complex, unpredictable, and not all structured the same. A high-maintenance investment, they are not your everyday "buy and hold" security. One of the most common mistakes by advisers is the failure to recognize which PIPE is right for which clients (if any). But with professional guidance and due diligence, an adviser can determine the risk tolerance, exposure allocation, and exit strategy for a client who may be suitable for a PIPE. And while large, sophisticated investors like Warren Buffett, hedge funds, and Hicks, Muse & Tate have typically done PIPE deals, there's room for the smaller wealthy investor to get involved as well.

"We're seeing more and more interest from high net worth individuals to take part in private placements," says Paresh Patel, an associate in corporate finance at Shoreline. "People are more inclined to do the due diligence themselves. They'd like to get the best possible entry to a company."

In brief, PIPEs are private sales of securities in publicly held firms, with the number of shares and price negotiated between buyer and issuer. Valuations can range from less than $10 million to $300 million or more. Issuers typically are companies that have completed an initial public offering and have since had short or erratic trading records and are struggling to maintain trading volume. In addition, the companies are often troubled, with business plans that have yet to prove out, a lack of funds for capital-intensive projects, or similar woes.

"The company has already taken the step of putting itself out in the public market, with unsuccessful results," notes financial adviser David Blain of D.L. Blain & Co. in Newburn, N.C. "Dealing with public companies means investors benefit from greater disclosure and reporting requirements. But the main drawback to a PIPE versus straight private equity is questionable weakness in the return component. After all, they otherwise wouldn't be going back to the private market."

PIPEs can take any number of forms-convertible preferred stock (the most popular use), common stock, a mix of common stock and warrants, convertible debt, and structured private equity. Each PIPE is by design customized to be flexible to meet a specific need or objective of the company offering it. These instruments are usually sold at a discount to the current stock valuation or provide features to hedge their risk. The terms you'll see offered can include conversion price, dividends, redemption, covenants and protective restrictions, and warrants.

PIPEs are sold to investors under two different labels-the fundamental deal and the technical deal. In the first, the issuing company has some attractive fundamentals, such as sustainable revenues, good operating cash flow, or skilled management. The terms in a fundamental deal usually do not offer much downside protection, because investor demand is high and the issuers have more leeway. Fundamental deals typically use common stock, convertible preferred, or convertible debt as opposed to complex hybrid securities.

The second type of PIPE, the technical deal, requires much scrutiny and caution. Here the company is often in deep trouble, so the investor must have an expectation that an asset value can be created or salvaged down the road.

Because of their high uncertainty, technical deals are a buyer's market, with downside protective covenants more easily negotiated. In cases where warrants are used, a predetermined liquidation price is not set by the issuer because the company does not want to make commitments of how much it must give back to the investor. In turn, the adviser must be experienced in knowing when and how to exercise the warrants. The advice to give clients about technical deals is not necessarily to avoid them completely but rather caveat emptor, buyer beware.

Along with their complexity, PIPEs are also highly illiquid. The creation of a secondary market for the sale of PIPEs is difficult; these securities cannot be resold into the public market until a registration statement has been filed and approved by the SEC. To say the least, that can be a lengthy and expensive process.

Finally, PIPEs have a fabled reputation for turning "toxic" and falling into a so-called death spiral. A death spiral is essentially the massive dilution of the company's stock as a result of the issuer failing to set fixed conversion prices on the PIPE's convertible securities. With a floating conversion price, as the underlying stock price gets cheaper, investors buy or exercise options to buy more shares, thus diluting the value of the stock for all fellow shareholders. (Death spirals often result from hedge funds or speculators buying the company's debt and shorting its common stock, putting more downward pressure on the shares.) The general rule here is to avoid PIPEs that limit the upside for investors because of flaws in the conversion rights.

Despite all of these caveats, PIPEs do offer potential advantages. With a PIPE, valuation is primarily what you make it. You have greater control over how attractive the purchase price can be as opposed to merely buying into regular common stock, debt, or actively traded assets. If you or an investment group acting on your behalf are good negotiators, buying into the PIPE can get you a discount to the company's common stock price.

"There are a lot more bells and whistles in PIPEs to create return than there is to buy common stock," says Tim Holmes, a director of BayStar Capital, a private equity firm in San Francisco that has led investments in many technology and biotech companies, including Commerce One and XM Satellite Radio. "Over time, the PIPE market has evolved into a more sophisticated environment, with more controls put on them by investors. The professionals aren't speculating, they're looking to make a return."

What's more, PIPE investments are less prone to violent price changes than the shares of thinly traded issues. To compete for investment, issuers typically offer dividends on the preferred security. PIPEs structured with convertible debt can offer a hedge against bankruptcy risk, since debtors are paid back before equity holders when a company liquidates. Depending on the deal's structure and the company's needs, a PIPE could pay 10% or more in annual dividends to the investor, with equity potential above that.

So who could be a candidate for a PIPE? Generally speaking, financial advisers should recommend these deals only to accredited investors with at least $2 million in net worth who can afford an investment of $150,000 to $250,000 in a PIPE.

"A client has to be sure he or she can live without those funds once they are invested in a PIPE," notes Richard Hammel, CFP, who is chief executive of Hammel Financial Advisory Group in Brentwood, Tenn. "Once invested, the money is locked up and unavailable for the most part." Hammel has not put any clients into a PIPE yet, although he has reviewed and made private equity placements and dealt with alternatives in real estate properties, natural gas drilling, and oil rights.

If no single client can make a minimum investment in a PIPE, your firm could go into the PIPE as an institutional investor by pooling client funds and distributing shares of the security among your interested accounts. You could also consider a hybrid PIPE, also known as a structured equity line placement (SELP). Buying into these hybrids requires less capital, but the deals are rarer and complicated. SELPs work like a bank line of credit; an investor lends cash amounts to the issuer on an ad hoc basis, and the issuer repays the loan later with a negotiated amount of common stock shares.

Whatever the type of deal, make sure to do thorough due diligence on the underlying firms you are looking at. PIPEs ordinarily come through discreet offerings from an investment bank, venture capital firm, or well-connected business attorney or CPA. You'll have to survey their integrity as well as that of the actual security. A couple of common red flags to watch out for are an issue or sponsor in a hurry to do a deal or an issuer that refuses to compromise on the most simple terms.

If you will be actively negotiating on behalf of your client, create a list of favorable deal terms and features and try to get as many of them accepted by the issuer as possible (see "How to Go with the Flow" at left). The issuer will have a legal adviser, so your client should, too. Hire an attorney to help mesh your financial strategies with legal safeguards. Finally, you'll need to keep watch over the PIPE on a regular basis to ensure that it remains in accord with your client's goals and continues to offer its protective features.

Because the burden of evaluating and monitoring the PIPE falls heavily on the adviser, these deals can be time-consuming and costly. You may have to raise or impose fees on the client, which lowers the return potential (and may present a potential fiduciary issue). Be sure that you fully explain all of the expenses and charges associated with these securities to your client. "Investments like this are generally loaded with high fees and a lot of fat," Hammel says. "Advisers need to be careful to avoid or uncover any hidden fees."

In the end, the risk-reward equation will help guide your recommendation for a client. With hundreds of PIPE deals now coming on the market each year, there are real companies with built-in incentives to succeed available to consider. PIPE deals can now be more than pipe dreams.

How to Go with the Flow

Thinking about recommending a PIPE for your client? Here are some standard deal terms to evaluate before jumping into this esoteric alternative investment.

Deal Type

A fundamental deal is based on the strength of company's current financial condition.

A technical deal is based on more speculative future prospects or salvage value.

Price

Look for issuers who tell you the price is negotiable. Avoid those who try to dictate a specific number up front.

Underlying Securities

Should offer a mix of convertible securities, common stock with warrants, and convertible debt. Never choose one type of backing security. Convertible debt is valuable because you will be first in line for return of principal in case of insolvency.

Redemptions

Choose a fixed conversion price, not variable floating prices.

Anti-dilution protection

A clause that sets a hard price floor to restrict other investors from diluting the stock.

Low minimum holding period

Preferably as short as possible to offer your client an opportunity to get out if needed. Watch out for excessive penalties if granted.

Incentives

Dividend or interest paid at market rate or greater.

Option to buy additional shares

Some issuers try to cap the number of shares that investors can ask for in the future; look for potential to add to successful positions.

Flexibility

Ask if you can back a PIPE with collateral other than cash, such as real estate holdings.

-JBL

Jason B. Lee, CFMA, is a managing director of Lee, Pirelli & Co., a Washington based investment bank with expertise in equity private placements. He can be contacted at jasonblee@hotmail.com.

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