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Pipe Dreaming
By Loren Fox
10/16/06
Only a few years ago, the prospect of a public company raising equity capital from private investors caused shudders in executive suites. The market for private investments in public equities, or Pipes, had become a last resort for dying companies — especially those that went public during the dot-com boom and ran out of cash when the bubble burst. Some investors exploited the situation by demanding onerous terms in so-called death-spiral deals that forced companies to sell bigger stakes at lower prices over time.
That was then. Today, Pipes are becoming a reliable capital-raising tool for the most respectable of companies. Through August of this year, U.S. issuers raised $19.3 billion in 866 Pipes deals, according to Sagient Research Systems, a San Diego firm that tracks private placements. That’s nearly as much as the $20 billion raised in all of 2005, and it’s on pace to shatter 2000’s record of $24.3 billion.
In a typical Pipes deal, a company sells unregistered stock at a 5 to 15 percent discount to the public share price. Issuers accept such discounts because Pipes don’t involve the lengthy regulatory approvals and investor road shows required of public offerings. Often a company’s stock price declines once the public market knows a follow-on offering is coming. Issuers increasingly see Pipes as a more efficient and flexible alternative. That’s attracting big companies to join the small-cap issuers that traditionally have offered Pipes. Indeed, money raised through Pipes in the first half of 2006 equaled 28 percent of the proceeds of public secondary offerings, up from 15.3 percent in 2004.
“It’s a very diversified market,” says David Stadinski, who oversees the product for Piper Jaffray & Co. “As this market has really come into its own, you see more companies using this as just another source of financing.”
That’s a big change from the peak of the dot-com bubble, when death-spiral deals accounted for about one quarter of Pipes issuance. Today they are just 2 percent. Big investment banks like Citigroup and Lehman Brothers are arranging Pipes for prestigious clients. And buyers of the private stock — once mainly sharp-eyed hedge funds — now also include private equity firms and mutual fund complexes.
As a result, deals are getting bigger: $19.7 million, on average, during the first half of 2006, up from $11.6 million during 2004. In May ethanol distributor Pacific Ethanol raised $138 million — 20 percent of its $680 million market value — to fund the construction of new plants. The Fresno, California–based company completed the transaction in two weeks, a big improvement over the six to 12 weeks that a follow-on offering would have taken, says CEO Neil Koehler. “There’s real value to being first to market with new ethanol plants,” he explains. Consequently, Pacific was happy to do the deal at a 10 percent discount to its public valuation.
The biggest risk for issuers: information leakage. The Securities and Exchange Commission has been probing hedge funds that may have learned of planned Pipes offerings and then shorted the issuers’ stocks in advance of the deals. Such short sales may count as insider trading if they’re based on confidential information, according to an SEC official. In May hedge fund Deephaven Capital Management paid $5.75 million to settle SEC charges that one of its portfolio managers engaged in this kind of insider shorting; in the settlement, Deephaven didn’t admit or deny guilt.
Market players say such shorting has become rare. “The risk of not playing by the rules has gone way up,” says Bryon Roth, chairman of Roth Capital Partners, a Newport Beach, California, investment bank that is one of the most active Pipes placement agents. The firm maintains detailed records of those it has spoken with about potential Pipes and requires them to certify that they haven’t shorted the stock.
Some investors won’t even short after a Pipe deal closes, although that’s a common hedge. “We don’t short against unregistered stock, and we specify that in our term sheets,” says Adam Benowitz, co-founder of Vision Capital Advisors, a New York hedge fund. “Pipes were made for people to invest, not trade.”