Cleaning the Pipes
Mention the word PIPE (private investment in public equity) to a public company CFO, and he's apt to recoil in horror. He's sure to have had the idea pitched to him, and he's also sure to have heard of companies that have spiraled into bankruptcy soon after arranging one. Dozens of floundering companies, including eToys, AtHome, and Winstar Communications, have slid into financial ruin in part because of PIPEs gone awry.

The favorite form of PIPE is the convertible preferred share, which gives holders the right to convert their shares into common stock, typically at a premium to the company's share price at the time. As valuable as a long-term private investor can be for public companies, the private market also has predatory investors that, when they smell blood in the water, will move in for the kill.

Certain hedge funds and private equity groups have pushed more than a few companies into a "death spiral" with so-called toxic convertibles that have exercise prices that reset if the public stock price falls. However supportive a private investor might seem, a floating conversion rate provides incentive for an investor to work against a company--shorting the public stock to lower the conversion price of the preferred shares.

The result can be a snowballing dilution that swamps public shareholders. "You dance with the devil when you have to," says Lemler.

Companies can and do set conditions that the investor cannot work against them. But that doesn't stop other investors from selling stock short. The negative publicity surrounding toxic convertibles, however, has helped clean up the PIPE market. And with so much private capital looking for a home, growing numbers of public companies are tapping the market.

"Not all PIPEs are bad," says Lemler, who helps public and private companies find suitable private investors. "People have wised up, and there are a lot fewer abuses in the market."

When structured correctly, a PIPE can provide essential capital and a potentially valuable business partner for a public company. TransMontaigne's Logan says several large private investors have remained shareholders since the company went public in 1997. "We look for investors who've been in hot kitchens and don't get uncomfortable," he says.

Very often, private investors can provide valuable management help and strategic support for a public company as well. Consider Salton Inc., headquartered in Lake Forest, Illinois, a maker of home and kitchenware products such as the George Foreman Grill. Three years ago, CEO and founder Leon Dreimann needed $80 million to buy back 6.5 million shares from another company, Windermere. Through boutique investment firm Barrington Research, Dreimann hooked up with New York-based private equity group Centre Partners. Centre came up with half the equity in the form of preferred shares, and the banks provided the rest.

Today, two Centre partners still serve on Salton's board. "They've made a major contribution to our business," says Dreimann.

With public stock prices the way they are, a lot of capital-strapped companies could use that kind of help.

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