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The PIPEs Are Flowing

Small public companies can find it less costly to raise new money privately, but only if they can find the right investors.
Ronald Fink, CFO Magazine
November 1, 2004

When Evergreen Solar needed a fresh infusion of capital in 2003, the public markets were not the place to go. True, Evergreen had encountered little difficulty going public in November 2000. But that was before the stock-market bubble popped, and before Enron's demise fouled conditions for any company that even vaguely posed an investment risk. "The public markets were shut down for almost every type of energy company," says CFO and co-founder Richard Chleboski.

Investing in the Marlboro, Massachusetts-based solar energy equipment manufacturer isn't much safer today. Its business, like biotechnology and other research-and-development-oriented manufacturing, requires considerable capital to produce expensive products, and lots of time to produce significant returns. And the public markets these days are notoriously impatient.

So in May of last year, the company turned to the private markets via a hybrid security called a PIPE (for private investment in public entities) — an instrument developed by Wall Street in the late 1990s, and once associated with the kind of "last resort" capital that companies with poor fundamentals were forced to seek.

For Evergreen, which is considered to have healthy prospects despite the market's skepticism last year, the deal provided $29.5 million in additional financing, in the form of preferred stock convertible into common equity. Enticing institutional investors was a discount of 25 percent from Evergreen's public-market price — compared with an average 9 percent discount for other PIPEs at the time — and warrants giving an investor the right to sell the stock at a hefty 125 percent premium over the PIPE's offering price after the deal was registered with the Securities and Exchange Commission.

Evergreen is far from alone in getting capital to flow through PIPEs instead of the public markets. According to Sagient Research Systems, a San Diego firm that tracks PIPE deals, the number of transactions completed so far this year has already exceeded last year's 926, and should approach 2000's record of 1,253 (see "Wrenching Up Again, below"). The Evergreen PIPE was unusual in key respects, though, and generous pricing wasn't the most critical difference. The conversion rate was fixed, for one thing, and Chleboski and his team did the deal without hiring an investment bank to help arrange it. Those differences helped Evergreen avoid the problems that other small, yet-to-be-profitable companies have experienced trying to raise money through PIPE deals — problems often associated with their attraction for short-selling speculators interested in driving down the price to make a killing. Indeed, last June Evergreen raised another $20 million through a second PIPE, this one for common stock placed through a bank. And it has seen its stock price climb 124 percent since its first PIPE issue.

Broken Pipes
Other corners of the PIPEs market continue to attract trouble. Among the most worrisome of the potential woes is the possibility of stock-price manipulation. Last summer, the SEC launched an inquiry into apparent PIPE-related price manipulation, suspecting that short-selling in advance of transaction announcements was causing huge declines in the share prices of several PIPE issuers and increasing the cost of the deals. In one suspected case last November, involving small software maker Faro Technologies, short-selling was believed responsible for driving the price down 11 percent in advance of a $40 million deal. And some companies have fared even worse. Pharmaceutical maker Durect, for instance, saw its stock lose nearly half its value between the announcement and closing of a deal done earlier this year.

In response to similar problems with shorts in the larger market involving shelf registrations of public securities, the SEC recently eliminated a rule allowing short-selling within six days of stock issuance based on such registrations. But some experts say that regulatory action caused the stock-price manipulation to migrate to the PIPEs market. So the SEC may have to take a similar step to protect PIPEs, increasing what is currently the light level of regulation over hedge-fund activity. In any case, "the SEC is clearly focused on short-sale activity" in the PIPEs arena, says Eleazer Klein, a partner in the New York law firm Schulte Roth & Zabel LLP.

The up-front damage from hedge-fund short-selling wouldn't be the end of the problems faced by some PIPEs transactions. In fact, such activity has cost some issuers a significant amount of market value after their deals' closing.

In the most extreme cases, when companies with weak fundamentals allowed conversion rates on preferred shares to change with the price of the common stock, short-selling buyers of PIPEs have driven down the stock price afterward. That can force the company to issue more and more equity to the shorts, until the company goes bankrupt. At that point, investors can pick up what's left of the assets at bargain prices.

Some observers say the classic example of this "death-spiral" phenomenon was a PIPE issued by eToys Inc. in June 2000, allowing such investors as Angelo Gordon & Co. and Promethean Asset Management (an affiliate of the investment bank that arranged the deal) to exchange $100 million in convertible preferred shares for cash or common stock at a floating rate. Sure enough, the Internet toy retailer went belly-up nine months later.

Experts say death-spiral PIPEs have become relatively rare now that issuers have wised up to the tactic, or have sufficiently improved their balance sheets so they needn't accept such onerous terms. In fact, fixed conversion rates, and floor prices below which no further issuance is allowed, are now common. And they inhibit the kind of short-selling that can produce a vicious circle of more and more equity issuance at ever-lower prices until the company agrees to an acquisition by the investors or goes bankrupt. But some observers warn that a few companies desperate for capital are still being tempted into this trap. "I'm not sure [potential death-spiral PIPEs] aren't still out there," says Spencer Feldman, a partner in the New York office of law firm Greenberg Traurig LLP.

Neither is Klein of Schulte Roth. While he says he himself hasn't negotiated such a deal since the late 1990s, Klein believes the new SEC rule limiting insider trading on shelf registrations of public deals is putting pressure on very small PIPEs issuers to grant investors more room to short. "They have to give investors the ability to hedge," says Klein.

Bankers contend that PIPE investors are being unfairly blamed for management's mistakes, and that death-spiral PIPEs have served to delay rather than hasten issuers' bankruptcies.

In any case, definitive data on such deals is difficult to find. Of this year's PIPEs, Sagient reports that 7 percent are structured; that is, they contain such terms as variable conversion rates. While that percentage is far lower than the 39 percent in 1997, the proportion of the PIPE-deal universe did rise last year from the 2 percent low it hit in 2003. Another research firm that tracks PIPE deals, Private-Raise, finds that the percentage of deals with a variable conversion rate but without a price floor has increased this year after bottoming out in 2003 (see "The Door in the Floor," below). In 2001, the proportion was roughly twice what it is this year.

But caution is warranted for any company raising capital through a PIPE. Even with absolute protection against death spirals, companies can find PIPEs putting downward pressure on their stock price. Some dilution may be inevitable, in fact, thanks to the market discount at which the securities are typically issued. That instantly creates potential arbitrage for investors that buy with the express purpose of exiting by the SEC registration date — a situation most PIPEs are set up to allow. Usually these transactions require issuers to register with the SEC, enabling PIPE investors to sell their shares to the public, within 90 days of a PIPE's closing. And that naturally appeals to hedge funds and other short-term investors, which are even less patient than mutual-fund managers and other public investors. The bigger a PIPE's discount, of course, the greater the attraction for these private-market participants, and the greater the potential dilution to public shareholders.

Tower Semiconductor, for example, issued a $16.1 million PIPE at a 30 percent discount last January, then watched its stock fall 52 percent over the next six months. Bidville, an Internet auction house, issued a $2.2 million PIPE last December 22 at an 89 percent discount and lost 86 percent of its market value by late June.

Even companies that have done PIPEs at small discounts have sometimes fared poorly. Keryx Biopharmaceuticals saw its stock lose 28 percent in value six months after it issued a $32 million PIPE at a 6 percent discount last February. The stock has since recovered, though, and is now up some 15 percent since the PIPE closed. The initial weakness may have reflected the fact that this was the company's second PIPE deal in three months, and that it issued the $15 million offering the previous November at a deeper, 15 percent discount.

But even some companies that have issued PIPEs at a premium have seen their stock prices fall afterward. Inyx Inc., a pharmaceutical company that specializes in drug-delivery systems, issued a $1 million PIPE last December 31 at a 4 percent premium, yet its stock has fallen 20 percent since then.

Looking Long-Term
Of course, CFOs of small public companies without positive cash flow and in need of capital may have little choice but to issue a PIPE on generous, or even perilous, terms if more-prudent public and private avenues aren't open to them. The good news, as Evergreen's experience shows, is that there are steps that issuers can take to limit the dilution of a PIPE deal, or to avoid it entirely and instead watch their stock price rise instead of fall.

The essential challenge is to find the right investors. Ideally, that means long-term buyers prepared to ride out short-term ups and downs, instead of in-and-out traders looking for a quick killing or short-selling vultures seeking distressed assets on the cheap. But locating patient, long-term investors isn't easy. While Chleboski insists he found several in Perseus, RockPort Capital Partners, CDP Capital-Technology Ventures, and Nth Power, he spent the better part of a year lining up these and other funds. That largely reflected his being turned down by the one underwriter he trusted enough to do the deal, leaving him to find private investors on his own.

But while the deal took more time to complete than it would have with bank involvement, Evergreen saved the usual 7 or 8 percent fee that underwriters charge. (Evergreen did pay a financial adviser a fee for a fairness opinion.) More important, perhaps, is that forgoing investment-bank help gave Chleboski more control over who would buy the shares. That's not always possible when a company turns to an investment bank to underwrite a PIPE transaction, particularly if the company is dealing with a large, "bulge bracket" firm. Getting the wrong investors "is always a risk with a PIPE," says Chleboski.

On the other hand, long-term investors were the only ones likely to be interested in Evergreen, at least at the time, says Chleboski. "Even if we wanted to go to short-sellers," he says, "we wouldn't have been able to." He's not being entirely facetious. Public companies with, say, $1 billion in market capitalization may find it easy to raise $50 million from a hedge fund intent on selling the stock short, he notes, without hurting other shareholders. Simply because of the relatively small size of the PIPE transaction, says Chleboski, "the stock won't suffer, and everybody's happy." So hedge funds aren't automatically wrong for a PIPE, at least if the PIPE issuer is big enough to withstand their short sales.

Ironically, though, smaller companies need PIPEs money the most. And as with all financing, more begets more. A year after Evergreen did the May 2003 deal on its own, Chleboski found the bank that had turned him down on its first transaction amenable to arranging a second — for the usual fee, of course. And that transaction took only two to three months to complete.

Playing Solo
Issuing a PIPE without a bank, as Evergreen did, is fairly popular. According to Sagient, almost a quarter of this year's deals, and a third of last year's, involve no placement agent of any kind.

Another firm doing without a bank last year was Seattle Genetics, which issued $41 million in convertible preferred shares in July. The biotech firm managed the trick in half the time Evergreen took, attracting such biotech investors as JP Morgan Partners and Baker Brothers Investments.

Seattle Genetics's faster path may reflect the more mature biotechnology industry, compared with solar technology. There are some 280 publicly traded companies focused on biotech, compared with a handful on solar tech. Of those 280 biotech firms, fewer than 30 are profitable, so even cash-flow-negative companies like Seattle Genetics may be able to get PIPEs financing on favorable terms. "Still," says CFO Tim Carroll, "the industry needs continued capital infusions."

Following the success of its PIPE, Seattle Genetics raised another $66 million in a secondary public offering last February, and now has some $100 million in cash on hand. Of that, the company expects to spend $32 million to $36 million this year on R&D and marketing for three drugs now in clinical trials. That's a deeper pool than most biotech firms have. But it takes anywhere from 8 to 12 years to bring a drug to market, Carroll says, so biotech companies like his are likely to attract only the longest-term investors, and may have less to worry about from short-sellers as a result.

Still, Carroll contends there's no reason for any company with good fundamentals to avoid doing a PIPE on its own, so long as it has developed strong relationships with early-stage investors, or can do the due diligence required to know which ones will stick with the company. Of course, that also means letting investors do their own due diligence, which takes months rather than weeks, as with a public offering.

In Seattle Genetics's case, Carroll agreed to provide potential investors that signed a nondisclosure agreement with certain information on the company's scientific capacity, intellectual property, financial controls, spending patterns, and capital structure. The investors focused most intently on the company's scientific abilities, its most critical asset.

Yet the CFO insists that going it alone was worth the extra time, effort, and disclosure risk. "Dictating [to banks] that you want certain buyers isn't feasible," says Carroll. "They have much more control over the process."

Ronald Fink is a deputy editor of CFO.

Control Freaks
A Connecticut court ruling may lead to more-generous PIPE deals.

A court case in Connecticut recently played down the power of investors to control a company's fate through a private investment in public entities, or PIPEs. But the case's outcome may only encourage investors to seek more-generous terms.

The Connecticut state pension fund filed suit in 2002 against Forstmann founding Little & Co. The New York-based investment-management company, run by senior founding partner Theodore Forstmann, had been hired by the fund to invest its assets. Several of the Connecticut fund's investments had gone bad, including a number of PIPE transactions. The fund sought a return of $120 million, which it claimed was its share of the $2.5 billion that Forstmann Little had put into PIPEs issued by XO Communications and McLeodUSA, two telecom companies that later filed for bankruptcy. Connecticut state treasurer Denise L. Nappier contended the investments were too small to fulfill the fund's investment mandate.

But Forstmann's investments gave it two seats on McLeod's board and a shot at control of XO that might have been successful had the ante not been upped by Carl Icahn. Forstmann thus gained considerable control of one company's assets — and almost did the same with another's — without putting up as much money as it would have had to in public offerings. That benefited the Connecticut pension fund.

Nonetheless, the court recently ruled in favor of the pension fund. The jury, however, made no award to the fund for damages, so Forstmann has claimed complete vindication. The state of Connecticut's response is unclear at this point. —R.F.

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