Capital Markets

Out of the Public Eye

With both interest rates and equity investors' expectations rising, more public companies are turning to private deals for capital.
Ian SpringsteelJanuary 1, 2000

With Internet companies raising investors’ expectations to absurdly high levels, more down- to-earth companies are finding it harder than before to raise capital through secondary public stock offerings. Without a dot-com tale or similarly impressive growth story to hype, these companies find much weaker demand for their securities.

“The public markets right now tend to be very binary– either you can raise capital at a good price, or not at all,” says Michael Haynes, assistant treasurer of Sirius Satellite Radio Inc., a broadcasting company based in New York.

Rising interest rates and a tepid high-yield market haven’t helped. Rates on B-rated, 10-year debt, for example, now exceed 13 percent, compared with 10 percent a year and a half ago.

So an increasing number of companies are turning to a new type of private market for equity. Unlike a 144a offering, a privately offered form of public security that requires some public disclosure, the newer types of private deals require no disclosure whatsoever. That helps explain why many issuers have come to prefer this route over both the public markets and 144a offerings–at least as a stopgap measure.

The lower profile of strictly private deals can dampen public investors’ concern over dilution from the issuance of additional equity. In fact, the strategic nature of many of the deals often boosts the price of the common. Meanwhile, the creative twists possible can help companies manage their balance sheets.

Limited Access

Consider RCN Corp., a telecommunications company based in Princeton, New Jersey. Not long after David McCourt, RCN’s chairman and CEO, met Paul Allen, co- founder of Microsoft and now a venture capitalist, at an investment conference, RCN secured a $1.65 billion private equity investment from Allen’s Vulcan Ventures Inc.

The company now has enough cash on hand to fund its capital expenditures through early 2003. “We were looking for a deal that would help to insulate us from the vagaries of the capital markets,” says Bruce Godfrey, CFO of RCN.

Similar deals are attracting other public companies as well, including those whose access to new equity is limited by a lack of analyst coverage or liquidity.

On the other side of the deals, fund managers that have traditionally stuck to private companies have become more open to taking minority stakes in public ones. Reason: The bull market has pushed up prices of private companies as well as public ones that have generated great expectations, so it’s tough to make new investments that will produce the returns these investors have enjoyed in the recent past.

Because they make large investments, it isn’t cost-effective for such investors to buy stakes in low-priced public companies through the public markets. The news that they’re buying would induce potential sellers to hold out for a higher price before the purchase could be completed. With a private deal, the price is simply negotiated between the company and the investor, often at a sizable premium to the current market price.

As one buyout fund manager puts it: “We can’t buy these types of stakes in the public market without pushing share prices much higher, and most of these companies couldn’t sell such stakes publicly without pushing their share price lower. In effect, there’s an inefficiency in the public markets right now for many companies, particularly smaller ones.”

Among private equity investors that have turned their sights on public companies are venture capital firms like Vulcan and corporate VC funds run by such companies as Intel and Microsoft. Also entering the fray are buyout firms like Hicks, Muse, Tate & Furst; Apollo Management LP; and Charterhouse Group International. It’s tough to say exactly how much is available to public companies from these investors.

All told, there’s an estimated $150 billion to $200 billion available in venture capital funds and buyout firms, but much of that is earmarked for investments in private companies and traditional buyouts.

What Pressure?

Of course, inviting large minority stakes from these types of investors puts added pressure on management. Consider Top Image Systems (TIS) Ltd., a Tel Aviv, Israel-based data processing and imaging software firm that did an IPO in the United States three years ago, raising $7 million, and which has since been listed on Nasdaq. A weak stock price and little analyst coverage made raising another round of equity in the public markets a nonstarter.

Instead, last October TIS secured an investment from Charterhouse Group International, a New York­based venture capital and LBO group. The initial investment will be $15 million placed in newly issued common equity shares of the company, priced at the average closing price of the 15 days prior to the close of the transaction. Charterhouse will invest another $10 million at similar terms.

But while Charterhouse now has a stake of 40 to 45 percent of TIS, management is comfortable with the decision because of the clear benefits of the deal and the dynamics of the relationship with Charterhouse. “This gives us a large institutional holder interested in the long-term growth of the company,” says Izhak Nakar, chairman and CEO of TIS. And Nakar says Charterhouse has assured him it will rely on the existing management team to pursue its strategy, though it will provide guidance when appropriate.

But the typical deal is far from straightforward. Many, if not most, of these private placements are made in the form of convertible preferred stock, instead of common stock or straight debt, to exploit features of both types of securities.

For investors, the appeal of convertible preferred securities includes a fixed yield in the early years and the chance to benefit from appreciation in the common stock before conversion. But private equity investors especially covet the fact that they stand ahead of holders of the common for the proceeds of asset liquidation in the event of bankruptcy.

A Blank Sheet

Also, the distinction from common stock allows much more to be done regarding rights and covenants. That gives the two sides a blank sheet to work with when negotiating.

For issuers, the convertible nature of these deals minimizes dilution, since nearly all such deals are done at a premium to market price, in exchange for the coupon. And this is often noncash and pay-in-kind, spreading any dilutive effect out over time.

Consider again RCN’s deal with Vulcan, which is a convertible preferred stock investment paying a 7 percent dividend. Convertible at $62 a share, the security was priced 40 percent over RCN’s stock when the deal closed. An earlier deal, last May– $500 million of convertible preferred stock, with a 7 percent dividend and a strike price of $39 a share–went for 30 percent over the price of RCN’s stock at the time.

What’s more, convertibles are treated for balance-sheet purposes as equity, which can help a company’s debt rating. In the fall of 1998, for instance, Sirius (previously called CD Radio Inc.) needed about $600 million to finish the build-out and launch of a satellite network. The company earlier had raised about $500 million from an IPO of equity, a bank credit facility, and a high- yield bond issue, and would return to the public markets for at least some of the additional funding.

But management didn’t feel it could count on public investors for the entire amount. Profits still lay too far beyond the horizon. And Sirius wanted to maintain a relatively conservative balance sheet, as the company was rated only CCC+.

“Even though we didn’t need the money immediately, when the opportunity to do a private deal arose, we were interested,” says assistant treasurer Haynes.

That opportunity turned out to be a $200 million commitment from Apollo Management LP, an investment group in New York and Los Angeles.

Talk about complex deals. The junior convertible preferred shares were split into two tranches. The first would be a $135 million placement with a 9.2 percent dividend, convertible at $30 a share. The second would be optional for Sirius, structured as a put by the company to Apollo for an additional $65 million within one year at the same terms.

The put feature helped get Apollo to step up to the plate. “Apollo would have liked to buy an even larger piece of the company,” Haynes explains. The put gives it the opportunity. “But,” he adds, “we wanted to maintain our flexibility to access the capital markets in the most cost-effective way. The put allowed us to know that we could have that additional amount of equity when we wanted it.”

Sirius’s experience also shows that private deals can help ease reentry into the public markets. Nine months after the deal with Apollo, the satellite broadcaster raised another $200 million from the public in common stock and convertible subordinated bonds. “Apollo helped to validate our business plan,” explains Haynes.

Princes Only

Of course, not all companies can get such private financing. After a mention in an early 1999 Wall Street Journal column on private investments in public biotechnology firms, New Enterprise Associates (NEA), a venture capital firm based in Menlo Park, California, was deluged by calls from antsy biotech finance executives looking for new cash. But as of October, NEA, with $500 million of venture capital under management, still had very little invested in public companies.

“We’ve looked at a lot of companies, but we’ve kissed a lot of frogs,” says Sigrid Van Bladel, a partner at NEA. “We’re very picky, but as a firm oriented mainly toward venture capital investments, we have to be, as there’s a lot of risk in the exposure to the ups and downs of the public markets. There has to be solid upside for us, and a strong strategic imperative for the investment. Many of the companies we’ve looked at were running out of money for good reason.”

One investment last year was a $6 million stake in Connectics Corp., which develops dermatology and arthritis treatments, and so far has performed well. The stock had risen more than 60 percent, to $6.50 a share by late November.

The challenge for other CFOs is to convince private investors that their companies can do much the same thing.