In this article, Azmat Motiwala who is currently pursuing Diploma in Entrepreneurship Administration and Business Law from NUJS, Kolkata, discusses how is a PIPE transaction different from an ordinary private equity transaction?

Introduction

It can be very challenging for small and mid-sized public companies to raise money sometimes as they do not have the same level of access to capital markets as compared to larger counterparts. Lack of exposure to institutional investors, a dearth of analyst coverage and low trading float are some of the hurdles they face. Investment banks too tend to focus on easy prey.  The capital markets have attempted to provide such companies with access to needed capital by creating an increasingly popular financing technique commonly known as a “PIPE” (Private Investment in Public Equity)

Meaning of PIPE

In a private investment in public equity (PIPE), a private investment firm, a mutual fund or another qualified investors purchases stock in a company at a discount to the current market value per share for the purpose of raising capital.

A traditional PIPE is one in which common or preferred stock is issued at a set price to raise capital for the issuer, whereas a structured PIPE issues common or preferred shares of convertible debt. Owing to the hard time small- to medium-sized public companies have accessing more traditional forms of equity financing and to the fewer regulatory issues, this financing technique is more efficient than secondary offerings.

Publicly traded companies could utilize a PIPE when securing funds for working capital, expansion or acquisitions. The business typically obtains funding within two to three weeks, rather than waiting several months or longer, as with a secondary stock offering.

An example of PIPE is the May 2014 Platform Specialty Products Corporation $300 million PIPE. An additional 15.8 million shares of common stock were issued at $19.00 per share. The proceeds were used for general company purposes.

Types of PIPE Transactions

In a standard PIPE agreement, investors purchase stock in a private placement. PIPE investors purchase stock below the market price for protection against the price going down.

In a traditional PIPE agreement there is a pre- determined price and investors purchase common stock or preferred stock that is convertible to common shares. If the business is merged with another or sold in the near future, investors may be able to receive dividends or other payoffs. Therefore, traditional PIPEs are typically priced at or near the stock’s market value.

With a structured PIPE, preferred stock or debt securities convertible to common stock are sold. If the securities contain a reset clause, new investors are shielded from downside risks, but existing stockholders are exposed to greater risk of dilution in share values. For this reason, a structured PIPE transaction may need stockholder approval.

Difference in PIPE transactions

The transaction expenses that are lower than the expenses that an issuer would incur in connection with a public offering. Also, the issuer will expand its base of accredited and institutional investors. For fixed price transactions, investors will have less incentive to hedge their commitment by shorting the issuer’s stock. the transaction is disclosed to the public only after definitive purchase commitments are received from investors. Investors receive only very stream lined offering materials or information, including publicly filed Exchange Act reports and a transaction can close and fund within seven to ten days of receiving definitive purchase commitments. This is beneficial for the investor as he receives a discount to the current market price (in order to compensate for the initial resale restrictions).

However, in such transactions, investors will require a discount to market on the purchase price (in order to compensate for the initial resale restrictions) and there will be a limit on the number of “blackout” periods for the issuer while the resale registration statement is effective.

Investors generally limit their diligence investigation to discussions with management and the company’s independent auditors. Traditional PIPE purchasers generally do not negotiate for themselves ongoing negative covenants or covenants relating to information rights or corporate governance.

The price is set through discussions between the placement agent and the issuer, just as it is during the course of an underwritten (firm commitment) offering. Typically, PIPEs are priced at a modest discount to the closing bid price for the stock to compensate for the temporary illiquidity of the purchased shares. Often, in variable/reset transactions, the price is set based on a formula that relates to the average closing price of the stock over several days preceding the pricing.

In a fixed price transaction, the purchaser bears the price risk during the period from execution of the purchase agreement until the closing. In a variable/reset price transaction, the price risk is shared between the investor and the issuer. Usually, the investor will negotiate some price protection for itself

In the past, placement agents would call investors and advise them of pending deals.

While this information was supposed to be confidential, it became increasingly clear that potential investors, or friends of potential investors, were trading on the basis of this information, typically by shorting the stock of the issuer in anticipation of a PIPE being priced at a discount to market.

The SEC in US is currently investigating these trading practices and the expectation is that significant enforcement actions will soon be forthcoming. However, to their credit, most reputable placement agents have determined to clean up their own practices by requiring potential investors to sign agreements acknowledging that they may receive this market information in the future and agreeing not to trade in the related securities once they are made aware of a potential deal.

As PIPEs transactions have proliferated, they have become a favoured investment of short-term arbitrage investors. These investors purchase PIPE securities, not based on the investment quality of the company, but rather on market mechanics, such as the ability to borrow shares to sell short to hedge their investments and the amount of float in the marketplace.

These investors typically purchase PIPE securities and immediately sell a similar number of shares short. By doing so, they are able to “lock-in” a profit on the transaction because of the difference between the market price of the stock and the discount offered to the PIPE investors. As soon as they are legally able to do so, they unwind their hedge, in effect using the shares purchased in the PIPE to offset their obligation to deliver the shares sold short.Having locked in their profit on the transaction, the investor then is free to hold the warrants for whatever upside potential there may be in the underlying stock.

While short-selling is an important technique in maintaining the integrity of the financial markets, in a PIPEs transaction, this type of unchecked short-selling can spell disaster for the issuer. Frequently, investors have sold shares short without having located the shares they are required to deliver in the sale. As a result, there can be huge downward pressure on the price of an issuer’s stock as the investor is allowed to carry a “failed” trade until it is able to complete settlement using, in effect, the shares purchased in the PIPE.

Ideally, a PIPEs issuer would like all of its securities to flow to buy-and-hold investors. These investors need the same level of liquidity because of investment restraints and valuation issues, but are not typically active traders in the securities they purchase.

In some cases, investors have held their shares for many years, becoming a part of a stable investment base and a ready source of future financing. Placement agents know from experience which investors are short-term arbitrageurs and which ones are longer-term investors. However, depending on the quality and reputation of the placement agent, it may not have access to the “best” investors, or the more desirable investors may shy away from a deal because of the participation of “bad” investors.

A reputable placement agent will try to build an order book that best suits the needs of a particular issuer. However, there are plenty of placement agents that are active in this market who would sell the PIPE to anyone in order to earn a fee. Here again, counsel experienced in the marketplace can be quite helpful in steering deals to good placement agents and advising issuers with respect to particular investors. PIPEs issuers also need to understand and abide by the “rules of the road” for PIPEs investments.

While some deals will of necessity require stockholder approval, an issuer who needs capital is not likely to want to submit a deal to its stockholders if a change in structure avoids the obligation to do so. Further, because a PIPE transaction is a private placement of securities under federal securities laws, it is important to preserve the exemption. How the PIPE is marketed and what prior financing activity the issuer has done may significantly impact the issuer’s ability to do a PIPE transaction. Finally, an issuer that is quoted on the Over the Counter.

Conclusion

PIPEs have become an increasingly popular mechanism for small and mid-sized public companies to raise needed capital especially in the US. If it is done correctly, a PIPE can offer tremendous advantages to an issuer and can be an efficient and cost-effective way to raise money. However, PIPEs do have risk and can be exploited at the issuer’s peril if not done properly.