This article has been written by Anupam Bhaduri, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.com.
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What is a private investment in public equity?
The investor, as we commonly imagine, is a person who invests in the company with the sole interest of deriving gains from the company. That, however, is far from the complete picture. Ever since the talks for an investment transaction begins to take place, the investor is equally interested in the exit options available as much as he is in the prospective gains that he could derive from the deal taking place. This is where investors often prefer PIPE transactions.
PIPE transactions or what is better known as private investment in public equity is a form of financing a listed company where the shares of the listed company are allotted to venture capital or private equity investors. The publicly listed companies are aimed for as they offer a better alternative for an exit option. Since they operate in a known and existing market, a predetermined exit option is already available to the investor even before the deal begins taking shape.
Types of PIPE transactions
PIPE transactions can be broadly determined into the following categories. They are:
- Standard PIPE agreements- In the case of standard PIPE agreements, the investor buys stocks of the issuing company in a private placement. The price determined for the newly issued stocks is lesser than the market price as a protection measure against the prices of the stock going down.
- Traditional PIPE agreements- In traditional PIPE agreements, the price of the stocks being bought are pre-determined and the investor buys the shares in the form of common or preferred stocks that are convertible to common shares. This is done with the intention that if at any future point of time the company is merged or sold off, the PIPE investor shall have can opt to receive dividends or any other means of payoffs. This leads to the buying price of the shares for PIPE transaction being priced close to the stock’s market price.
- Structured PIPE agreements – In this form of PIPE transaction, the debt or securities sold to the PIPE investor are in the form of convertible to common stock. The agreements may contain a reset clause for the securities issued where the new investors are protected from downside risks. The existing shareholders are however open to the risk of dilutions of share values. A structured PIPE transaction thus requires a shareholder’s approval and is time-consuming as compared to the other two.
Current market value and PIPE
In case of a PIPE transaction, the transfer or allotment of shares or securities happens at a price that is lower to the current market value. This finance strategy is extremely beneficial because the number of rules and regulatory issues associated with such transactions are significantly less and also provides immense value to small and medium-sized public organisations because of the difficulties they face when it comes to availing more conventional forms of equity financing.
How a private investment in public equity works
A publicly listed company opts for PIPE to secure working capital for day-to-day business or acquisition purposes. As consideration, the company receiving the investment may issue shares or securities in favour of the investor at a reduced price than the stock price. This equity created never goes to sale in the stock exchange. The large investors purchase the stocks in a private placement followed by a registration statement filed by the issuer with the relevant stock exchange regulatory body. The difference with the PIPE transaction with secondary share offering is that in case of a PIPE, the funds are received within weeks whereas the latter would take months.
Consideration for PIPE buyers
A PIPE buyer has to take into consideration certain elements once the deal has taken place. In case of a PIPE transaction, the securities purchased by the investor cannot be resold until any price-sensitive non-public information gathered through due diligence has been made publicly available by the company or has turned stale. The securities purchased by the investor if unregistered would make the investor be deemed as an affiliate of the issuer. This means that the investor would need registration rights to sell the entirety of his shares. The PIPE investor may also be given control rights to a limited extent and adequate board representation based on the amount of equity stake held by the PIPE investor.
The key considerations for a PIPE investor thus would be, in the case of convertible shares, securities and/or debt- the pricing terms which are inclusive of the amount of conversion premium, the dividend rate whether it is ascertained on a cash-pay or cumulative basis, and the liquidation preference which encompasses the issue price accrued along with unpaid dividends if any. The liquidation preference holds an important value in the case of a convertible instrument along with providing the investor with downside protection, board representation and vesting of negative rights. It also includes a change of control premium, protections against anti-dilution (including adjustment to conversion prices) and protection to the issuing company in the form of standstill provisions which inhibit the investor from acquiring new shares and increasing its ownership in the company and restrictions on hedging or shorting the securities of the company.
The parties to a PIPE transaction should also consider the tax implications. The pre-closing regulatory approvals should also be carefully considered. In the present scenario, from the issuer’s point of view, a protracted period before the ability to close on a PIPE and utilise liquidity might be a significant deterrent for the issuer to engage in discussions.
Advantages of PIPEs
The most important advantage of PIPEs is that they are a source of quick investment when traditional approaches to raising equity yields no result. Although PIPEs may be argued to be an expensive source of capital raising procedure for the issuers in some respects, the PIPE funding allows for a necessary alternative in the present scenario given the difficulties in public equity issuances amidst the volatile and uncertainty in stock markets as well as the potential obstacles in obtaining finances from banks. PIPEs, on the other hand, assure quick transfer of funds as compared to the process of public issuance of securities. In addition to that PIPE transaction have the promise to lead towards expansive business partnerships between the issuer and the investor or may also act as a catalyst for the appreciation of the stock price of the issuing company. However, the issuer must keep in mind that if standstill provisions are not in place, the company might be forced to have defensive concerns.
Commonly, the usage of convertible preferred debt and or stock options over common stock is preferred in a PIPE transaction by the issuer company. This is because typically because the stock is released at a discounted price and as well as because of the differentiation of the investment acquired by the company from other public market investment schemes.
Disadvantages of PIPEs
In most cases of a PIPE transaction, the issuance of the shares takes place at a reduced price per share than what is the current market value. While at a glance it may seem beneficial to the investor due to the higher percentage of stakeholding in the target company, an in-depth analysis provides for the following. The market price for the issuance is set based on the current crisis of the target company. This means that the impaired view of the transaction is entirely based on the short term goals. This is dilutive to the interests of the existing shareholders.
In addition to this, the stock price of the target company faces an issue better dubbed as ‘overhang’ due to the investor’s right to resell the stocks. In certain agreements, it is specified that if an event were to happen where the decline of stock prices crossed a certain level, issuance of additional shares would take place in favour of the investor at a significantly reduced price. Short-sellers take advantage of this situation and further accelerate the decline of the market price which further leads to the increase in the stake equity of the PIPE investor. In order to prevent this, agreements stipulate a minimum stock price below which no compensatory shares shall be issued. Agreements may also contain a provision which automatically or forcefully converts the issued convertible securities into common stock in the event that the stock price increases above a pre-determined price in a specific period of time. This is entirely at the discretion of the issuing company.
A real-world example of PIPE
One of the most well-known instances of a PIPE transaction is the GrubHub and the Yum! Brands deal back in February 2018. Yum! Brands is more popularly known as the proprietor of KFC and Taco Bell. In February 2018, Yum! Brands announced that they would be investing n amount of $200 million into GrubHub through a PIPE transaction. The liquidity gained by GrubHub helped it to develop its network in the United States and in turn develop a far more consistent ordering environment for clients of both organisations. The deal also ensured that the Board of Directors of GrubHub was increased from nine to ten to accommodate a delegate from Yum! Brands.
As observed, small and mid-sized firms often opt for PIPE transactions. The reason can be mainly divided into two main but interrelated fronts. Primarily, it gets difficult for these firms to raise capital from conventional structures of financing available to listed companies. Secondly, and as has been discussed above, fundings received through PIPE can be ready for usage within weeks instead of the commonly available options which take.
However, this form of transactions has its own sets of pitfalls if the issuing company is not careful enough.
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