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VCs are turning to PIPEs

Venture capitalists across the globe are slowly turning their attention towards investing in public equities, an investment known as a ‘PIPE'. Michael Chin and Melissa Schubert of Jones Day discuss this deal type and its attractions for venture capitalists.

During our discussions with Asia-based venture capital firms, we continually hear about the lack of good investment opportunities. While US venture capital firms have had the same complaint, they have also seen new possibilities for investments in public equity, or ‘PIPE' transactions.  These deals involve the acquisition of equity issued by a company whose securities are publicly traded in the US capital markets. In the current environment, PIPEs may well represent the right balance between risk and reward for VCs.

In a PIPE transaction the investor acquires by means of a private placement a large block of equity that the issuer registers for resale, either at or shortly after closing. While in a basic PIPE the investor buys a set number of shares at a market price with a lockup period and a discount to the investor, other varieties of PIPEs, called ‘structured' PIPEs, may involve other investor incentives.

Such enticements may include warrants exercisable in the future, prioritised payments if the company goes out of business, and, if the deal is for convertible stock, ‘reset' provisions that tie the conversion price of the shares to the performance of the stock for a certain period of time after the closing of the deal.

The ‘toxic' reputation
Unfortunately, some of the structured PIPEs led to PIPEs gaining a reputation a few years ago for being ‘toxic,' with some of the securities sold in PIPE transactions being labeled ‘death spiral converts'. This was largely due to opportunistic hedge funds buying convertible debentures in lieu of straight common stock, with the conversion rate set at a predetermined discount to the market price. In the event, if the stock fell (which is what most stocks have done over the past couple of years), the issuer had to issue more shares to the investors, who recouped their capital by shorting the stock, further driving the price down. Ultimately, this type of financing can drive companies into bankruptcy.

The PIPEs that are becoming popular with VCs these days do not carry such onerous terms - as of the beginning of April 2002, only two per cent of all PIPEs this year were structured ones. Venture capital firms are jumping on to the PIPEs bandwagon with increasing enthusiasm, judging from the numbers. In 2001, there were 1,064 PIPE deals, raising a total of $15.2bn. While this was down from the $24.4bn raised in the 1,252 PIPE transactions entered into in 2000, the 2000 highs can be mostly attributed to the atypical numbers for all kinds of deals entered into that year. So far in 2002, there have been 695 PIPE deals raising a total of $9.8bn.

The list of the top ten PIPE Investors (as compiled by www.placementtracker.com) includes EM Warburg, Pincus & Co, one of the world's leading private equity investment firms, as well as well-known buy-out firms such as Hicks, Muse, Tate & Furst and Forstmann Little & Company, mutual funds such as Janus Capital Corporation, and hedge funds such as Citadel Investment Group.

So why are these straightforward cash-for-stock deals becoming so popular with VCs?

The attractions
First, PIPE transactions are less risky than traditional VC early-stage investments. The large losses sustained by the VC industry over the past year have led private equity firms to become much more risk averse when choosing investment opportunities. Public companies are a safer bet than private companies. Private equity investors typically have access to better financial information when investing in a public company rather than a private company.

Further, VCs are now seeking to invest in young companies that have completed products, customers and sales - even profits - instead of the riskier true start-ups. As many such companies went public in the overheated markets of 1999 and 2000 instead of privately raising second and third rounds of venture capital, (and therefore now bear strong similarity to private companies in which VC firms would be making later-stage investments), PIPE investments are a natural progression for VC firms.

Second, PIPE transactions have an upside that is appealing to VCs. With tumbling valuations for listed stocks, many VCs believe that there are a lot of under-valued companies out there. Such depressed valuations mean a potentially large return when the markets come back. Many investors believe they can get better valuations now in the public markets than they can in the private markets. The discount negotiated by the PIPEs investor, typically between  ten to 15 per cent off the market price, further adds to the upside.

Third, the exit strategy for PIPE deals is appealing. Traditional investment exit strategies such as initial public offerings or mergers are currently moribund. In a PIPEs deal, the investor is guaranteed publicly tradable shares within a certain timeframe, thus greatly reducing the risks of holding an illiquid investment.

Fourth, issuers like PIPE transactions because they get their injection of capital quickly, and potentially with lower costs than those involved in a public secondary offering. While public secondary offerings and PIPE transactions will both eventually involve registering with the US Securities and Exchange Commission, requiring filings and negotiations with the SEC, in a PIPE transaction such activities come after the issuer has received its money from the investors, not before. In addition, PIPE transactions are often negotiated directly between the various investors and the issuer, eliminating the need to pay an investment bank underwriting or financial advising fees. With issuers eager to enter into PIPE transactions, VCs may have an easier time putting these deals together.

Fifth, PIPE transactions are one of the few capital-raising methods currently available to public companies with smaller capitalisations. With the US stock markets at the lowest levels seen in years, making new public issuances of stock is simply not a possibility for most companies. Therefore public companies, particularly the ones with smaller market capitalisations, are increasingly looking for funds from large institutional investors. This gives VCs some leverage in negotiating the terms of the PIPE transaction.

PIPE deals may well be one of the few bright spots in an otherwise bleak investment climate, and Asian VCs should consider broadening their range of available potential investments to include PIPE transactions.

Michael Chin and Melissa Schubert are lawyers at Jones Day in Hong Kong.

Tracing its origins to 1893 in Cleveland, today Jones Day encompasses more than 1,800 lawyers resident in 24 locations and ranks among the world's largest and most geographically diverse law firms. The firm acts as principal outside counsel to, or provides significant legal representation for, more than half of the Fortune 500 companies, as well as to a wide variety of other entities, including privately held companies, financial institutions, investment firms, health care providers, retail chains, foundations, educational institutions, and individuals. For more information please visit www.jonesday.com

This article first appeared in the Asian Venture Capital Journal, November 2002.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com