The heat is on for funds' Pipe strategy

The Financial Times
by Jason Huemer
March 15, 2004

The crusade by Eliot Spitzer, New York's attorney-general, against market timing in mutual funds has opened a Pandora's Box, leaving hedge funds wondering what other practices will appear on the regulatory radar screen. To some, there is one obvious candidate: the so-called Reg D hedge fund investment strategy.

The Reg D sector, also known as the "Pipe" sector, for private investments in public entities, refers to the market in which securities in public companies are purchased directly in negotiated transactions, usually at a discount to current value. These sales are made under the auspices of Regulation D of the 1933 Securities Act, which allows the sale of certain unregistered securities to qualified investors.

Pipe financing has legitimate applications but it has also witnessed its share of abuse and controversy, so much so that many practitioners have come to be known as corporate America's loan sharks.

Perhaps the most controversy has been generated by "death-spiral" or "toxic" converts, convertible bonds that have a resetting conversion price, granting more stock to the Pipe investor as the stock price declines.

These bonds became especially popular several years ago, in the wake of the telecoms and internet bust, as rapidly sinking companies grasped at straws to keep themselves afloat.

As the true impact of these deals became felt, with massive shorting driving the companies' stocks further down, a number of transactions resulted in litigation, including Ariad Pharmaceuticals and Log On America, both of which sued hedge fund Promethean Investment Group.

These cases were settled but not before the world caught a glimpse of the hardball tactics employed by some Reg D investors in stripping value out of fading companies.

Because of its unsavoury reputation, many hedge fund investors avoid Reg D or Pipe investments. But while they may avoid firms such as Promethean or BayStar, two of the largest Reg D-focused firms, they may not realise how much exposure they have through multi-strategy firms. In fact, over the past few years, some of the largest buyers of Pipes have included firms such as Citadel, Angelo Gordon and Ramius, all blue-chip names in the hedge fund business.

Defenders of the Pipe strategy focus on cases in which the capital gives otherwise failing companies a new lease on life. They also say that bad publicity has made toxic converts a thing of the past. The data support that contention: figures compiled by PlacementTracker indicate that issuance of such so-called structured Pipes fell from a high of almost $3.2bn in 2000 to under $250m last year. It is worth noting, however, that year-to-date tallies already eclipse the 2003 total.

Pipe investors also stress that they make more money if the stocks they buy go up rather than down. That argument, however, is misleading at best. A closer look reveals that taking directional exposure would be a sucker's bet. In fact, a recent University of Virginia study looked at 2,158 Pipes issued by 1,062 firms from 1995 to 2000 and found that the median abnormal return for Pipes in the 12 months following issuance was -40.7 per cent for "protected" deals (including reset converts) and was -26.7 per cent for "unprotected" Pipes (fixed-price deals).

Instead, it seems that much of the return in the sector has been generated by arbitrage trades - buying securities at a discount and capturing a spread through short sales or options. While this offers an attractive risk-adjusted return to the manager, it usually has the effect of driving the stock price down sharply, shifting the burden to existing shareholders.

The SEC has said it is looking at all areas of the Pipe financing market. Unfortunately for regulators the sector may be difficult to police since it is largely private and most investors play within the letter, if not the spirit, of the law.

In one rare exception, the SEC last year completed an enforcement action against Rhino Advisors, alleging the firm manipulated the stock of Sedona Corporation through a toxic convert and shorting. Rhino agreed to pay $1m to settle the complaint.

Far more interesting are Sedona's civil actions, which expose a tangled global web of offshore investment vehicles, Canadian brokerage firms and even a US investment bank, Ladenberg Thalmann, in a story that makes Rhino's involvement look like just the tip of the iceberg.

Despite the difficulty in regulating the sector, many believe more can be done, starting with one of the biggest smoking guns in the industry: shorting into the overnight convert market (bonds marketed privately for next day issue). While the subsequent equity hedging activity could be expected to depress the company's stock price, what is remarkable is that the price action often begins before any announcement, meaning some investors may be shorting on material non-public information. Where there's smoke, there could well be fire.


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