Looking Out for Desperation Finance in PIPEs Deals

By Matthew Goldstein
April 9, 2004

When publicly held companies find themselves strapped for cash and unable to tap capital markets, they increasingly are turning to a type of financing that can spell big trouble for existing shareholders: private investment in public equity transactions.

This year the dollar value of so-called PIPE deals is on a pace to eclipse the totals tallied in each of the last three years. In fact, with 392 companies raising $5 billion, 2004 is shaping up as the second-best year ever for these transactions, according to information compiled by PlacementTracker.

PIPEs are popular with hedge funds because buyers usually get preferred stock or bonds that convert into shares at discounted prices. The deals often include sweeteners, such as warrants, that permit the investors to buy additional shares at prices well below what ordinary investors would pay on a public market. In return, the companies, many of which would have difficulty tapping the public market for financing, get badly needed cash.

But the deals have major downside for existing shareholders, who suffer immediate dilution when an outside investor receives new shares, particularly at a discount to the market price. More alarming, Securities and Exchange Commission sources say, these negotiated investments are drawing increasing scrutiny of late because of the potential they create for savvy investors to manipulate stocks.

Last year, for instance, Rhino Advisors paid a $1 million fine after the SEC charged the unregistered investment advisory firm with manipulating the stock of Sedona by shorting the tiny software company's shares following a $3 million PIPE deal. Regulators charged that Rhino shorted the stock on behalf of one of its clients, Swiss-based Amro International, which had purchased a $3 million convertible note from Sedona in a deal negotiated by Rhino.

The terms of the PIPE deal entitled Amro to more shares of Sedona stock if the company's share price fell significantly before the date the note was due to convert. But the PIPE also prohibited Amro from trying to hedge its interest by shorting Sedona's shares during the life of the note.

So, the SEC alleges, Rhino began shorting the stock as proxy for its client, in a move that dramatically drove the share price down and meant Amro ultimately collected more shares of Sedona stock than it otherwise would have received. Amro, which wasn't charged by the SEC, benefited from Rhino's action, because it got a ready supply of stock to cover earlier short bets it had made.

Long before the Rhino Advisors case, PIPEs had a bad rap on Wall Street, since many deals were structured on overly favorable terms to the hedge funds. The worst of the PIPEs were so-called "toxic converts," convertible debt notes with a bottomless conversion price that sometimes sent stocks into a downward death spirals.

Toxic converts got their name because unlike typical convertibles, which only get converted into shares when a stock rises to a fixed price, the conversion price for these notes keeps getting adjusted downward when the underlying stock fell. The drop in the stock price also meant that buyers were entitled to receive more shares when the conversion occurred.

But the bottomless conversion feature inspired short-sellers, including many of the hedge funds that bought the bonds, to literally short the stocks to death. Toxic converts were little more than desperation financing for companies on the brink of bankruptcy.

Today, true toxic converts are rare. But cash-strapped companies are increasingly turning to so-called structured PIPEs, convertible notes that include limited downward conversion features that can still result in painful, if not fatal, results for shareholders in a down market.

This year, PlacementTracker says, 35 companies have completed structured PIPEs with a combined value of $390 million. All of last year, there were 71 structured PIPEs, raising a total of $267 million.

The stocks of those companies, on a weighted basis, are down an average of 11% one month after the deals were completed, says PlacementTracker. On an unweighted basis, the stocks are up an average of 19%, but that's only because of the skyrocketing performance of a handful of small stocks.

Some of the companies doing structured PIPEs this year include the now-delisted over-the-counter drug company Vaso Active Pharmaceuticals, semiconductor manufacturer Tegal (TGAL:Nasdaq - news - research) , telecommunications company Corvis (CORV:Nasdaq - news - research) and Cellegy Pharmaceuticals (CLGY:Nasdaq - news - research) .

An increasingly common structured PIPE is one called a "company installment," which requires the issuing company to make periodic payments of principal and interest in either cash or stock. A company that chooses to make these periodic payments in stock is subject to an automatic downward conversion feature if the company's stock has declined in value since the offering.

Robert Kyle, executive vice president for PlacementTracker, says company installment PIPES are not as problematic as toxic converts, because the company has the option of making the payments in either cash or stock. But he says a cash-strapped company with a falling share price could still find itself squeezed.

"It can be onerous if a company doesn't have the money to pay it back," said Kyle. "But it's not infinitely dilutive."

By far the biggest structured PIPE this year is the $225 million deal pulled off by Corvis in early February. The two-year convertible notes, which have a fixed conversion price of $5.75, also include a periodic installment payment provision.

Investment bankers with the securities arm of Bank of America (BAC:NYSE - news - research) sold the notes to a group of eight hedge funds, including Highbridge International, Ramius Capital and Millennium Partners. All three hedge funds have been active PIPE investors this year.

Kyle says it's unusual to see a company as big as Corvis, with a market capitalization of $1 billion, resort to a structured PIPE. He says that's an indication that Corvis had a hard time raising financing through more conventional means.

A spokesman for Bank of America Securities declined to comment on the PIPE offering. But a Corvis spokesman says the telecom company likes the "flexibility" of the deal.

"It's an efficient way to raise cash," says Andrew Backman, the Corvis spokesman. "We have the flexibility to pay it back in either cash or equity. I don't view that as a negative."

Shares of Corvis have fallen 18% to $2.02 since the deal closed on Feb. 9.

Meanwhile, less than a month after Vaso Active's $7.5 million PIPE deal, the SEC suspended trading in its shares "because of questions regarding the accuracy of assertions" by the company about its lotion for fighting athlete's foot, Termin8. On April 8 the Nasdaq Stock Market delisted the stock, after the company disclosed that it also is being investigated by the Food and Drug Administration and the NASD.

The sole investor in Vaso Active's company installment PIPE was Millennium, a hedge fund led by Wall Street impresario Israel Englander, which is one of several big hedge funds implicated in the mutual fund trading scandal.


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