MAY 3, 2004

A Pipeline To Bargain Deals
Through little-known PIPEs, investors buy shares of listed stocks at favorable terms
Suppose you're an investor who could persuade a company to sell you shares of its stock for less than the last price on NASDAQ or the Big Board. Wouldn't that give you an edge up on the public investor? Well, that's precisely what a group of hedge funds did in January with modem maker Novatel Wireless (NVTL). By negotiating a private transaction with the San Diego company, fund firms such as Omicron Capital and Vertical Ventures were able to buy shares at $7 when they were trading for $9 on NASDAQ. Recently shares were $21 -- a robust 133% gain for the regular investor, but an even sweeter 200% for the hedge funds that still hold the shares.

Such bargain-price deals -- known as Private Investments in Public Equity (PIPES) -- are becoming popular among sophisticated investors. Some hedge funds specialize in these deals, but PIPEs have also attracted buyers such as Berkshire Hathaway's (BRK) Warren Buffett and mutual-fund manager Bill Miller of Legg Mason Value Trust. Most of the companies are not household names. They include SuperGen (SUPG), a biotech firm, American Water Star (AMWS.OB), which makes flavored-water drinks, and Empire Resorts (NYNY), which operates a race track in Monticello, N.Y., and hopes to build a casino and resort nearby.

Broadly speaking, a PIPE is a transaction between a public company and select investors involving equity or equity-related securities such as convertible bonds or convertible preferred stock. The buyers negotiate favorable terms, such as price discounts or warrants to receive additional shares should the stock hit a target price. In exchange, they agree to hold the securities for a set time, often one year, after which they can sell. "Discounts can range as wide as 50% for weak companies to 5% for strong ones," says Steven Dresner, publisher of the PIPEs Report, an industry newsletter.

Why would companies sell shares at a discount? Some may be cash-strapped and unable to borrow from a bank. But even healthy companies make these deals, because they're often cheaper and faster than issuing new shares. A typical secondary offering "takes six months to do and costs at least 10% of the deal's value in underwriting fees plus legal costs and road show expenses," says Andy Reckles, co-manager of the Palisades Equity Fund in Roswell, Ga., which specializes in PIPEs. "I can turn a PIPE deal around in two weeks for much less."

Most of the companies that do these deals are relatively small, which can make them risky. Still, the PIPE investor can come out ahead of the public investor if the stock goes down. That's because PIPE funds often hedge their risks by selling the stock short. A manager who buys a $10 stock for $8 can short the publicly traded shares and lock in that $2 difference, ensuring a gain of at least 25%, no matter which way the stock moves.

The average PIPE fund delivered a 12% annualized return for the five years ending Feb. 29, net of fees, vs. -0.1% for the Standard & Poor's 500-stock index, according to fund tracker Hedge Fund Research. Palisades Equity, run by HPC Capital Management (CPDM), also in Roswell, has been one of the best performers. It has delivered a 79.6% annualized return since its inception in December, 2001, rising 25.1% in 2002 and 143.9% last year. "The critical component to our performance was the quality and strength of our PIPE deal flow, not how the stock market performed," Reckles says. During 2002, Reckles structured most of his deals so he received convertible bonds that could be swapped into equity at a fixed price. Such bonds retain their value and pay interest even if the stock market declines. But in 2003's recovery, Reckles favored discounted stock PIPE deals with warrant kickers -- options to buy more shares of a company cheaply if the stock rises above a certain price. That effectively leveraged his portfolio as the stock market soared.

Pipes have their risks. The selling company could go bankrupt or engage in fraud, in which cases the PIPE investor may be locked in as the shares plummet. And shorting shares as a hedge may not always be an option: The shares may be too illiquid to short, or the company may oppose it. "We will short a stock only if a company gives us permission to hedge our position beforehand," says Lawrence Goldfarb, general manager of BayStar Capital, which is in Larkspur, Calif. "If we did otherwise, we'd never get another deal." If shorting is impossible, the investor may opt for convertible bonds.

Getting your money into PIPEs isn't easy. First, you must have a net worth of at least $1 million or an annual income above $200,000 -- what it takes to buy into any hedge fund. (Fees are similar to those of most hedge funds: 1% to 2% annual management fee, plus 20% of the profits.) Even then, PIPE funds are a small and not well-known subset of the hedge fund world. "Often you have to know somebody who knows somebody to get into one of these funds," says Brian Overstreet, CEO of Sagient Research Systems, a firm that tracks PIPE deals. "Unless you have a lot of money, chances are you won't hear about them." In fact, because of the increased regulatory scrutiny of hedge funds, several PIPE funds declined to reveal their performance to BusinessWeek for fear regulators would interpret it as advertising, a no-no in the hedge fund business.

A good source for investors is the PIPEs Report's Dresner (516 364-8431). He knows most of the major fund managers and is willing to help accredited investors find a match for free. (He will charge the hedge fund a fee if the pairing is successful.) If you want to do your own research, a subscription to his newsletter is $1,950 a year. Another alternative is to examine the funds with the highest deal volume in size and quantity at While volume doesn't ensure great returns, it can drive performance. "Someone like Larry Goldfarb at BayStar Capital knows everybody in the business," says Sagient's Overstreet. "He may not have the best returns in any given year, but he will certainly get the deal flow." On the free portion of Sagient's Web site, you'll find listings of the top dealmakers. You can purchase a detailed report on an individual fund for $225. An annual subscription to Sagient's site costs $30,000.

All this may seem like a lot of effort and expense to get into an investment. But given the inherent advantage PIPEs funds have, it may be worthwhile.

By Lewis Braham