PIPEs Flowing Despite LP Concerns
Joe Christinat

With the public markets still feeling the effects of a prolonged slump and with $100 billion of private equity overhang sitting on deck, one would expect an increase in PIPEs. Sure enough, based on the rate occurring thus far in 2003, PIPEs are showing an annual increase for the first time in three years.

There were some 1,100 PIPE transactions totaling about $18 billion in 2002, according to the investment research firm PrivateRaise LLC, and the current pace of deals hints at a year-over-year jump in the number of PIPEs and total dollar amount. As of July 23, there have been 598 PIPEs worth a combined $9.3 billion, New York-based PrivateRaise reported.

Kevin Albert, managing director of Merrill Lynch's private equity arm expects that that there will be an increase in the "good" PIPE deals, the kind of transaction that gives general partners an amount of power and control that they can justify and thereby earn the incremental fee they're getting.

"But there's a lot more scrutiny now," he says. "One of the firms we're raising money for spends a lot of its time justifying why they're even doing PIPEs."

Indeed, the trend toward PIPEs has prompted a mixed reaction from the buyout community, in large part because these deals (a private sale of restricted securities to a relatively small number of institutions or individuals.) aren't what limited partners are paying their general partners to do.

"Since LPs are paying premium fees, we're looking for our money to be value-added, not passive," says Erik Hirsch, chief investment officer at Hamilton Lane.

In most people's eyes, taking a position in public securities doesn't count, adds Hirsch.

"The lack of value-added investing is troubling, particularly in light of the lack of liquidity," Hirsch says.

"We've found that PIPEs are more of the tail wagging the dog," says another LP. "This is just a mechanism to get out a lot of capital. Investment bankers saw an opportunity to get GP money out there and manufactured these deals. But I don't think the returns will go any higher than 20%, and certainly won't reach the numbers LPs require."

Perhaps most disconcerting is that PIPEs don't give the LBO firm any control. "Very rarely, even if the buyout group has one or two board seats, do they ever have any control," replied another LP.

But despite the criticism about PIPEs, market players say the outcry hasn't been loud enough to prevent LBO firms from doing them. Phil Smith, a partner with Ropes & Gray, says that while PIPEs are indeed a topic of discussion and an area of concern with LPs, there is not a huge pushback from them.

"These deals are mostly market-driven," Smith says. "They're a result of a lack of solid buyout opportunities in the private sector."

Since many of the public companies getting private money are solid performers with depressed stock prices, many of these deals do in fact look great on paper.

Despite the fact that LPs have been giving others a lot of heat over doing PIPEs, "many of these deals are solid investments, with substantial opportunity to create value down the road for all the company's shareholders," says Niv Harizman, managing director with Credit Suisse First Boston.

"Some LPs are averse to PIPE deals just because it's a public company, and that's the wrong reason," adds one buyout pro. "But they'll change their mind down the road if they make their money."

Buyout shops have traditionally been involved in some of the largest PIPE deals, and 2003 has been no exception. The top three deals this year all involved buyout shops: Apax Partners' $250 million investment in clothier Phillips-Van Heusen Corp.; the $200 million PIPE in electronics maker Flextronics International Ltd. by Silver Lake Partners and Integral Capital Partners; and Warburg Pincus' $125 million investment in plastics manufacturer Wellman Inc.

Some other notable deals included The Blackstone Group's $55 million PIPE in petroleum refiner Premcor Inc., the $50 million PIPE in Sirius Satellite Radio Inc. by Apollo Capital Management and Blackstone, and Welsh, Carson, Anderson & Stowe's $35 million investment in telecom provider ITC-DeltaCom.

To public companies in need of a cash infusion, a name can be just as substantial, or more so, than the dollar amount attached.

"A Blackstone or a Welsh Carson involved in a PIPE deal puts a rubber stamp on it," says Bob Kyle, executive vice president at PlacementTracker, which researches and tracks private investments. "Companies are ecstatic when a buyout firm gets involved."

Indeed, it sure is when the common alternative is standing by as your stock gets shorted into the ground by a hedge fund and your market cap slides into dot-bomb territory.

James Tenanbaum, an attorney with Morrison & Foerster LLP, says that one advantage for a private equity shop in doing PIPE deals is avoiding costly legal proceedings.

"Going private can lead to lawsuits from shareholders, but that could be avoided with a PIPE deal," he says. "Dilute the investors, but let them stay involved. If this is done correctly, and the buyout shop has the desired level of control, then the risk of litigation is cut down."

But is all this worth ticking off some of your LPs? As a relatively new phenomenon in the buyouts world, many see PIPEs as a necessary evil.

And until the current-albeit slight-upturn in the public market proves it's more than just a hiccup, PIPE deals will remain an acceptable option for buyout pros.

It's something the LPs will probably have to stomach.

Copyright 2003 by Thomson Financial. All rights reserved.