Pipe Dream or Problem?
June 05, 2004
The type of financing that backfired on Connecticut's pension fund and Forstmann, Little & Company is not just alive, but thriving.
Often called private investments in public equity, or Pipes, the deals can be irresistible to big investors and small companies alike. Companies get cheap money, and the new investors get a stake in the company at less than the public would have to pay.
The chairman of Palm Harbor Homes, a seller of manufactured housing, was approached last month by a group of investors. The group offered to lend his business millions of dollars and would do so in just 24 hours. In return, the investors would get bonds that could be converted into common stock and a nice interest rate.
"We thought it was a smart thing to do for our shareholders," said Lee Posey, chairman of Palm Harbor, which was able to borrow $65 million at about 2 percentage points less than it could have otherwise.
But Palm Harbor's old shareholders have not fared well. The stock has slid nearly 11 percent since the deal was announced, reflecting the fact that the new securities will diminish their stake.
In the typical deal, the new securities dilute the holdings of existing share owners by 5 percent to 20 percent.
Some critics bristle at the practice as unfair to smaller investors and even assert that big investors may be trying to manipulate market prices to make the deals more attractive for them.
"It leads to market inefficiencies that clearly benefit those who play the game, and hurts the smaller investor who is not offered an opportunity to participate," said the manager of a small-capitalization mutual fund that does not invest in Pipes.
The Securities and Exchange Commission is gathering information from various market participants on these financings, according to people briefed on the inquiry.
Because small-company stocks have been market leaders, the cycle is right for big investors to pursue private financings, including Pipes and related securities. They usually receive securities -often in the form of common stock at a discount of 5 percent to 20 percent of the market price - or in the form of securities convertible into stock. The securities cannot be traded until they are registered, usually within 90 days of the offering.
Small companies, especially in cash-starved industries like technology and pharmaceuticals, are driving the issuance. So far this year, companies have raised nearly $7 billion through Pipes and related financings, on pace to finish ahead of the $12 billion total for each of the previous two years.
At the market peak in 2000, the issuance topped $24 billion, according to PlacementTracker, a research service. Pipes acquired a bad name soon after, when the market for small-company stocks plunged, and several companies that had issued them ended up in bankruptcy.
Forstmann Little is being sued by Connecticut over the state pension fund's share of losses from $2 billion in Pipe investments Forstmann purchased in XO Communications and McLeodUSA. Other buyout firms, including Hicks, Muse, Tate & Furst and the Thomas H. Lee Company, fared poorly as well.
Market participants say that some features that made those deals particularly dangerous have been modified and that the currents ones are less likely to blow up as spectacularly as they did for Forstmann Little's investors. For example, there are no more death spiral convertibles, which give owners of the securities the right to more shares or stock at a lower price as the share price falls.
"The world has changed dramatically," said Lawrence Goldfarb, managing partner of BayStar Capital, one of the biggest investors in Pipes and related financings. The average performance of the companies doing the private financings has been good of late. Stocks of listed companies that issued Pipes in 2003 rose 50 percent on average six months after the deal was completed, said Robert Kyle, executive vice president of PlacementTracker.
"These are high beta stocks," he said. "When Nasdaq does well, these companies do well."
Some investors suspect that buyers of Pipes and related private offerings are manipulating stock prices to improve the terms of the deals. Durect, a pharmaceutical company, raised $60 million last June through a private offering of convertible bonds. On the day after the financing was announced, the stock traded at more than 10 times its average daily volume, and lost nearly half its value, dropping to $2.52 a share from $4.
Whitney George, a portfolio manager at Royce & Associates, wonders if buyers put downward pressure on the stock by betting its price would fall. A lower stock price would have enabled the buyers of the Durect bonds to convert their securities to stock at a lower price. The conversion rate was based on the stock price when the deal was completed, two days after the announcement.
The offering "knocked off about a third of the stock market capitalization in the short term, diluted existing shareholders by about a third for the long term," said Mr. George of Royce, which manages mutual funds specializing in small-capitalization companies and which owned 10 percent of Durect at the time.
A market participant said the heavy trading could also be a result of pressure on the stock from investors hedging their positions. The stock has since rebounded to $3.75. A company spokesman did not return phone calls yesterday.
One investment adviser, Rhino Advisors and its president, Thomas Badian, agreed to pay $1 million last year to settle an S.E.C. investigation that it had manipulated the shares of a software company called the Sedona Corporation by arranging for short sales "that contributed to the decline in price of Sedona's stock," the commission said. Rhino and Mr. Badian neither admitted nor denied wrongdoing as part of the settlement.
"The Rhino investigation is continuing,'' said James Coffman, assistant director of enforcement at the commission. "We are interested in market participants who assist in these kind of activities."
Separately, the commission has requested information about trading in shares of companies before and after such financings are completed, according to people briefed on the matter.
Some well-known hedge funds participate in the financings, including Ramius Capital, founded by Peter Cohen, the former Shearson Lehman chief executive. Another big investor, Fletcher Capital Management, is led by Alphonse Fletcher Jr., a former trader at Kidder Peabody who sued the firm in 1991 over his compensation package and recently pledged $50 million to efforts to improve race relations.
Mutual fund managers are also buying private equity in companies that they already own part of. Funds managed by T. Rowe Price, Janus Capital and Legg Mason have bought Pipes.
"It's an opportunity for us to make a meaningful investment in a company without moving the market," said Jay Markowitz, a biotechnology analyst at T. Rowe Price.
Shares of Keryx Biopharmaceuticals, a developer of drugs to fight cancer and diabetes, raised $32 million through a Pipe financing in February. Its shares are up more than 24 percent.
The stock held up in part because the Pipe was sold to a group of investors that largely focus on health care stocks, including fund managers like T. Rowe Price that previously owned shares in the company, said Michael S. Weiss, the chief executive of Keryx. "They were really making a core strategic investment in our company," he said.
In other cases, Pipes have not done well, Mr. Weiss said, because their shares are sold to short-term traders, "who are purely driven by the arbitrage" of buying the Pipe and shorting a company's existing shares.
Despite their opportunity to buy at a discounted price - and their insistence that things have changed - big investors are not immune to problems.
Mr. Goldfarb's fund, BayStar, invested last October in a private placement of convertible preferred stock in the SCO Group, a technology company. A few months later, BayStar demanded its money back in a dispute over how SCO's management was handling litigation related to its interest in the Unix operating system.
SCO's stock has fallen 75 percent since BayStar's investment, although Mr. Goldfarb said his loss was much smaller. "This is a lesson in why a smart investor would hedge their Pipe investment," he said.
On Tuesday, SCO agreed to redeem BayStar's convertible preferred stock, which had a face value of $40 million, for a mixture of cash and common shares. In return, the fund agreed to certain restrictions on selling the stock.