Investing With A Built-In Exit Strategy

VCs are singing the praises of private investments in public equities

Mitchell Kaye, chief investment officer of Xmark Funds, a New York City private equity firm, is an unabashed bargain shopper. Last December, his funds took a stake in World Heart, an Ottawa company listed on the Toronto Stock Exchange and Nasdaq that's developing a fully implantable heart pump called HeartSaver. At the time, when World Heart shares were selling for C$6.02, Xmark bought special warrants that entitled it to purchase World Heart shares at C$5.50 but that also included another warrant to buy shares at C$6.01 in the next two years—a little better than a two-for-one deal. The transaction, known as a private investment in public equities, or PIPE, has also gained popularity among VCs as depressed valuations of small public companies with good prospects have become more attractive than illiquid private investments.

Xmark invests in PIPEs issued by life-sciences and medical-device companies. Kaye figures that more than 500 small public companies in these sectors may need to raise an average of $10 million each this year. "It's not hard to take a small piece of that pie and be successful," he says.

Unlike traditional private placements, PIPEs are privately negotiated transactions that usually involve 10 or fewer investors. Issuers often use warrants, as in the World Heart deal, but may also use convertible preferred shares that can be turned into common stock at a fixed price. Some convertible PIPEs permit investors to change the conversion price; others convert at a discount to the fluctuating stock price. PIPE investors often get cash back from a company sale before common stockholders do and may be able to restrain the company from taking on more debt. They may also earn dividends not available on the common shares.

PIPE issuance rose from a total value of $5.4 billion in 1997 to a peak of $24.4 billion in 2000 (see chart). The market has since slowed but remains frothy. Structured deals sporting price protection for investors represented more than half the PIPEs issued from 1996 to 1998. Many were "toxic PIPEs" issued as floating convertible preferred shares. Speculators would convert below market prices, sell the shares, and make a killing on shares they had shorted earlier.

These days, only a small fraction of the deals are structured PIPEs. As they go mainstream, top investment banks are becoming big players, matching thirsty small-cap companies with investors. Banc of America Securities, Lehman Brothers, and Merrill Lynch are among the top placement agents this year, according to research firm Direct Placement. VC firms such as Technology Crossover Ventures, General Atlantic Partners, and Oak Investment Partners are now jumping into the PIPEs market.

Last November, General Atlantic led a $95 million PIPE for struggling corporate e-mail provider Critical Path in a vote of confidence in the messaging-infrastructure market. Critical Path received $30 million in cash and was able to retire $65 million in debt. General Atlantic got preferred stock convertible into common shares at $1.05; at the time, the common was trading at $1.13. The stock has since drifted below the conversion price, but General Atlantic is also collecting a fat 8 percent dividend.

Now Warren Buffett is dabbling in PIPEs. In July, his company, Berkshire Hathaway, along with fund managers Longleaf Partners and Legg Mason, bought $500 million of convertible notes from Level 3 Communications, attracted by the telecom's strong financial position. The notes pay 9 percent interest and convert to common shares at $3.41, 18 percent above the $2.89 closing price before the announcement but well below the $4.36 closing price the day of the deal.

PIPE investors have a good thing going. "We build in as many features as we can to skew the odds of investing in a difficult market to our favor," Xmark's Kaye says. It's one more way that pros have an advantage over individuals—unless of course that pro is investing your money.