Investment Dealers' Digest

The Rise Of Rights Offerings

April 9, 2009

Cash constrained hedge funds that once drove the buying in the private investment in public equity (PIPE) market are increasingly turning away from such deals. Instead, many funds are increasingly considering rights offerings.

“The PIPE market is in disarray,” says Fred Johnson, director and head of confidential equity offerings at William Blair & Co. “Small-cap and mid-cap companies are using rights offerings as a tool. It’s serving as a temporary replacement to the PIPE market.”

Indeed, according to recent PIPE market league tables published by Sagient Research, $3.9 billion was raised in 180 transactions in the PIPE market in the first quarter. In the same period a year ago, $43.4 billion was raised through 266 deals.

“Historically, hedge funds have been the biggest investors into PIPEs. A unique thing we saw in the first quarter is hedge funds are shying away from PIPES and are not as prevalent as other investors in the PIPE market,” says Robert Kyle, executive vice president of Sagient Research.

This is due in part to the fact that companies that pursue PIPE deals are often illiquid, according to Johnson. “The typical profile of a would-be PIPE issuer does not currently appeal to hedge funds and mutual funds reeling from redemptions. If they enter into a position there must be liquidity,” he says.

Enter rights offerings, which according to Steven Siesser, chairman of Lowenstein Sandler’s specialty finance group, can be a cross between a PIPE and a registered direct offering. A key difference, however, is that a rights offering can be structured so that it’s not subject to a stock exchange’s 20% shareholder approval rule. Nonetheless, Siesser says corporate boards of directors are increasingly embracing rights offerings. “Boards of directors are saying ‘if we are going to raise capital at these depressed levels, we want to give existing shareholders a chance to participate, too,’” says Siesser.

Investment banking fees associated with these deals are modest, with bankers routinely earning several hundred thousand dollars per offering. “Lesser fees that may apply to rights offerings do not dictate what’s being done for a client,” says Johnson. The reason for lower fees is due to the fact that a rights offering is designed for existing investors and provides them an opportunity to acquire additional shares at a discount to current valuations without diluting their existing stock. Since the issuer taps into an existing shareholder base, bankers do not need to market the deal to new investors.

But investment bankers continue to market these deals and are increasingly targeting hedge funds as a backstop investor or standby purchaser, which is an institutional investor that promises to acquire all of the outstanding shares in a rights offering that are not exercised by shareholders. In return for being a backstop, the firm receives a fee from the issuer. The fees associated with a rights offering rise when there is a backstop, earning investment bankers between 4%-7% of the deal.

Currently there are about 10 rights offerings in registration with the Securities & Exchange Commission, and many of the deals are expected to come to market in the next 30 days.

“Many PIPE hedge funds have stopped investing and those who remain are more insistent on liquidity, which a rights offering gives them. The hedge funds that are around, together with private equity and venture capital funds, are the primary candidates who would backstop these deals,” says Siesser.

Meanwhile, as hedge funds consider rights offerings, the private equity community has been stepping up to the plate. Deltek Inc., a software company, filed for a $60 million rights offering on April 3. The deal is scheduled for April 14. New Mountain Partners II, New Mountain Affiliated Investor II, and Allegheny New Mountain Partners - a trio of private equity firms that are also Deltek’s biggest shareholders - have committed to participating in the offering and to exercise both their basic subscription and over-subscription privileges.

United America Indemnity, a Cayman Islands insurance and reinsurance company, recently announced a $100 million rights offering. The firm entered into a backstop agreement with an affiliate of Fox Paine & Co., its largest shareholder, for the entire amount of the deal. Fox Paine will earn a $7 million fee from United America Indemnity, sources say.

Siesser is advising four clients on rights offering transactions, outpacing the amount of such deals he's seen over the past 10 years. “We’re still getting calls to do PIPEs and registered direct deals, but we’re getting as many if not more calls for rights offerings,” he says.

The companies on file with the SEC for a rights deal are not necessarily turning to these offerings as a last resort. “Some are companies not whose backs are up against the wall but ones that need capital. In some cases the companies are under duress, but others are simply doing these deals as an optimal way of raising non-debt - companies that have a good use for proceeds,” says Johnson.

William Blair is involved in at least two of these transactions. The market cap of each issuer falls below $100 million, and neither company is looking to raise more than $50 million. Johnson declined to name those companies, but noted that rights offerings were once dominated by companies in the financial services sector. In today’s market environment, however, companies across various sectors in need of capital — including retail, healthcare and biotechnology — are turning to these deals.

“When rights offerings are popular, it’s a testament to how bad the capital markets are. Except for the benefit to existing investors, they are the dark horse of capital raising alternatives,” says Siesser.