Looking through the PIPE - opportunities for private equity investors

Private equity sponsors have historically invested in PIPE transactions (private investments in public equity) but to a lesser extent than venture capital and hedge funds. PIPE transactions are typically structured as a minority investment in a publicly listed company and the investor does not receive the full panoply of control rights and protections that a private equity sponsor is used to receiving in a customary leveraged buy-out transaction. Although most PIPE transactions offer the possibility of a healthy and quick return due to pricing discounts, short term liquidity options and creative structures, private equity sponsors have frequently shied away from passive investments in public companies for a number of reasons, including the perceived lack of need for immediate liquidity and the desire to control the target company.

However, as record amounts of capital are now available to private equity sponsors and the "mega fund" trend continues, the investment opportunities to deploy that capital will also need to grow. Consequently, we may see private equity sponsors taking a fresh look at PIPE transactions. Two recent transactions of note in this regard are the $3.3 billion investment by Blackstone in Deutsche Telekom and the $350 million investment by Texas Pacific Group, General Atlantic and Newbridge Capital in Lenovo. Although PIPE transactions could present fresh investment opportunities, private equity sponsors need to be wary of control and liquidity impediments, limited partner perception of such investments and any limitations on PIPE transactions in the sponsor's limited partnership agreement or other fund documents.

Advantages and Challenges of PIPES

In the United States, public companies often desire to secure equity financing without spending the additional time and expense of a public underwritten registered offering. For most public companies, the primary alternative is to complete a PIPE transaction involving a private placement of equity securities under the Section 4(2) exemption of the Securities Act of 1933 (the "Securities Act"). Since there is already an active public market for the securities of the company, such investments are usually accompanied by a commitment to register the equity securities for resale within a short time frame following the investment.

A PIPE investment in the United States typically provides certain benefits to the private equity investor, including:

Discount Pricing - In a PIPE transaction, issuers may offer securities at a modest discount to the market value of the company's securities. This discount can range from five to twenty-five percent and is often reflective of the illiquid nature of the securities (e.g., the more illiquid, the higher the discount). It is also common for private equity investors to be issued warrants with a fixed or variable/reset exercise price as a "sweetener." Where the PIPE involves convertible securities, the company may be able to command an effective price closer to (or possibly above) the fair market value of the company's publicly traded securities, which price would reflect the value of the preferences of the securities acquired by the investor.

Public Market Liquidity - Once the resale registration statement with respect to the PIPE securities is declared effective by the SEC, investors can sell the securities into the public market. To ensure immediate liquidity, investors very often will insist on penalty provisions that require an issuer to make payments if the resale registration statement does not become effective within prescribed time periods (typically within 60 to 120 days of the closing of the PIPE transaction).

Speed to Closing - Since the issuer is a public entity in which a substantial amount of public information is available and since a resale registration statement is usually filed after the PIPE transaction is closed, a PIPE transaction can be completed in a fraction of the time it takes to purchase registered securities or private securities unless other applicable legal requirements are triggered.

However, a PIPE investment may also present challenges and pitfalls to the private equity sponsor, including:

Control and Liquidity Impediments - A private equity sponsor may be able to negotiate for the right to designate directors or board observers and, in some circumstances, limited blocking rights on corporate events. However, private equity sponsors are still "passive" investors in PIPE transactions and therefore do not control the board or the timing or outcome of major corporate decisions or liquidity events. Even though most PIPE transactions offer public market liquidity in short timeframes, in some circumstances, private equity sponsors may be restricted from selling for a specified time period.

Fund Document Restrictions and Limited Partner Perception - Private equity sponsors need to be wary of any restrictions on PIPE transactions in their limited partnership agreements or other fund documents. Although PIPE investments may not be legally prohibited under the sponsor's fund documents, as a result of the control and liquidity impediments often encountered, limited partners may not be very receptive to these types of transactions.

Type of Securities

Although many PIPE transactions in the United States are structured as a sale of common stock, PIPE investments made by private equity investors frequently involve the purchase of convertible preferred securities or convertible debt to protect the private equity investor's downside risk. The purchase price for the convertible security may be a fixed price or a floating price based on a formula that relates to the average closing price of the issuer's common stock over the several days preceding the pricing.

The conversion price of the convertible security purchased by a private equity investor in a PIPE transaction is usually subject to anti-dilution protection and may be variable or contain a reset mechanism that automatically adjusts the conversion price downwards (thereby allowing the investor to acquire more shares at no additional cost) if the market price of the issuer's common stock falls below the conversion or reset price fixed at the time of issuance. Issuers in variable/reset deals may negotiate a "cap" or "floor" to limit their exposure with respect to the maximum number of shares that may be issued as a result of stock price fluctuations or other conditions. Although variable/reset deals are not very common, they may be appropriate to protect investors in situations where the issuer may be subject to outstanding litigation or govern mental investigations or other potential distress situations.

Legal Requirements

Private Placement

The primary legal consideration in any PIPE investment is ensuring that the company takes all steps necessary to make the investment a valid private placement. Section 4(2) of the Securities Act provides the exemption from registration for private placement transactions, and Regulation D provides the roadmap to compliance with a 4(2) exemption. To qualify for the registration exemption, both the company and the investor must meet certain requirements; however, the most common (and most important) requirement of the private equity investor is meeting the criteria for an "accredited investor" under the Securities Act.

The requirements of the company are more involved. The company must conduct the PIPE offering in a manner that does not involve any general solicitation or advertisement. In this context, a company that had considered a public offering and filed a registration statement with the SEC may be deemed to have engaged in a general solicitation for the offering, and the company would have to completely abandon that offering by withdrawing the registration statement for a period of time before engaging in the PIPE transaction. Rule 155 under the Securities Act has limited this period of time to a mini mum of 30 days following the withdrawal. Additionally, the company will need to review its history of private and public offerings of securities to ensure that the PIPE transaction is not "integrated" with another offering. Such integration could have the effect of invalidating the company's ability to rely on the 4(2) exemption or Regulation D and require the company to register the offering with the SEC.

Since a PIPE transaction inherently involves a private placement of securities and a subsequent public offering, the PIPE transaction has higher integration risks. To ensure that the PIPE transaction is respected as two separate transactions, the initial private placement must be "complete" prior to filing of any registration statement for the under lying securities. In the standard PIPE transaction, meeting this requirement normally does not pose a problem since the registration statement is filed following the closing of the PIPE transaction.

Shareholder Approval Requirements

Many PIPE transactions involve the issuance of a significant percentage of the company's outstanding securities. As a result, the company may need to solicit the approval of the company's shareholders if required by the rules of the exchange on which the company's shares are listed. As an example, all companies listed on the Nasdaq or the New York Stock Exchange are generally prohibited from issuing shares in excess of 20% of their outstanding listed shares without shareholder approval although certain exceptions may be available to this requirement. Doing so could subject the company to a delisting from the securities exchange. It is important to note that this requirement cannot be circumvented by, for example, attempting to treat sales to different investors at different time periods as individually falling below the 20% threshold, unless those sales are clearly not part of the same offering. For most public companies, the shareholder vote process will extend the closing of the transaction by two to four months.

Recent Notable Transactions

Two recent notable PIPE transactions illustrate both some of the advantages and challenges of PIPE transactions for private equity sponsors. These transactions, both of which involved investments made outside the United States, are the Deutsche Telekom and Lenovo Group Limited transactions.

In April 2006, the Blackstone Group made a $3.3 billion investment in Deutsche Telekom. The investment was through the acquisition of outstanding shares held by another investor, but it had characteristics similar to a PIPE transaction. Blackstone obtained an approximate 4.5% equity stake in Deutsche Telekom, and received the right to designate one member of the 20 member supervisory board of the company. Blackstone also agreed to a two year lock-up as part of the transaction. The investment was reportedly financed with about $1 billion in equity and $2 billion in debt, and the company's shares pay a current dividend that will help offset interest expense on the debt. Blackstone paid a modest premium to current market price for the shares.

In May 2005, Texas Pacific Group, General Atlantic Group and Newbridge Capital Group invested $350 million in Lenovo Group Limited in Hong Kong in connection with Lenovo's acquisition of IBM's personal computing business. The investors in this transaction received convertible preferred stock and war rants as well as the right to designate two members of the board of directors for at least three years. The investors also agreed not to transfer any shares for one year following the acquisition. The conversion price for the preferred shares and the exercise price of the warrants were equivalent and represented a 7% premium to market price. The preferred shares were convertible into approximately 10% of the outstanding shares of the company and the warrant shares, if exercised, would represent approximately 2% of the outstanding shares of the company.

Both the Deutsche Telekom and Lenovo transactions are attractive in that they enabled the sponsors to deploy a significant amount of capital in securities that promised them the possibility of public market liquidity after the expiration of the lock-up period and conferred upon them certain governance rights. How ever, in both cases the sponsor will only have a relatively small stake in the target companies and limited board representation and therefore will be able to exert only a limited amount of control over the target company with respect to management of the company and potential liquidity events rather than the degree of control to which they are accustomed.

Conclusion

As increasing amounts of capital are allocated to private equity, the opportunities to deploy that capital will need to grow. Private equity investors may increasingly look at PIPE transactions. In addition, public companies may find that the combination of a PIPE investment and debt financing is a more attractive financing alternative to straight debt financing for acquisitions or other growth strategies. PIPE transactions offer many advantages to private equity sponsors and are often great investment opportunities but they also present different control and liquidity dynamics than the typical private equity sponsor is accustomed to.

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