Hedge funds spur private equity offerings.

The amount of hedge-fund money flowing into public companies has skyrocketed in the past year, thanks to a financing mechanism known as PIPE, or "private investment in public equity."

PIPE investments, which involve the issuance of large chunks of new stock to a qualified investor, rose 20 percent in the first quarter, to $6.03 billion, according to PlacementTracker, a unit of Sagient Research Systems of San Diego, which provides data on private placements.

PIPE offerings cost less than public offerings and require minimal regulatory oversight, making them attractive for small companies. The companies typically agree to discount the shares by anywhere from 5 percent to 20 percent, with the agreement that they can't be resold to the public for two months or more.

Many investment bankers and lawyers say that hedge funds are changing the dynamics of capital-raising and the capital markets by taking large positions in small companies and profiting on their trades.

"The PIPEs market is very, very lucrative," said Mark Klein, a partner at Kirkpatrick & Lockhart Nicholson Graham LLP in Los Angeles, who represents brokerage firms that issue PIPE shares to hedge funds. "It's so difficult to do an IPO now and if a company wants to raise $30 million, this allows quick access to the public markets."

Roth Capital Partners LLC of Newport Beach ranked second behind New York's Rodman & Renshaw LLC as the top placement agent for PIPE transactions in the U.S. Local companies that are active PIPE investors include Yucaipa Companies Ltd. and Oaktree Capital Management LLC. (Yucaipa's planned $150 million investment in Pathmark Stores Inc., for example, is a PIPE.)

With so much money involved, it was only a matter of time before regulators took notice.

Last month, Securities and Exchange Commission Chairman William Donaldson said he was concerned about "the crowding of hedge funds into similar investment strategies," and "the difficulty that this implies for hedge fund managers eager to post market-beating returns."

He has called for increased oversight of the $1.3 trillion hedge fund industry. But it is unknown whether U.S. Rep. Chris Cox, R-Newport Beach, who has been nominated to succeed Donaldson, will pursue a similar course.

Concern about hedge fund investments also intensified when the credit ratings on General Motors Corp. and Ford Motor Co. were slashed to junk-bond status last month, signaling losses for many funds. In addition, the SEC has launched investigations of several hedge funds that may have illegally profited from their PIPE investments.

Easy route

Companies that offer PIPEs avoid the lengthy process of hiring an investment bank for a follow-on offering and going on a road show to drum up support from potential investors.

The process for PIPEs is simpler. Each one is tailored for the issuer's needs with a specific investor in mind. The issuances can include preferred stock, common stock, a mix of common stock and warrants and convertible debt. Demand among investors is so high that the bankers don't have to shop them around to investors.

The main problem is that PIPEs can have the short-term effect of flooding the market with stock, driving down a company's share price. Hedge funds have profited by selling short the shares of a stock before a public announcement of the PIPE financing, leading to allegations of market manipulation.

"A lot of these companies were so volatile that the only way a hedge fund could make money was to short the stock, which is a perfectly legitimate strategy," said Perrie Weiner, a partner at DLA Piper Rudnick Gray Cary US LLP who has defended hedge funds in nearly a dozen civil cases brought by companies that issued PIPEs.

None of the cases has come to trial, said Weiner, adding that hedge funds provide "financing (companies) couldn't have gotten anywhere else."

Part of the stigma of PIPE transactions stems from the "death spiral" deals of 2000, in which dozens of companies allowed conversion rates on preferred shares issued to hedge funds to change based on the performance of the common stock.

Such onerous terms had the net effect of forcing companies to issue more shares, leading some to bankruptcy. Then the hedge funds bought the assets at bargain prices, and owned the companies outright.

These days, PIPE transactions are more likely to have contractual limits set around the timing of short-selling or the amount of stock that can be sold short.

It's not uncommon for a hedge fund to invest in as many as 40 to 50 PIPEs a year, with each investment ranging from $500,000 to $20 million. Some larger publicly-held companies also are turning to hedge funds for capital, and large banks like J.P. Morgan Chase & Co. are becoming active as placement agents.

New regulations in February will require managers running hedge funds with at least 15 clients and $30 million in assets to register as investment advisors with the SEC. According to the Managed Funds Association, a hedge fund trade group, nearly 35 percent of the 900 hedge funds in the U.S. have already registered.

"The market is much more mature now and is getting to be closer to mainstream, particularly in sectors like health sciences," said Jay Beaghan, managing director at USBX, a boutique merchant banking firm in Los Angeles.

Shrinking Pipes

The bigger a company gets, the fewer equity
private placements it makes.

Market Cap *     Placements

Under $50           234
$50-$99              74
$100-$249 *          53
$250-$499            21
$500-$999             6
$1-4.9 billion        6
$5 billion+           0

* Millions

Source: Raisestats Data, 1/1/05-3/31/05