Increasing your PIPE line of operating capital.

After three seasons of declining stock prices in most major equity markets, scores of CFOs are scrambling to find new ways to raise enterprise capital. Many are turning their attention back to private equity. At the forefront is a little known, highly controversial yet increasingly popular structured security known as a Private Investment in Public Equity, better known on Wall Street as a PIPE.

Simply defined, PIPEs are sales of equity securities in publicly held firms for which the number of shares, price and terms of the investment relationship are privately negotiated between buyer and issuer. They can be creatively structured using various investment vehicles, including common stock, common stock plus warrants, convertible preferred stock, convertible debt or structured private equity.

Probably the leading reason for issuing a PIPE is anticipation of a capital-intensive event like a merger, acquisition, product line expansion, mezzanine bridge, working capital buffer or recapitalization.

This type of fund-raising differs hugely from venture capital, as investors are rarely able to vie for board seats--nor do they have a say in how and on what the capital shall be spent. PIPEs offer a unique flexibility in that they are open to both institutional and individual investors, as long as the buyer can afford to meet fairly high minimum investment thresholds (for individuals, this typically means putting together a syndicate of contributors).

Terms are also quite flexible, and can be written to favor either the issuer or buyer; conversion price, dividend, redemption, covenants and protective restrictions, and warrants are all fair game in negotiations. "There are a lot of sellers who must learn to negotiate with a few buyers. Many prices start out very low," says Larry Allen, CEO of The New York Private Placement Network, LLC. According to investment banker Harlan Kleiman, CEO of Shoreline Pacific LLC, between 1995 and 2000, PIPE deals grew eight-fold, and the total number of completed deals reached 3,300 by 2002. But after peaking in 2000, the market fell in 2001-2.

Recent corporate scandals have put a temporary bump in the road for PIPE issuers. That, coupled with an increasing popularity in real estate private equity, has caused the number of deals and deal value to fall slightly from their peak.

There are several myths about PIPEs, all of which should be dispelled. One suggests that issuers are deeply troubled companies that may be on the verge of bankruptcy, have poor fundamentals and an atrocious credit rating, or are offering an unattractive public stock to buyers.

Another misconception about PIPEs is that they are the easiest type of securities to structure. Wrong! No two PIPEs are alike; each is customized to the specific needs of both the investor and file company at the time a placement deal is struck. Because investing in these securities is such a complex, technical process, investors are typically sophisticated and will likely put tougher negotiating demands than is customary of retail investors on the issuer through a lengthy, rigorous due diligence period.

Because most PIPEs are structured with common equity, people also jump to the conclusion that PIPEs are more liquid than other types of private equity instruments. That's just not so.

But there are many legitimate reasons for sound companies to issue PIPEs. For one, a firm may simply be a middle-market player that often flies under the radar, generating little awareness of its stock. As a result, trading volume is low, and cash flow from the sale of equities falls short of fundraising expectations.

Similarly, a firm may be the victim of bad timing. Being unlucky enough to initiate an initial public offering (IPO) during a horrific stock market environment, such as the one we are now just recovering from, is another reason that CFOs must find ways to supplement private equity with a public float.

"The IPO market is bone-dry, and many of the companies still owned by the funds are on life support. Until disillusioned investors are appeased, they're reluctant to bankroll new investments that could help kick-start the economy," notes Mara Der Hovanesian, a New York business reporter who follows PIPEs.

Smart CFOs typically have covenants that require a minimum investing period so that fickle investors won't pull the principal shortly after investing. Even if common equity does back the PIPE, that equity is probably in the form of exercisable options with either time expirations long into the future or premium strike prices.

Creating inherent illiquidity through these covenants shifts power to the issuer. The worst fear a CFO has is that an investor will short the investment after the capital has been spent on operations, and there is no way to pay the buyer back.

PIPEs should also be thought of as illiquid because an original buyer cannot resell the security back into the public market without a SEC registration statement being filed and approved. This is not an easy and hassle-free process for a buyer by any stretch of the imagination. The advantage to the issuer here is that stock prices won't be disrupted by speculation and stock market inefficiency.

To compensate an investor for this illiquidity, PIPEs are typically sold at a discounted price and also may offer attractive incentives like dividends, include certain clauses that mitigate risk (which other investors don't have) or offer downside protection on the principal. Another big benefit: PIPEs can be adequately negotiated with the help of internal corporate counsel, making them cheaper to initiate than a secondary public offering, which likely will require engaging expensive investment bankers and spending heavily on a road show.

CFOs also like PIPEs because deals are more discreet and not under heavy regulatory scrutiny, with no mandates for public disclosure of terms and placement amounts. Deals can be flexibly structured to address the specific financial needs of the project the company is trying to fund. Insider information about the firm may also be selectively shared with one investor and not others, where this is strictly prohibited through insider trading and "equal playing field" laws in the public markets. Company secrets such as pending FDA approvals, strong future earnings or new acquisitions can give an issuer a rationale for factoring an increase in future valuation, inflating the PIPE's buy-in price.

More compelling still for CFOs, funding is received at the date of closing, before the securities are even registered. With a secondary offering, laws explicitly prohibit collecting on the placement until after registration. There is also no limit on the number of PIPEs a company can issue, even to the same investor.

Then, the Downside

Despite the benefits to issuing a PIPE, there is some serious downside potential. Structuring these securities requires rigorous attention to every possibility. PIPEs have been infamous for something known as a "death spiral," which is essentially the dilution of the company's stock price as a result of the issuer failing to set fixed conversion prices on the convertible securities in advance, instead of at the time of conversion.

PIPEs use a floating conversion price that moves up and down with the market. As the stock price becomes cheaper, savvy investors try to obtain more shares, thus diluting the value of the stock. As other investors see this dilution happening, they, too, buy more shares, bulking up as protection against devaluation. However, this merely exacerbates the dilution. To prevent this, issuers need to set conversion caps and price floors to limit the lowest level of an exercise price.

Critics, mainly corporate attorneys worried about liability risk, also charge that PIPEs encourage CFOs to be greedily short-sighted about financial planning and raising capital. Basically, they fear that too many private equity commitments will cause high default probability at time of payout. In other words, if a mass of concurrently running convertible PIPEs become due to be exercised at the same time--and, hypothetically, all investors elect to sell out--the issuer will be unable to make the payments. Hello, class action lawsuit!

Moreover, there is a perception question that may linger because PIPE deals are typically off-balance sheet investments--something that has been heavily frowned upon by regulators in a post-Enron world.

Some might even argue that striking private deals with investors behind closed doors is like asking to be sued. Marshall G. Berol, chief investment officer of Malcolm H. Gissen & Associates LLC, expects lawsuits to rise as PIPEs continue to grow in popularity. "Investors start by writing a letter and hope that the [issuer] sees the light of day, [but it all] usually ends up with a lawsuit," he says.

Should something go wrong and an investor become disgruntled, an issuer can easily try to assert "buyer beware" knowledge on the part of sophisticated investors. But, fundamentally, that does not preclude buyers from exercising consumer rights litigation that calls for disclosure warnings and fair dealing by the issuer. Proving that fraud occurred isn't easy, but interpretation of the law can be subjective--so even perceived fraud could leave an issuer with huge legal costs.

How They are Structured

There are generally two types of PIPE deals. The first is called a "fundamental deal," which is mainly pursued by attractive firms with strong earnings, plenty of cash and low debt levels. Essentially, an issuer justifies the security's valuation based upon its quality of current financial condition, as measured by revenue run rate, bottom-line growth and operating cash flows.

Qualitative factors like strength of management, relative market share and marketing strategy may also be investment criteria. The terms in a fundamental deal usually lack many downside protection features because demand for the PIPE is high. Fundamental deals also commonly use common stock or convertible preferred, as opposed to complex hybrid securities that can confuse investors.

The alternative PIPE deal is called a "technical deal," where investors invest based not upon "actuals" but on future prospects, and thus prefer equity ownership down the road, at liquidation, when the firm's fundamentals are likely to be stronger. Because of the uncertainties, there is a strong buyer's market, and many downside protection covenants will be easy to negotiate for.

Here, the issuer struggles to maintain high asset quality and is unable to offer investors many upside benefits, like dividends. Typically, technical deals are structured with common stock that is not heavily traded. This illiquidity makes it difficult for the investors to get out of the investment quickly during rapidly fallIng prices. In cases where warrants are used, a predetermined liquidation price is not set by the issuer because the issuer does not want to commit to how much it must give back to the investor at time of sale, to reduce risk of default.

Technical deals are often more worrisome because they draw speculators; given enough of them, the death spiral effect could ensue. Convertible debt is also more widely used than it is with fundamental deals, leading CFOs to fret about paying off PIPE investors before equity holders during insolvency.

Are They Appropriate?

Is a PIPE right for you? Basically, you have to examine a couple of things about your business. If your capital goal is large and is time-sensitive, striking a private deal is probably the way to go, since the process is cheaper and faster. But companies with poor fundamentals relative to their sector benchmarks should think twice about being issuers.

To be a technical PIPE issuer, you need to screen investors carefully to ensure that they are not investing merely for opportunistic motives. Accordingly, debt is a major decision driver. If you already are stacked with payback commitments, a PIPE will simply put more stress on the liabilities portion of your balance sheet.

Clearly, a PIPE is not right for every company. "It's the Wild West. These new products are totally unproven--and there's some debate about how effective [PIPEs] will be," argues David Snow, editor of private equitycentral.net. But CFOs should definitely view them as an available option in increasing the pipeline of operating capital.

Jason B. Lee is a Certified Financial Management Analyst and a Managing Director with Lee, Pirelli & Co., an investment banking firm in Washington, D.C. He can be reached at [e-mail].