PIPES: Public Investments in Private Equity Jennifer Marietta-Westberg

1. PIPES: Public Investments in Private Equity Jennifer Marietta-Westberg U.S. Securities and Exchange Commission May 2, 2007 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission. Marietta-Westberg, SEC

2. What is a PIPE? Negotiated sale of equity securities to private investors (typically hedge funds). These securities can be of many types. For example, common stock PIPEs are contracts for common stock or securities (usually priced at a discount) that will convert into common stock. Equity can be publicly traded once it is registered. From 1995-2000, $29 billion was raised through PIPEs. This accounted for almost 25% of the public equity issued during the period (Chaplinsky & Haushalter 2006). Marietta-Westberg, SEC

3. Growth in PIPEs Marietta-Westberg, SEC

4. PIPEs vs. Private Placements PIPE investors are not usually long-term shareholders. PIPE investors tend to be passive. PIPEs do not usually provide control rights such as board seats. Instead PIPE investors receive substantial cash flow rights. However, PIPEs do raise a similar amount of proceeds as other private placements, with average PIPE proceeds equaling approximately 16% of the issuer’s equity (C&H 2006). Marietta-Westberg, SEC

5. Empirical Facts PIPEs are used most by firms facing operating difficulties or with information asymmetries (Gomes and Phillips 2005). 84% of PIPE issuers have negative operating cash flow (C&H 2006). 50% have declining stock prices in year preceding issue. (C&H 2006) 28% of PIPE issuers are delisted within 24 months of offering (C&H 2006) The size of the PIPE discount is 14% for simple contracts and 35% for more complex contracts (C&H 2006). Marietta-Westberg, SEC

6. PIPE Issues Insider Trading: There is evidence that some traders with early knowledge of a PIPE have profited by shorting the stock before the PIPE is publicly announced. NYT article from 8/14/2006 states that the SEC filed four lawsuits against individuals and hedge funds that had profited on nonpublic information about PIPEs. Parties with knowledge of the PIPE appeared to short the stock and then cover with shares obtained at discount through the PIPE, locking in the PIPE discount. Marietta-Westberg, SEC

7. PIPE Issues, cont. 2. Post-Issue Performance Discrepancy Existing shareholders earn abnormal returns of -16% through 12 months and -33% through 24 months (C&H 2006). PIPE investors consistently exceed benchmark returns for 3 to 12 months post-issue (C&H 2006). Marietta-Westberg, SEC

8. PIPE Issues, cont. 3. Possible Regulation Avoidance Media reports and investment bank marketing pieces project PIPEs as a method to avoid time-intensive and more costly public deals. Same sources report everyone “wins.” Issuers receive cash quickly and relatively easily Investors receive discounted stake Brokerage firms receive fees Marietta-Westberg, SEC

9. SEC Public Comment Excerpts from a 2/23/2007 speech by John White, Director, Division of Corporation Finance, SEC, at the 29th Annual Conference on Securities Regulation and Business Law in Dallas, TX. “Another item of recent staff focus has been disclosure in certain so-called ‘private investment, public equity’ or PIPEs offerings and whether the registered resale offering is, in substance, a primary offering by the issuer.” “…staff's concerns with convertible securities where the securities are convertible into a large number of shares of common stock relative to the issuer's outstanding shares and where there is insufficient disclosure about the market impact and cost of these transactions.” “…not worried only about disclosure — we also are concerned about the shelf registration system being used in circumstances not intended to be covered by those rules.” “Our disclosure operations staff has undertaken a screening process to identify potential problematic transactions and will be seeking enhanced disclosure where appropriate.” Marietta-Westberg, SEC

10. Explaining Poor Performance Is the PIPE security just a signal of a poor quality firm? Hillion and Vermaelen (2004) argue that the offer price discount is the most important predictor of poor long-term performance. They argue that this is not just signaling, but also a result of faulty product design. They recommend changes in contract design, such as adding warrants in exchange for reducing the discount. Marietta-Westberg, SEC

11. Changes in Access to Capital Final Report of the Advisory Committee on Smaller Public Companies, 4/23/2006. “Allow all reporting companies listed on a national securities exchange, NASDAQ or the OTCBB to be eligible to use Form S-3, if they have been reporting under the Exchange Act for at least one year and are current in their reporting at the time of the filing.” (currently need > $75M in public float) S-3 offering vs. PIPEs: importance of cash-in-hand investor demand for PIPEs (with discount) vs. standard primary offering (without discount) . Marietta-Westberg, SEC