By Steven Dresner and Susan Chaplinsky

Here’s a product that generates alarm and pained cries that institutional investors are running around harming small-cap and mid-cap companies: PIPEs. PIPE stands for private investment in public equity. In a PIPE deal, a public company typically issues unregistered equity-linked securities to a kaffeeklatsch of power investors at a discount to the price of the issuer’s common stock at the time the deal is closed. The issuer commits to registering the securities with the Securities and Exchange Commission so they can be resold to the public, typically within 90-120 days

Everyone is happy, no? Public companies get a much-needed cash infusion quicker, with less fanfare, and at better terms than they could otherwise score from Wall Street, while investors get a chunk of the company’s securities at a discount to the market price.

PIPEs hit the headlines starting in 2000, when high-growth, small-cap companies in desperate need of financing — typically tech and telecom companies — turned to the PIPEs market. But instead of getting the financing that would save them, the companies tanked. Within a year of their deals closing, dozens of companies with so-called “death-spiral” or “toxic” structured PIPEs had lost 96 percent,

97 percent, 98 percent of their value. The list is a Who’s Who of failed enterprises: MicroStrategy Inc., Quokka Sports, Log On America, Ariad Pharmaceuticals, IFS International Holdings and eToys, just to name a few. Total PIPEs issuance that year was $24.7 billion.

In a typical death-spiral structure, a company issues convertible preferred stock or convertible debentures that convert into common stock; however, instead of being fixed, the conversion price changes based on how the issuer’s common stock performs after the deal is closed or over some predetermined period in the future (or some other trigger). If the price of the common stock falls within that period of time, the conversion price drops according to a set formula, enabling the investor to get more stock for the same amount of principal. The problem with that structure, as issuer after issuer — as well as public investors — discovered, was that PIPE investors had every incentive to pound the price of the common stock down after the deal closed so they could rake in more stock.

Last year, as of November 1, total PIPEs issuance was $10 billion, on par with issuance volume in 2002 and 2003 (total issuance in each of those years hovered around $12.5 billion). The number of deals in the first 10 months of last year was a high 1,026, approaching 2001’s 1,040 deals. Investors include a broader swath of hedge funds, corporations, mutual funds, pension funds, private equity firms and venture capital funds than was the case a few years ago.

So is it bad news that the PIPEs market, four years after its Annus Horribilis, is expanding its reach? Not necessarily, although criticisms abound.

Myriad lawsuits and civil litigations have come and gone, and the PIPEs market has changed. Structured PIPEs — deals that offer investors price protection through conversion prices that are reset or variable — represent a far smaller portion of the overall PIPEs market nowadays. In 2000, structured PIPEs represented 13 percent of the total PIPEs issuance, according to PlacementTracker, an industry research firm; through November 1 of last year, structured PIPEs were 7 percent of the market.

The current structured deals are also designed differently. They typically include hard or soft floors that prevent “high-level dilution,” thereby reducing the incentives of investors to push the stock down, says Steven Dresner, publisher of “The PIPEs Report” and co-author of “PIPEs: A Guide to Private Investments in Public Equity.” Many PIPE contracts also specify that the investors cannot short-sell or can only short a certain amount of the company’s stock over a period of time. Regarding the death-spiral structures of a few years ago, Dresner says: “It’s so 2000. It’s totally irrelevant.”

What’s behind the change?

First, data. There is an increasing supply of data and research about the PIPEs market. PlacementTracker, a research firm launched in 1999, was the first to publicly report information on transactions, their structures, their investors and the bankers that helped raise the money. PrivateRaise, another research firm, provides data and analysis on PIPEs and Rule 144A placements for the private equity market. More data and understanding of PIPE structures has prompted a broader range of investment banks and investors to test the waters.

Another reason for the development of the PIPEs market was the 2001-2002 massive market correction after the tech bubble burst. The financing options that once existed for high-growth companies dried up and blew away, and the number of PIPE deals declined. But the PIPEs market didn’t shut down the way the IPO and secondary markets did, says Brian Overstreet, president of Sagient Research Systems, which owns PlacementTracker. “For companies that were already public and needed to raise capital, the only place was the PIPEs market,” he notes. “They realized it wasn’t such a bad alternative, and when the market came back in 2003 those same companies kept coming to PIPEs to access capital. Now bigger companies, bigger investment banks and bigger investors are involved in the marketplace.” Companies with larger market caps that have accessed the PIPEs market in 2004 include Corvis Corp., Allegheny Energy, OMI Corp. and WebMD

Still, it’s the appeal of the market to hedge funds that sets many portfolio managers’ teeth on edge. The sharpest criticism is that PIPE investors — primarily hedge funds — are profiting at the expense of an issuer’s existing shareholders. The PIPEs market is seen as secretive and nontransparent. In addition, the issuance of a PIPE, whose unregistered securities can eventually be converted into common stock, dilutes the stock price by increasing the number of shares outstanding.

In a way, all this is true. Neither institutional investors nor fast money will venture into a market if the risk-reward ratio isn’t beneficial. At the same time, companies issuing PIPEs tend to be distressed and there’s a limited supply of investors ready to pony up the necessary cash. Hedge funds can be seen as last-ditch investors — or, alternatively, as venal speculators. (PIPE investors also face risks: they hold illiquid unregistered securities for a period of time and can’t be certain that the issuer’s stock price won’t capsize while they’re long the securities.)

For those not in the PIPEs community, there is limited transparency into the market. After a PIPE deal closes, the issuer must file a Form 8-K with the SEC, but the documents are legal, lengthy and complex, and extracting information that may be market-moving is no walk in the park. “If someone’s only contact with the PIPE market is peripheral, and they’re not reading through the filings, I can see why they may feel they don’t know what’s happening and why it would be confusing,” says Sagient’s Overstreet.

Speaking at an Investment Company Institute conference on mutual funds in September, Harold Bradley, chief investment officer for U.S. growth equity at American Century Investments, said that PIPEs hurt the issuing company’s shareholders and that hedge funds operating in the PIPEs market “move stocks around without transparency.” That “steals performance from my investors and my mutual funds,” he added. He called for “regulatory help right now.”

The SEC isn’t expected to heed the call. “Our concern is adequate disclosure of information,” says SEC spokesman John Heine. “With regard to public operating companies, it has often been said the SEC is a disclosure regulator and not a merit regulator.”

Nonetheless, the SEC is always concerned about market manipulation and is reputed to be investigating activity around a number of PIPE transactions. Market participants say that the SEC has been requesting information from broker-dealers about short sales in connection with particular PIPE transactions. In a case that highlighted the Commission’s focus, the SEC in February 2003 sued Rhino Advisors, an unregistered investment adviser, for manipulating the price of Sedona Corp.’s common stock by selling the stock short on behalf of a client that had a stake in a structured PIPE; the SEC further charged Rhino, which knew the client had agreed not to short the stock while the convertible debt was outstanding, with hiding the short sales from Sedona by running them through a series of broker-dealers. Rhino settled the case for $1 million.

Nowadays, with the PIPEs market maturing, PIPEs are increasingly becoming a more mainstream financing vehicle.