How Public Investment in Private Equity Works

When a publicly traded company needs more money for expansion, acquisitions, or working capital, managers sometimes seek funds through a secondary stock offering. This involves a lengthy process of filing paperwork with the Securities & Exchange Commission and spending weeks touring the country to sell investors on the offering. Or a company can get the money a faster, easier way: through a PIPE.

A PIPE, or private investment in public equity, is a financing technique in which a public company raises money from a private party rather than on the public stock exchanges. These are also commonly known as private-placement deals. In a PIPE, a private investment firm, mutual fund, venture-capital firm, or other investor purchases a block of newly issued shares of company stock.

PIPE deals are appealing for public companies because they face fewer regulatory hurdles than a stock offering. They can also be accomplished fairly rapidly: in two or three weeks versus at least several months for a secondary stock offering.

There are three different varieties of PIPE transactions:

• Standard: This agreement allows the new investors to buy company shares in a private placement. The company agrees to register the new shares with the SEC soon afterward, with the registration taking effect usually within a month of the registration filing. If the SEC elects to review the registration filing, the process can stretch out for several months. This waiting period allows PIPE investors to purchase their shares at a discount to the public market price as protection against possible stock price declines.
• Traditional: This involves either the sale of common shares at a fixed price or the issuance of preferred stock that's convertible to common stock at a preset price. These deals may also give the PIPE investors the right to receive dividends or other payoffs if the company is sold or merged in the near term. As a result of these extra perks, traditional PIPEs are usually priced at or near a stock's current market value.
• Structured: This involves selling either preferred stock or debt securities, which are convertible to common stock. The difference here from a traditional PIPE is the conversion price to stock can be variable or contain a reset clause that may adjust the price downward if the stock price falls. This setup protects the new investors against downside risk but exposes existing shareholders to more risk of dilution in the value of their shares. As a result, structured PIPE deals may require shareholder approval.

One dark side to PIPE transactions: If a PIPE deal isn't structured well, it can drastically dilute the value of the existing shareholders' stock. As the stock price falls due to the issuance of the large block of new shares to the PIPE investors, it triggers the automatic issuance of more shares to preserve the value of their investment, which in turn causes more dilution.

This cycle can start a downward spiral in the company's share price. These situations are known as "death spiral" PIPEs or toxic transactions. Expert legal counsel in structuring the PIPE deal is important to make sure the new PIPE funding doesn't endanger the company's stock value.

Business reporter Carol Tice contributes to several national and regional business publications.