Private Investment in Public Equity
Private Investment in Public Equity (“PIPE”) is a way by which a company can obtain equity capital to finance itself. The term refers to the sale of publicly traded security by a company to private accredited investors (the “Investors”), and it is a hybrid structure lying between private placements and public offerings. Usually, the Investors are able to buy the equity at below market price – typically between 5% and 20% less. A number of countries allow PIPE structures, including the United States (the “U.S.”), Australia, Canada and the United Kingdom, although the exact mechanics and regulatory framework vary by jurisdiction.

The Basic Mechanics of a PIPE
Although individual PIPE structures differ, a typical U.S. PIPE structure relies on the following factors:
Securities: The types of securities that may be sold include: common stock, convertible debentures, warrants, convertible preferred stock, or other equity-like securities (collectively the “Securities”) of an already-public company.
Structure: These Securities can be arranged in various permutations and pricing structures, depending on the PIPE terms required; the resulting PIPE may be considered structurally pure, standard, traditional or non-traditional as appropriate, with allocation of market risk, certainty and liquidity varying, depending on the purchase agreement.
Financing: PIPE opportunities are available at different levels of market capitalisation. Microcap range PIPE investments tend to be less popular as the issuer is often in its early developmental stages, and has yet to show a high potential for growth in the longer term. Most Investors gravitate towards the mid-market (approximately US$25 million to US$100 million).
Regulation: The sale of the Securities is not subject to pre-closing review by the U.S. Securities & Exchange Commission (the “SEC”). However, the Securities are not freely tradable by Investors until the registration is filed and effective (typically between 60 and 90 days after the offering). Depending on the PIPE terms, in the event filing of a registration statement is delayed, the company may be required to pay liquidated damages to the Investor to compensate for the lack of liquidity. Once the SEC declares the resale registration statement effective, the Securities are unrestricted and freely saleable.
Profit: The Investor typically holds the Securities, anticipating that following the restricted period or in the longer term, the price will increase beyond the discounted price paid or at which they converted.

PIPE Market Participants
Investors: Historically, Investors were sophisticated public market entities whose primary concerns were the core facets of the company, plus the nature of public investment markets, such as float, volatility and volume. Such Investors were generally passive and did not seek to become involved in the company’s management. More recently, traditional venture capitalists, distressed funds and venture funds have invested in PIPE; they are increasingly demanding more protections and rights in the company, thus triggering securities and corporate governance issues.
Investors often establish their own investment criteria, such as limitations on the target industry sector or geography, as well as minimum share price or trading forum. Investors generally look for companies making a significant contribution to an industry sector and that have the size and scale to generate future growth; otherwise, the investment can be deemed too risky.
Issuer: Sectors likely to see the highest demand for PIPE are those with a large proportion of young, high growth companies, that do not yet have enough available capital to finance future growth; these include healthcare, pharmaceuticals and biotechnology, financial services, energy and technology.
AdvantagesOverall, the structure of a PIPE offers the issuing company the speed and predictability of a registered public offering, without the associated costs, whilst providing Investors with nearly liquid Securities. However, PIPE activity is also affected by existing market conditions.
Investors: Interest in PIPE increases when other investment opportunities become less attractive, perhaps due to legal changes and other regulatory factors, or prevailing interest rates.
Issuer: PIPE investment becomes increasingly viable where companies have no alternative sources of capital, such as occurred during the 2008 credit crisis. Companies’ need for liquidity to repay debt or finance operations can be major drivers in the choice of offering a PIPE. PIPE deals tend to happen quickly – within a few days or weeks - allowing companies fast access to large amounts of funding, thus postponing capital shortages and bankruptcy, with few disclosure obligations.
Furthermore, PIPE expenses are comparatively low; in fact, the registration statement, of which a short-form filing is often available (unlike in public offerings), is not required to be filed until after the company has received the investment proceeds.

For Investors, the benefit of PIPE is profit from future sales of the Securities; traditionally this has been seen as a long-term investment. However, as the popularity of PIPE has increased, it has attracted Investors and brokers who are less concerned with medium to long-term growth and more focused on short-term fees and profits. Arguably, this has increased the risks of PIPE, as the abuses outlined below have led to increased SEC attention towards PIPE structures and the parties involved in profiting from them; Jeffrey Friestad, an SEC lawyer said during one such 2006 PIPE court victory, “…it represents our ongoing commitment to stamp out fraud and ongoing abuses in the PIPE market.” It has also left issuing companies vulnerable to unscrupulous Investors and brokers.

1. Short Sales
Although PIPE deals are subject to less regulation by the SEC than other options, such as public offerings, the SEC has pursued some PIPE structures as a violation of U.S. federal security laws.
Early Sales & Naked Borrowing: In PIPE structures, one common but problematic practice is short sales. Although these are legal in the U.S. a trader is supposed to first borrow the Securities in order to sell; he then replaces the borrowed Securities with replacements purchased later at a lower price. It is illegal to use Securities obtained from the PIPE to repay those borrowed; doing so means, effectively, the Investor has sold PIPE Securities too early. The SEC and Nasdaq have also taken steps to curb traders who attempt naked-short selling, that is booking the sale without identifying the Securities to be delivered in the sale.
Manipulation: For the company, short sales can be a major risk. Investors may be tempted to short the company’s Securities where the price is not fixed, in order to hedge their commitment. The SEC will investigate Investors who, interested in short term gains, manipulate the Securities through downward pressure and bet it will fall; this enables the Investor to convert their Securities at a lower price.

2. Insider Trading
The SEC has determined that knowledge of an upcoming PIPE deal may constitute material non-public information and thus may restrict any holder of that knowledge from trading.
Such advanced knowledge of a PIPE can make the Securities extremely attractive to traders anticipating a drop in value. The SEC is particularly concerned where brokers tip-off other clients to trade Securities on unannounced but pending PIPE transactions.

3. Structure
Some trading exchanges, for example Nasdaq and the American Stock Exchange, have rules that require PIPE transactions to be approved by stockholders if they are not structured within their criteria (such as issuing no more than 20% of the company’s total shares outstanding). This means that an issuing company should pay careful attention to meeting any relevant regulations in structuring their PIPE.

4. Death Spirals & Toxic Converts
If structured incorrectly, PIPE transactions may significantly dilute existing shareholders’ equity and force the company to descend into a ‘toxic spiral’.
This occurs where the Investor holds a privately placed convertible security with a conversion price linked – commonly at a discount – to the market price of the company’s common stock, and no floor or cap. The discount assures a profit on the sale thus creating an incentive to quickly sell the Securities. As the company’s market price falls, the company must issue more Securities under the terms of the PIPE thus creating further price drops and a death spiral. This risk is well understood and few structures would include a death spiral convertible; however, some companies are willing to enter into such terms where they have urgent capital needs that cannot be met elsewhere.

In challenging economic times, PIPE represents a cost-effective and fast method of obtaining funding for the company, with the possibility of sizeable long-term profit for Investors. However, particular attention should be paid to regulatory requirements and structure, to ensure that risk allocation and potential for abuse is understood and acceptable to both parties.
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