What are PIPE transactions?
The SEC has defined a PIPE transaction as follows:
“PIPE” stands for “private investment in public equity.” In a PIPE offering, investors commit to purchase a certain number of restricted shares from a company at a specified price. The company agrees, in turn, to file a resale registration statement so that the investors can resell the shares to the public. To the extent that they increase the supply of a company’s stock in the market, PIPE offerings can potentially dilute the value of existing shares. (Source)
Hedge Fund Investments – PIPE transactions
PIPE transactions can be a part of a hedge fund investment strategy and in some cases a whole investment strategy. Generally hedge fund managers who focus on PIPE investments are hoping for a large exit strategy such as a reverse merger or a public offering. Such managers have experience in the PIPE space and have concluded many PIPE transactions.
For such hedge fund managers, there are many considerations with regard to these investments including:
Structure – hedge fund managers who invest in PIPEs can be very creative when it comes to the structure of their hedge fund. The fund can be structured as a private equity fund, a normal hedge fund or a combination. A manager should discuss the options with his attorney.
Side Pocket Investments – based on the structure of the fund, the manager may want to institute side pocket investments. Side pocket investments allow a manager to segregate certain illiquid or hard to value assets until a disposition of the asset. A side pocket investment would be more likely in a normal hedge fund or a combination fund. Many PIPE hedge funds have side pocket investments.
Lock-up – because of the recent market volatility and the rush for redemptions, many managers are re-examining their lock-up periods. For hedge funds with investments in illiquid securities, this is especially important from a cash management perspective. The manager should spend some time discussing the lock-up with the attorney; the lock-up should generally be a little longer than the expected time horizon of the investments. For example, if the fund will make PIPE investments which is expected to have an 18 month duration then the lock-up should not be only a year.
Investment program – the manager will need to define the areas and limits of the investment program in the offering documents. While broad and vague investment programs have generally been acceptable, it is likely that investors are going to want to know more specifics of the program going forward. The manager will want to describe what types of companies it will invest in, what types of securities it will recieve (common stock, warrants, and convertible instruments), what the manager looks for in a potential company/ management team, what is the expected duration of the investment, among other items. Of course the manager should include a component dealing with its risk management procedures as well.
Fee range – generally PIPE investments will follow the standard fee range for hedge funds. The manager may choose to institute a higher management fee. Additionally, thought should be given to the fund’s expenses in making investments.
Risks and Other Considerations for PIPE hedge funds
Liquidity – the PIPE securities which the hedge fund owns are not liquid. Accordingly the hedge fund manager will need to closely manage the hedge fund’s cash. While manager used to be able to rely on some sort of credit facility to take care of the fund’s cash management needs, this is not as likely to be the case in the tight credit markets today.
Valuation – like many hedge fund strategies the central concern for hedge funds with a PIPE program is going to be valuation. The fund will hold some of the more illiquid assets – restricted securities which cannot be sold for a certain amount of time. As with other programs with liquidity issues, the basic methods of valuation include: (1) book value; (2) outside valuation agent; or (3) by formula. There are advantages and disadvantages to each one of these methods and if you need to have a valuation methodology your lawyer will be able to help you to decide on one of theses methods. A manager should also discuss the valuation with the administrator and the auditor as well.
Contractual risk – there is a risk that the underlying company would not honor the contractual provisions of the PIPE transaction. In such a case it is likely that a hedge fund would seek to enforce its contractual rights through the court system which is both time consuming and expensive.
Regulatory risks – there are various regulatory risks associated with PIPE investments. Central is an investigation into the PIPE transaction by the SEC. As discussed in greater depth below, the SEC is very interested in PIPE transactions. There is also the risk that, as a reseller of securities, the fund may deemed to be an underwriter which would subject it to further regulation – the hedge fund manager and attorney should discuss this issue.
Due Diligence – the fund managers must conduct research and due diligence on the underlying company. This type of research is typically more involved than many hedge fund investing strategies. If the manager will be conducting in-person reviews of the company and the company’s management team, the manager should discuss this with the hedge fund attorney so that the offering documents explicitly state that such expenses be paid by the fund instead of the management company.
SEC on PIPE transactions
The SEC has taken many enforcement actions over the years on PIPE transactions. Hedge fund managers should be especially aware of this because the SEC is on the lookout and the fines are stiff. Below are a few of the many actions the SEC has taken to stop abusive PIPE transactions:
SEC v. Deephaven Capital Management, LLC (release)
In this case a hedge fund manager traded on insider information. The manager received information that a PIPE transaction would be announced and sold short the publicly traded securities of the company. When the PIPE transaction was announced, the stock went lower and the fund made large gains. The manager had to disgorge the profits and was subject to a fine.
SEC v. Joseph J. Spiegel (release)
This case represents a classic PIPE case – the hedge fund manager agreed to participate in a PIPE transaction and then sold the company’s stock short, against representations that he would not. When the restricted stock became unrestricted, he used this stock to cover his previous short. The manager had to pay a fine and was also barred from association with any investment advisor for five years.
SEC v. Jeanne M. Rowzee, James R. Halstead, and Robert T. Harvey (release)
In this case fraudsters promoted investments in PIPE transactions but never invested the money and instead spent lavishly on themselves. In classic Ponzi Scheme fashion, the fraudsters solicited new investors to pay off the original investors.
As always, please feel free to contact us if you have any questions. Additional resources which relate to this post include: