PIPEs: The Growing trend in the Capital Markets
PIPEs. Not the ones in your house, but private investments in public equities. So what is it anyway? A PIPE is any private placement of securities into an already public company to accredited investors. In conducting a PIPE offering, a public issuer relies upon some of the same exemptions from registration that private companies use in offering securities, primarily the rules around Regulation D private placements under Rule 506. Investor Ventures offers PIPE Transcations.
So why are PIPEs back in the news? At the end of June, Google Capital, a growth equity investment fund, invested $46.35 million into Care.com, Inc. (CRCM), a publicly-held home care provider via a PIPE. In the aftermath of this announcement, many people are questioning whether this will lead to an increase in the use of private investments to help fund public companies.
First, let’s take a look at the advantages, drawbacks, and other important points that issuers and investors should consider when participating in a PIPE.
The Advantages of PIPE
PIPEs have several advantages over a public equity raise for issuers. First, it costs less to conduct a private offering than a public offering, largely due to the lower legal and operational costs of selling private securities. Less offering material is required to conduct a private placement than a public offering and can, in some cases, close faster than a public offering. For a private placement, all that is required is some sort of offering document that adequately discloses the risks of the offering. This is compared to a full S-1 in a public offering, which is very specific and can get quite lengthy.
Another advantage of a PIPE is that the issuer does not have to disclose the offering until firm commitments have been received from potential subscribers. This benefits the issuer by preventing short sellers or other market participants from using knowledge of the upcoming private offering to impact the public stock price prior to the offering closing.
One traditional advantage for an issuer doing a PIPE is the expansion of its accredited investor base. However, in a post JOBS Act world, many issuers are taking advantage of general solicitation to access larger investor pools in the private market.
PIPEs may have benefits for investors as well. One advantage of investing in a PIPE over a regular private placement is that, in most cases, the issuer will file a resale registration with the SEC, which once declared effective, provides these investors with liquidity. This is a significant difference from purchasing a normal private placement. One of the difficulties around purchasing a private placement is the lack of a liquid secondary market and the requirement that any secondary sale occur under either Rule 144A or the 4(a) (1½) exemption. With a resale registration statement on file with the SEC, investors in a PIPE are able to sell their shares sooner and with significantly more ease than investors in a normal private placement.
Additionally, because this liquidity is dependent on the resale registration statement being filed and the possibility of black-out periods, the investors receive a discount to the current market price. So investors potentially get the benefits of both a private security, the discounted price, and the (eventual) liquidity of a publicly registered security.
The Drawbacks of PIPE Capital Raises
While there are many advantages, there are several drawbacks to an issuer raising capital through a PIPE. The first is the common practice of discounting the price of the security from the market price. This serves as a compensation to investors for the initial lack of liquidity. While this may provide investors the benefit of getting shares at a discount, the issuer receives less actual capital for its stock, potentially making it a less attractive source of capital.
Another drawback is that the investor pool is limited to accredited investors. Under the traditional private placement rule 506(b), an issuer can only market to accredited investors who the issuer or broker has had a substantial relationship with, who attested to having an income of $200,000 or more during the last two years or a net worth of $1,000,000 excluding their primary residence. This limits the pool of investors significantly. Again, with the advent of Rule 506(c) allowing for general solicitation, a pre-existing relationship is no longer required as long as steps are taken to verify the investors’ accredited status. As a result, this may no longer be as much of a drawback as it has been historically.
Another thing issuers need to be aware of when deciding to pursue a PIPE is the amount of shares being offered. Because a PIPE is an issue of a public company, usually meaning a company listed on one of the stock exchanges, there are rules around how much stock a company can issue without receiving prior consent from current shareholders. NASDAQ Rule 5635(d) and NYSE MKT section 713(a) both require shareholder approval for transactions other than “public offerings,” involving the sale of common stock at a price less than market price or book value, which equals 20% or more of the common stock or 20% or more of the voting power prior to the offering. NYSE Rule 312.03(c) is a similar rule that requires shareholder approval prior to the issuance of common stock. For larger listed companies, 20% is a high bar that would require a massive issuance, but smaller listed companies may run afoul of this restriction if they are not careful. Companies must be cautious—being delisted by the exchange is one potential consequence of violation.
The final drawback is the limit on the number of black-out periods. As part of a PIPE transaction, an issuer generally must keep a resale registration statement effective for an agreed-upon length of time so that the securities may be sold without reliance upon Rule 144. As a result of changes in the offering, the issuer may occasionally have to suspend the use of the resale registration statement to amend it or to remedy a material misstatement or omission. These suspensions are usually referred to as black-out periods, during which investors will have limited liquidity. As a result, investors will often negotiate a limit on the length and number of black-out periods. The existence of black-out periods with limited liquidity is a significant drawback to investors, which in turn, affects issuers.
PIPEs A Growing Trend?
Perhaps. While it takes more than one transaction from a well-known company like Google Capital to demonstrate a trend, we believe that as private markets continue to become more efficient and transparent, the use of private capital to fund public companies will continue to increase in popularity. According to the SEC, in 2014 alone, $1.3 trillion was raised through private placements, considerably larger than the amount of public debt and equity raised in the same period. In light of the recent growth in the private market, it is likely that more and more companies will turn to private placements for their capital needs, including follow-up funding made through PIPEs.