This paper explores the Private Investment in Public Equity as a strategy used by Private Equity Investors. The paper evaluates the future prospects of this instrument in the country, and takes into consideration the rising arguments that question the sustainability of the investment in listed equities in a private equity context.
The paper is based upon desktop research, and draws heavily upon public data and information available in various journals and online resources. A list of references has been provided in the end stating the sources in order of appearances in the text.
Introduction to PIPEs
A typical PIPE transaction involves purchasing securities of publically listed companies by the means of a private placement. The transaction may occur at the market price (at par), or at a premium or a discount. Since the sale of such securities need not be pre-registered with the market regulators (SEBI in case of India), the securities have a restricted characteristic and cannot be sold off instantly by investors in the secondary markets. Consequently the company will usually agree to register the restricted securities with the market regulator to provide liquidity to its investors. Such an act is usually pre-decided while entering into the PIPE transaction. Hence a PIPE transaction offers dual benefits, swift and predictable placements to the companies and liquid investments to the investors.
Because of the fact that capital can be raised on a predetermined time frame (similar to a QIP issue) , without any intermediation from the market regulator PIPEs will continue to be an attractive option for raising funds for public companies.
Investors in PIPE transactions will demand for some sort of penalty provisions in case the resale registration statements are not filed or do not become effective within stipulated time limit (typically 30 days for filing and 90-120 days for effectiveness)
Types of PIPEs
PIPE transactions have many variations - varying in terms of the deal structure, the terms included in the deal and the investor base involved in the deal.
Standard PIPE and Pure PIPE:
In a pure PIPE deal the investor gets into an agreement to buy securities in a private placement with an imposed condition of the registration statement being issued immediately after the closing of the placement, which in turn allows for resale of these securities in the secondary markets. Thus the closing of the transaction is delayed till the time the registration statement is issued i.e. the effective date of registration statement. This gives investors immediate liquidity by giving them the option to resell the purchased security right away. However there are major legal concerns in such a deal due to which a large section of investment banks and PE funds will not accept such transactions.
On the other hand, in case of a standard PIPE deal the placement of the securities is closed not only prior to resale registration statement coming into effect, but also prior to the filing of the registration statement with the market regulator.
There is an agreement in the transaction documents that ensures that the company files for registration of such securities within a specified time period after the closing of the transaction. The agreement also makes sure that the company obtains the effectiveness of this registration statement through its best possible efforts. The illiquidity risk inherent in such deals is a major reason for such deals usually happening at below par prices in the markets.
Usually under traditional PIPEs the common equity stock is sold at a fixed price (usually at a 5-10% discount to the prevailing market price). It may sometimes also happen that instead of selling the common stock, the investor is sold convertible preferred which may later be exchanged for common stock at a pre-determined conversion price (the price at which the conversion of preferred to common stock occurs). Such preferred stocks impart various powers to the holder including the right to receive dividends, receive the purchase price before any distribution to common stockholders in case of liquidation of the company's assets. These paybacks give investor a moderate compensation for the additional risk they bear by investing in PIPEs as a consequence traditional preferred stock PIPEs transactions happen at prices very close to the prevailing market prices.
Structure PIPE deals involve sale of convertible securities, which could either be convertible preferred stock or convertible debentures. In either of the two cases the investor can convert them to common stock at the conversion price. The conversion price in such a case is not fixed and is dependent on several variables that adjust the conversion price as per the market price. In case the market price of the company's common stock falls below the existing conversion price the conversion price will be adjusted to a lower price level. Structured PIPEs are good for its investors since they provide price protection but at the same time they induce a risk of substantial dilution to the company's common stockholder.
Under normal circumstances a structured PIPE transaction will require prior approval from the shareholders before the securities are issued to the proposed investors.
The 'Death Spiral' PIPE phenomena:
If a PIPE transaction is not structured in the right manner it may lead to significant dilution of shareholder equity. Such noxious deals are usually built over convertible debentures or convertible preferred stocks that have a variable conversion price which is a function of the market price of the company's common stock at a discount. The discount gives an inbuilt economic gain, which incentivizes the investors to immediately sell off the stocks rather than holding them. Excessive selling may make the stock prices of the company dip, which would then in turn require the company to issue more stock as per the terms of the PIPE transaction. This additional issuance would further dip prices. This would lead to a domino effect and the common stock is often said to have entered into a 'death spiral'.
The ill effects of a toxic PIPE deal are further amplified by their unpopularity with the institutional investors. Institutional investors are cautious of the negative effects of a toxic transaction. Just the declaration of a PIPE deal that could possibly lead to dilution, can have a negative consequence on the company's stock price due to investors going short on their positions in anticipation of unfavorable results.
Who are the Investors and what are their objectives of investing in PIPEs?
A large number of PE funds and Hedge funds have come into existence in the recent past. These include funds formed by private money managers, investment advisory firms and also funds that are surrogates of the major investment banks such as Goldman Sachs, Citi, UBS and Credit Suisse etc.
There are no constraints that limit the investment criteria of any of the hedge funds or PE funds. But in most case PE funds have a specific focus on a particular industry sector like healthcare, TMT (Technology Media and Telecommunications), real estate etc. Such focus helps fund managers to develop domain expertise and better understand the future prospects of the company's business. It has been observed that investments backed by a solid understanding of the industry are more likely to yield better returns as compared to more scattered investment portfolios. The focus need not be restricted in terms of industry but can also be on specific geographies, such as Latin America, Asia-Pacific, Europe etc. Several investors may choose to impose restrictions based on various criteria such as minimum required share price, companies with strictly positive NPV of future expected cash flows etc.
Additionally specific PIPE investments are sold and distributed to a large pool of investors. The target investors are based upon the kind of the PIPE Transaction (i.e. pure or standard, traditional or structured), the market size of the company including several other factors.
Traditionally, PIPEs were usually sold to sophisticated investors who considered not only fundamentals of the firm but also looked at the technical trends of the market forces such as trade volumes, volatility and investor sentiments etc. They were not interested in becoming a part of the board of directors nor do they seek for special rights apart for their right to resale registration. Very few of these transactions used to involve traditional PE investors, however lately a growing number of VC and PE firms have made investments in these PIPE deals.
Even though majority of these transactions are structured in a rather simple and straight-forward manner, it is quite common for VC investors to try and alter to the PIPE arena to enjoy full blown rights and protections that they typically seek with respect to private company preferred stock investments. It is very likely that such VC PIPE transaction will raise numerous concerns under the national securities laws (SecuritiesContracts (Regulation)Act), and corporate governance regulations.
A number of PIPE investors make their investment decisions based on the company's liquidity levels, e.g. they take into consideration the daily trade volumes on the company's equity stock. Such investors usually have a limited time horizon to their investments and their investment decisions are not long-term oriented.
The other major class of investors in the PIPE segment is the conventional private placement investors who focus on a long term investment perspective. Their investment decisions will not be based upon technical aspects such as market liquidity or trade volumes. They are more likely to carry out extensive and independent research and due diligence about the prospect deal. This research is very likely to be based upon the current and future prospects of the underlying business.
The Indian PIPE market
Private investments in public equities (PIPEs) have always divided opinions amongst India's GP and LP community, with the number of people sitting on either side of the fence rising or falling in line with the performance of the country's stock markets.
Between January 2008 - when the Indian stock market began its slide from an all-time high of more than 21,000 points - and 27 October 2008 - when the markets slumped to 7,697 points -detractors of the strategy had a field day, painting those GPs that include PIPE investments as a core part of their investment strategy as imprudent.
However, things have since turned around pretty quickly. The Sensex had recovered to a healthy 17,500 marking an increase of more than100 percent from the lows of October 2008. Those managers with a focus on PIPE investments are once again standing on more solid ground as the valuation of their listed portfolios remains on the rise. Taking advantage of the drop - and subsequent rise - in valuations seen on the listed markets, firms other than those like ChrysCapital and Nalanda Capital, which have traditionally invested heavily in the listed markets, have also become more active in this space.
In March last year, for instance, Norwest Venture Partners (NVP) made its first investment in a publicly listed Indian company when it acquired a stake of less than 5 percent in OnMobile, a telecom service provider, for about INR770 million ($15 million). The firm followed it up with an investment of INR1.2 billion in Shriram City Union Finance for a stake of more than 8 percent in July. Sequoia Capital India too has made a few investments in listed Indian companies since the stock markets bottomed out in October 2008. One of its most recent PIPE deal was the acquisition of a stake of about 6 percent in eClerx, a knowledge process outsourcing (KPO) firm.
In fact, in the first six months of last year, PIPE investments made up 20 percent of the total amount invested by private equity firms in India in terms of value, up from 15 percent in 2008, according to data from Venture Intelligence, an Indian private equity and venture capital research provider. The growth in proportion was echoed in terms of number of investments; PIPE investments as a percentage of all private equity transactions increased from 15.6 percent in 2008 to about 23 percent in the first six months of this year (see charts).
It seems PIPEs have won new - albeit opportunistic - fans amongst India's GP community since the downturn hit the stock markets, but is this enthusiasm shared by LPs? For many, there remain some strong arguments against the use of PIPEs by a private equity fund. The justification of private equity management fees is one of them. "Why pay 2-and-20 for a listed investment?" asks Low Han Seng, executive director and head of the private equity funds business at Singapore-based United Overseas Bank, which has backed between five and 10 Indian fund managers. "Fundamentally, I'm not going to pay fees because in a PIPE investment, you cannot be an active investor," he says. Low remains unconvinced by the claims of some GPs that they can secure additional rights to those that ordinary shareholders in a listed company can get.
Wen Tan, managing director at Hong Kong-based fund of funds manager Squadron Capital, which has been committing to India focused funds since 1996, says: "It's something we are less favourable about, to be honest: there's the increased dependency on movements in the public market to generate returns, and the fact that it is difficult for legal and regulatory reasons to structure the same levels of downside protection than you can in a private transaction."
He says that all things being equal, "there are other ways to get more bang-for-your-buck as an investor than by paying 2-and-20 fees for what is essentially a long-only public equities fund".
The fact remains that to justify high private equity management fees, most LPs need to be convinced managers can apply private equity standards - a level of influence on the company, access to management, voting rights - to all their investments. UOB's Low does, however, point out that in the last 12 to 24 months there has been a dislocation in valuations: managers have argued that while valuations have become much more attractive in the listed market, the same has not happened in the unlisted space. In some cases, managers have told him that they can find larger companies in the listed space, trading at better valuations. "In such cases managers have asked us if we can be more flexible - sometimes we can," he says.
Tan agrees there is money to be made in a climate like the one being seen now: "In a rising market the returns can be impressive, particularly in emerging markets where public valuation multiples can get much too far ahead of themselves when sentiment is strong."
However, he says that if one looks at the market on a risk-adjusted basis throughout the cycle, PIPEs are less attractive than 'proper' private equity.
Indian companies like to list
But it's not only now that managers claim there are richer pickings to be had on the stock markets than in the private space. A common view put forth by Indian GPs is that there are not sufficient opportunities to invest in the unlisted segment of India's economy, as many companies list at a much earlier stage of development than comparable companies in other countries.
Tan says that this is one reason why the trend toward PIPE activity will continue. "There are proportionately fewer large-cap businesses which are still private and - given that some GPs have been raising sizeable funds - it is highly likely that the relative lack of large-cap private investment opportunities will result in some of the available private equity capital spilling over into the public markets," he says.
Of course, PIPEs are not an India-specific trend. Tan points out that industry figures published last quarter suggest PIPEs were the largest single sub-segment of the private equity market in each of China, India and Southeast Asia.
Furthermore, there is an unshakeable view amongst many in the private equity industry that PIPE investments in India have worked. Managers such as ChrysCapital, which have maintained a heavy bias towards investing in listed equities, have produced returns that vindicate their strategy, one Indian GP says.
He adds that many of the same LPs who voiced their concerns about PIPE investments when public valuations plummeted last year seemed to have no objections to such transactions when the market was experiencing a bull-run. As valuations around the region continue to pick up in the public markets, increasing the likelihood of high returns from investments in listed companies, he expects LPs' stances against PIPE investments to soften again.
There are of course LPs who have never objected to PIPEs. The vast majority of the LPs who were new to Asia and looking to invest in 2007 and 2008 bought into the PIPE thesis, says UOB's Low. He says some GPs had the numbers to prove their thesis that PIPEs were the way to the best returns in the Indian market.
Placement agents say it is no surprise that PIPEs are so popular in India and the rest of Asia. For one, they give LPs and fund managers more liquidity than traditional private equity investments in unlisted companies. More importantly, he says, if one were to look at historical returns, Asian public equities have consistently outperformed Asian private equity in terms of returns generated for LPs when leverage used by private equity is factored in. This is important, he says, since levered private equity deals may generate better numbers, but they come with more risk. "It may not be traditional private equity," he says, "but it is one of the more popular ways to make money in Asia."
That PIPEs are here to stay in India, and in Asia more broadly, seems beyond doubt. Whether the debate that surrounds investment in listed equities in a private equity context will ever die down, however, remains to be seen.