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SEC Cracks Down on PIPEs

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Welcome to the law of unintended consequences

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The Wall Street Journal carried an article on July 8 about an SEC investigation into insider trading violations connected to a type of equity financing called a PIPE - Private Investment in Public Equity. As PIPEs are currently the primary means by which biotechnology companies raise capital, it caught my attention.

When a biotech company raises money, they'll often go and speak with an investment banker. This banker then "shops" the deal around to clients, seeking to learn how many people are interested in investing in the company. A price negotiation occurs, and shares are sold to the group of investors gathered by the banker. The shares are priced at a discount to the current trading price. Anything under a 10% discount is considered a good deal for the biotech company involved.

PIPEs have been gold mines to hedge funds. Particularly in the biotech space, the second a hedge fund gets a call from an investment banker they do two things: First, they tell the banker they'll take as many shares as they can get. Second, they short the crap out of the stock.

Why do they short? Wall Street has learned the additional dilution represented by the issuance of shares in a PIPE almost always drives down the price of the stock. In addition, the PIPE is priced at the current market value when the deal closes. If a company needs to raise $25 million, short selling the stock ahead of the pricing means the hedge fund gets more shares for their money than they otherwise might. Finally, it's a low-risk trade. Since the hedge fund gets stock at a discount of around 10%, any shares you short now are very likely to gain at least a 10% return since you can use the shares gained in the PIPE to cover your short sale. Worst case, your risk is defined - an unusual occurrence when selling short.

This ethically challenged and illegal practice has been especially burdensome for development-stage biotech companies. They constantly need to raise money. Their stock prices are very twitchy. They are absolutely news-dependent, so rumors have an abnormally high chance of successfully moving a stock.

There are more than a few biotech hedge funds whose annual performance is largely constructed not through good stock picking, but through manipulation of shares during PIPE offerings. Some funds get such a bad reputation for shorting ahead of the closing, they are often not invited into these deals. Unfortunately, the need to raise money is so absolute in the biotech sector sometimes you have to bed sharks to keep going.

The SEC recently decided to enforce insider-trading laws with respect to PIPEs. Once an investment banker calls a hedge fund to ask if they want to participate in a financing, the hedge fund is in possession of material inside information. The SEC correctly alleges that shorting based on this information is a violation of insider trading regulations.

The SEC has thankfully extended their net to the investment bankers as well. As if it were not bad enough the hedge funds were shorting, the trading desks of the investment banking firms get in on the action, too. They make money from facilitating and/or mimicking these trades.

The WSJ article mentions Bank of America, SG Cowen, Piper Jaffray, Jefferies Group, Roth Capital Partners, and Rodman & Renshaw as investment banks under scrutiny. They also mention California hedge fund BayStar Capital as a target, though the WSJ article makes clear the SEC hasn't named formal targets of the investigation. I'd expect this list - especially on the hedge fund side - to get much bigger.

All these firms are very familiar to anyone with a few years investing experience in the biotech space. Twenty PIPE transactions are currently under review at the SEC. You could increase that number by a factor of 10 and still not touch the bottom 2/3 of this particular iceberg. The SEC has to hope punishments related to this first group of 20 will chill subsequent violations.

Unintended consequences

One theoretical benefit of how PIPEs currently work is any company that can be shorted can raise money. Since shorting ahead of the PIPE dramatically reduces the risk of the investment, hedge funds did not have to be too picky who they gave money to. After all, they profited from the insider trading, not from the PIPE investment itself.

This SEC crackdown will change all of that. Risk will be reinserted into the equation and only companies who demonstrate they are deserving of additional capital will get it. Companies with sketchy data and/or early-stage companies will likely be shut out of the capital markets or will see the discount rise considerably.

Balancing this is the ability of investment bankers and hedge fund managers to exploit loopholes. We might also see more secondary public offerings, though the expense and time involved with those can be prohibitive.

PIPEs basically spelled the death of the toxic and death-spiral convertibles. I'd expect both of those heinous financing alternatives to return. In a convertible offering, a fund buys preferred shares that pay an interest rate with the principal amount payable in common shares at a later date. Any convertible tends to put a cap on the price of a stock, but toxic and death-spiral convertibles are a special bit-o-hell.

In a toxic convertible, the conversion price is not fixed. When the price of the common stock goes down, the conversion ratio of the loan amount moves accordingly. If the loan was $10 million, a price of $10 would convert to 1 million common shares. At a $5 share price, the loan would convert to 2 million shares. At $1, the loan converts to 10 million shares. You see where this is going, of course. This is a toxic arrangement since the holder of the convertible debt can short the company to oblivion at no risk as long as they limit their position to the number of shares they will get upon conversion. Every drop in share price increases the number of shares the convert holder can safely short.

In a death-spiral convertible, the interest rate of the note goes up as the common stock price drops. This means someone who shorts the shares can drive the interest rate so high it becomes a serious bleed on company cash flow. This puts the company in the position of having to sell more shares to raise cash or declare bankruptcy because they can't afford the interest payments. Either way, the short seller wins. Most of these convertibles allow the interest to be paid in shares or cash. If the company pays the interest in shares instead, they are hemorrhaging shares to the very person who is shorting them to oblivion.

Of course, if the company produces what they are supposed to produce then this tactic does not work since other market participants bid up the shares of the company's stock for fundamental reasons. All this means is the convert holder profits from the long position represented by the underlying convertible instead of their short selling efforts. Played correctly, there is little chance of the hedge fund losing. This is especially true since companies with toxic or death-spiral convertibles are persona non grata. For example, Biotech Monthly immediately drops a company from coverage if they do a toxic or death-spiral convertible. The downside risk is too great.

It will be very interesting to see how this latest enforcement action by the SEC will reverberate within the biotech community. Hopefully the unintended consequences won't outweigh the good caused by cleaning up the PIPE cesspool.


For more on PIPEs, read Prof. Succo's mailbag from May.

No positions in stocks mentioned.

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