By Stephen Lloyd and Gavin Gordon
Private Equity Special Report: Pipe dream
20 April 2009
29 August 2013
19 August 2013
24 April 2014
26 September 2013
30 August 2013
As the usual investors in public companies dry up along with the market, now’s the time for Pipes to come into their own.
Private investments in public equity (Pipes) are being mooted for private equity sponsors to create deal-flow and for public companies to obtain new sources of funding while traditional routes are constrained by market conditions.
With a Pipe, a private investor takes a minority stake in a publicly listed company, usually receiving some specific governance rights in relation to the target. The stake can be any size (although effectively limited to 29.9 per cent in the UK under the Takeover Code), but is typically 5 to 20 per cent.
For the target, having a committed long-term investor with a large stake may deter corporate raiders, and it also gains quick access to equity funding. The sponsor gains a seat on the board in a quick and certain deal.
Pipes have long been a feature of the US market but have never really taken off in Europe. The principal reason is that most European legal systems provide for statutory pre-emption rights on new equity issues, giving existing investors a right of first refusal on new fundraisings. Investor bodies have jealously protected these rights, with only small new cash issues exempted, and having to offer new equity to existing shareholders before making it available to sponsors has rendered such transactions unappealing for private equity investors.
Recently, however, the equity financing landscape has changed, and for two main reasons.
First, many listed companies are finding that the normally eager corporate debt markets are closed to them at any sensible price. Second, the considerable number of recent ‘vanilla’ equity issues have left institutional shareholders with empty coffers so that underwriting such issues has become difficult and expensive.
These factors have been coupled with some current trends in the private equity industry that make investments in Pipes more attractive. In particular, there is a lack of new deal opportunities, a desire to invest at or near the perceived bottom of the valuation curve and a lack of available leverage. A Pipe can also give the sponsor the ability to invest in listed companies that are more highly and cheaply geared than would be possible on a new private deal).
However, there are some downsides for sponsors in doing a Pipe. The limited partners who finance private equity may ask whether, as a minority in the target, the sponsor is really able to add value to the target on behalf of investors. This has led to some innovative proposals from sponsors, including, for example, using a Pipe to fund a transformational merger deal for the target. The sponsors are also sometimes restricted under their fund documents from making minority investments, although more recent funds mostly explicitly permit Pipes.
There are three key issues at the forefront of any Pipe negotiation. First, the type of securities offered. They will usually be ordinary shares or preferred shares (or warrants over them) but the deal might also be structured as convertible shares or loan stock. This is really a value question - where does the new security stand in the ranking for dividends and on a winding up? - and the outcome will be dependent on who has the negotiating leverage. Second, what rights does the private equity investor get to board representation?, and third, what other rights are available to the sponsor? These might include information rights, restrictions on sales or purchases, and conflict of interest rules.
The highest profile recent Pipe was the attempted TPG Capital investment in ordinary shares in Bradford & Bingley. That deal, at the height of the financial crisis, was criticised for avoiding pre-emption rights. The most controversial clause in favour of TPG was a right for it to maintain its stake if further equity issues were needed, and thus avoid the type of dilution the institutions were themselves suffering.
Other recent examples of Pipes have produced a compromise between the pre-emption requirements of institutional shareholders and the requirements of the new investor to maintain its investment even if existing shareholders wish to participate.
In some cases these have included a firm placing (not subject to pre-emption) to the investor of a sizeable amount of the issue at a discount to the market price. Two recent examples were a firm placing of ordinary shares at 9 per cent discount coupled with an open offer to other shareholders by Premier Foods; and Raven Russia, in which a financial investor (an existing shareholder) took 12 per cent preference shares and warrants - there was no associated pre-emptive offer but the broker would ‘assess demand’ for additional shares.
It remains to be seen how the tensions between institutional investors’ desire for pre-emption rights and the need to help companies in difficult markets resolve themselves. A variety of solutions will be seen in practice but there will undoubtedly be opportunities for private equity investors to participate. Whether they do so will depend on the view they take on investing in public companies whose usual supporters, equity or debt, are no longer so enthused.
Stephen Lloyd is head of the corporate practice and Gavin Gordon is a partner at Ashurst