The Unappealing Economics of PIPEs

New research shows that private investments in public equities (PIPEs) offer attractive returns, but those are driven by a small number of deals that deliver exceptional returns (“home runs”).

PIPEs are an important source of financing for many public corporations and are often used by special-purpose acquisition companies (SPACs) to finance their mergers with target companies. According to PrivateRaise, a leading database on PIPE transactions, between 2001 and 2015 there were 11,296 private placements of common stock by U.S. listed firms that raised $243.9 billion. Firms raising funds through PIPEs tend to be small, with 93% of common stock PIPE issuers having market capitalization below $1 billion.

Why do so many firms raise capital through PIPEs when they are considered to be expensive because the placements involve selling stock at less than the market price? Just how expensive are PIPEs? Jongha Lim, Michael Schwert and Michael Weisbach sought to answer these questions with their study “The Economics of PIPEs,” published in the January 2021 issue of the Journal of Financial Intermediation. Their database consisted of 3,001 common stock PIPE transactions by 1,523 U.S. firms listed on NYSE or Nasdaq between 2001 and 2015. Following is a summary of their findings:

  • The median investment was $10 million, with the mean (median) transaction involving the sale of 17.6% (11.4%) of the issuer’s pre-offering shares outstanding.
  • Unlike most private equity investments, PIPE investments generally are made by passive investors who do not play an active role in the management of the issuing company.
  • Hedge funds and private equity funds play a prominent role, participating in roughly two-thirds of the PIPEs in the sample and providing an average of 72% of the capital. However, there is a dichotomy, with hedge funds and private equity providing either the bulk of the capital or none of it.
  • PIPE investors received warrants in 39% of the transactions in the sample and purchased the package of securities at an 11.2% discount relative to their market value. The discount was much higher for PIPEs with attached warrants than without, averaging 20.1% for PIPEs with warrants and 5.7% for those without warrants. Also, firm size was negatively related to the size of the discount.
  • In addition to the equity and warrants, investors in PIPEs received a number of other rights, such as the warrants having anti-dilution protection – if there were another equity issue at a lower price, the strike price of the warrants would be adjusted downwards. Such rights provide further value.
  • As a result of the discounted purchase price, PIPE investors earn substantially higher returns than investors who buy and sell stocks of PIPE issuers or comparable firms at market prices. Over the year (two years) following the issuance, PIPE investors averaged a 12.1% (10.1%) buy-and-hold abnormal return compared to -5.2% (-8.0%) for investors who bought and sold the issuers’ stocks at market prices. Including the value of the warrants increased the returns to 17.4% over three months, 13.2% over six months, 12.1% over one year and 10.1% over two years.
  • The returns PIPE investors earn decline with the time they hold the investment because the offering discount accrues to investors immediately when the transaction closes. After that point, the long-run performance of issuing firms tends to be poor. As a result, investors tend to begin to exit as quickly as possible.
  • While the average return to PIPE investors is high, there is substantial skewness in the distribution of returns, with the median PIPE investment earning an abnormal return of just 1.7% over the year after issuance. PIPE returns are skewed because the returns of the issuing firms’ stocks are themselves skewed, and in addition, warrants amplify the returns of the best-performing deals while having no effect on the poorly performing ones.
  • PIPE investing is like venture capital investing in that “home run” investments are the driver of outperformance – they have lottery-like characteristics.
  • The stocks PIPE investors purchase are relatively illiquid because they are usually issued by small, poorly performing companies, which typically have high information asymmetry. Therefore, if a PIPE investor wishes to exit her position by selling shares in the secondary market, her ability to do so without depressing the price is limited unless she spreads the sales over a long period of time.