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.
Lim, Schwert and Weisbach explained: “PIPE investors have an incentive to exit their stock positions as quickly as possible to capture the discount and mitigate exposure to the issuer’s downside risk. However, two factors limit the ability of PIPE investors to exit their positions quickly. First, 81% of transactions in our sample involve issuance of unregistered shares that cannot be freely traded until they are registered with the SEC, which happens 100 days after issuance on average. Second, the shares of PIPE issuers are illiquid, so they cannot be sold quickly without putting downward pressure on the stock price. Consistent with the notion that PIPE investors have incentives to exit quickly, we observe increased trading volume and negative abnormal stock returns immediately after the registration date of PIPEs in our sample.”
To estimate the returns to PIPE investors controlling both for registration status and the limited ability of investors to exit their positions given the thinness of trading in the underlying stocks, Lim, Schwert and Weisbach calculated “holding period adjusted” returns, assuming that investors sell a constant fraction of the daily volume each trading day from the effective registration date until they liquidate their position. The returns from this strategy, which presumably could be executed with minimal price impact, led to returns that were still noticeably higher than investments in comparable firms at market prices. Assuming that investors sold 10% of the daily trading volume after registration, PIPE investors averaged a 19.7% abnormal return compared to 3.7% for market investors over an average holding period of 384 days.
Why do public firms raise such expensive capital?
Their research led Lim, Schwert and Weisbach to conclude that public firms use expensive PIPEs for the following reasons:
- Even though these firms are publicly traded, they are relatively small, with median book assets of $51 million.
- In the year prior to the PIPE issuance, operating performance tends to be very poor, with a median ratio of EBITDA to book assets of -22% (versus about 8% for the average company).
- They likely do not have access to public debt markets and appear to have limited access to bank loans – 93% of issuers lack a public debt rating, and the median firm has a leverage ratio of only 7.2% (versus about 19% for the average company). Only 7.2% of PIPE issuers have a long-term credit rating (versus about 30% of all companies in the Compustat database); and among the rated firms, less than one-third have an investment-grade rating.
PIPEs are utilized because the firms have limited choices as a result of ongoing operating losses and high cash burn rates – the abnormal returns earned by PIPE investors reflect compensation for providing capital to poorly performing firms that find it costly, or even impossible, to obtain financing from alternative sources.
Lim, Schwert and Weisbach concluded that PIPEs are an important, though expensive, source of financing for relatively small public firms without sufficient internal cash flow to finance investment and without alternative sources of capital. The cost of this financing is the expected return investors receive, which depends on issuing firms’ returns, discounts and warrants associated with the offering, and investors’ holding periods. Importantly, they concluded, “The performance of PIPEs as an asset class is driven largely by ‘home run’ deals with huge returns, which underscores the importance of diversification when undertaking illiquid investments with convex payoffs.” Keep this point in mind if you consider an investment in PIPEs.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: The information contained in this article is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. The analysis contained in this article is based upon third party information available at the time which may become outdated or otherwise superseded at any time without notice. Certain third-party information is based upon is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth®, Buckingham Strategic Partners® (collectively Buckingham Wealth Partners). LSR-21-50
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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”).