PIPEs aren’t just stock price killers anymore. Prominent companies like Kodak, General Electric, and even Goldman Sachs have used PIPEs to buttress their capital structures. Not only that – they are doing these with the assistance of major law firms, including Sullivan & Cromwell and Weil, Gotshal & Manges. It seems a distant memory, but not long ago, PIPEs were strongly associated with words like “toxic” and “death spiral.” In place of that, today, strained capital markets are contributing to a deluge of PIPEs and other PIPE-like structures.

PIPEs have been cleaned up, to avoid their past toxic behavior. These financings do come with added risks for the investor and, as a result, return-juicing features like warrants are often added as well. Nonetheless, they remain imperfect (e.g. illiquid securities, negotiation costs, and steep pricing discounts) and have therefore given rise to other unusual equity financing structures, including registered director offerings (RDOs) – also known as registered PIPEs – and equity line financings. Both of these alternative structures, along with PIPEs, seem to be gaining popularity in the wake of the still stultified capital markets.

As background, in a PIPE, an investor purchases, through a private placement and at a discount, a substantial position in targets’ securities. The securities, often made up of preferred or subordinated debt, are convertible into the targets common stock. The basic advantages of PIPEs are that they can be negotiated and structured more quickly, and with less transaction costs, than a public offering. For background additional information on PIPEs, please see the previous Westlaw Business Currents article Offerings Rising: PIPEs Opening Wide, available in the Related Resources panel.

Despite their increasing popularity, PIPEs have had quite a legacy to live down. Not long ago, many these structures had terms like “toxic” or “death spiral” applied to them. Today’s structured PIPEs take a number of approaches to avoiding the appellations which tarred the structure during the past.

Conversion features lie at the heart of PIPEs and their once toxic image. Essentially, PIPEs are built around non-registered, illiquid shares. To compensate for the added risk, they are structured to combine the greater investment security associated with preference shares, with the upside enabled by conversion features. In structures that will feel familiar to venture capitalists and other private company investors, some PIPE investors are given added incentive to enter these transactions. In a quest to provide them even further upside or, at minimum, avoid excessive dilution, they are accompanied by warrants and/or anti-dilution protections.

Fixed conversion prices provide a simple method for dealing with conversion price issues. One recent example is KKR’s $1.25 billion investment in asset manager Legg Mason Inc. The investment was structured as convertible preferred securities, which are convertible at $88.00 per share. Another example is British PE firm BC Partners $350 million PIPE investment into two series of newly created preferred shares of Office Depot Inc, each of which carries a fixed conversion price of $5.00 per share.

Even where the added equity upside is provided, avoiding open-ended warrant issuance is key with the use of PIPEs. This can be done by issuing warrants for a fixed number of shares and a fixed strike price. Berkshire Hathaway, for example, made PIPE investments into both General Electric and Goldman Sachs. The GE investment is structured as a $3 billion perpetual preferred stock investment. The shares pay a 10% dividend, are callable after three years at a 10% premium, and come with warrants to purchase $3 billion of common stock with a strike price of $22.25 per share. The $5 billion Goldman PIPE is structured similarly but is callable at any time with a 10% premium and warrants with the right to buy $5 billion of Goldman common stock at $115 per share. Yet another similarly structured transaction was KRR’s recent $288 million PIPE-like investment in the 10.50% senior secured notes of Eastman Kodak Co, which come with warrants that could leave KKR up to an 11% stake in Kodak.

Careful crafting of anti-dilution clauses provides a third route for dealing with price conversion issues. From the investor standpoint, dilution issues must be dealt with, often by pricing provisions. Most PIPE investors secure terms that protect their investments from the dilution caused by stock-splits, exchanges, additional stock offerings, or other dilutive actions.

Anti-dilution protection comes in two basic types: full ratchet and weighted average. A weighted-average formula takes into account the relative dilution that the specific event will cause and reduces the conversion price according to the formula. Echo Therapeutics, Inc. recent structured PIPE entailed warrants with weighted-average anti-dilution protection. A full ratchet provision, also sometime called a reset, automatically lowers the conversion price of the convertible security to any lower price at which the common stock of the target is issued. PIPEs with full ratchet provisions include: Biostar Pharmaceuticals, Inc. and Sino Clean Energy Inc, $3.6 million and $11.6 million PIPEs, respectively.

All of this is the outcome of recent history: in the early 2000s, “toxic” PIPEs used to provide price protection to investors by allowing them to convert their securities at a discount to the current market price. The “death spiral” moniker, which is commonly used, comes from the combination of above price protection and no limitation on the number of shares that a company could convert their stakes for. The mechanics of toxic death spiral started with the PIPE investor shorting the target’s common stock (causing a decrease in the stock price), and then converting a portion of the relevant securities (further depressing the common stock price though dilution), and the investors would continue the first two steps until the target was issuing nearly-worthless stock. The PIPE investors would then cover the short positions with its freshly-converted common shares, locking in profits.

The Securities and Exchange Commission (SEC) killed off the PIPE death spiral earlier this decade through pointed comment letters and enforcement actions. In a traditional PIPE, after closing the transaction, the issuer often registers shares through a Rule 415 shelf registration. The SEC took the position that a company wishing register more than a third of its shares for sale by a non-affiliate should expect comments on the appropriateness of the Rule 415 shelf registration versus a primary offering, which nipped the “unlimited convertibility” issue in the bud. Additionally, the SEC closed off the other end of toxic PIPEs in SEC v. Rhino Advisors, Inc. and Thomas Badian and SEC v. Edwin Buchanan Lyon, IV, et al. by pursing PIPE investors for short sales outside of contractually agreed upon terms, “naked shorting”, and insider trading.

Despite the fact that capital markets are still stressed, companies do have options other than PIPEs. A registered direct offering (RDO), if a company already has the legal documents and infrastructure in place, can allow for a fast paced and low transaction cost alternative to a traditional PIPE. The decision to use a PIPE verses an RDO is a question opting for the pricing discounts that PIPEs often carry, because of the illiquid securities, or paying more in upfront transaction cost to register the offering.

In an RDO, the issuer files a shelf registration statement with the SEC in anticipation of requiring financing. The registration and shares can be taken “off the shelf” at an opportune time or when the company needs money – fast. Investors can then be lined up and sold the registered shares, without as detailed negotiations or other agreements associated with a traditional PIPE.

The RDO’s benefits, in comparison to a PIPE, include reduced legal, administrative, marketing expenses. In September, Spectrum Pharmaceuticals received $47.5-million from existing institutional investors through a RDO. In June, Fuelcell Energy raised $24.2 million in an RDO. Other companies raising cash though RDOs include: Javelin Pharmaceuticals, Northern Oil & Gas, and China BAK Battery. Investors still want to get the most out of their investments and China BAK Battery’s RDO.

Another PIPE alternative is an equity line financing (ELF). An ELF is really a sub-category of PIPEs and is quite similar to the more common structure. ELF structure allows the issuer to "draw down" a line of capital committed to by an investor during a specified time period (typically 24 to 36 months)…sort of like a credit line. The kicker, and in this case it’s an equity kicker, is that the issuer draws on the equity line by making stock sales to the prearranged buyer. Overall, an ELF is a prearranged put option that lets an issuer sell its shares to a contractually-locked in buyer, at the seller’s discretion.

An ELF does suffer from the same drawback of the RDO, mainly a shelf registration needs to be in place and effective. It comes, however, with the added benefit of allowing the issue to only sell the shares (i.e. dilute existing shareholders) if it really needs the money. On October 6, 2009 ARYx Therapeutics, Inc. entered into a $35 million ELF with Commerce Court Small Cap Value Fund. MMR Information Systems and Emgold Mining Corporation recently entered in ELFs for $8 million and CAD $6 million, respectively.

PIPEs have grown up and moved up market – even Warren Buffet and Goldman Sachs are doing it. PIPEs are no longer relegated to the nether regions of the financial world. Instead, they are becoming a common place and constructive capital raising tool. There are downsides to a PIPE, which RDO and ELF structures may help some issuers address. Nevertheless, these transactions, with their discounts and equity kickers, are expensive relative to more to more traditional sources of capital. Nonetheless, these structures are all important capital raising tool in today’s strained credit markets. PIPEs, RDOs and ELF are helping to keeping the liquidity flowing and the capital markets plumbing in order.