PIPEs Are Smoking, Converts Turn To Ash

Now that convertible bonds, last year’s market darling and the favored capital-raising technique for such companies as troubled Tyco International Ltd., have lost their allure, is there any place to turn? Indeed there is: PIPEs, private investment in public equity, which now include privately negotiated convertibles.

Convertibles, those hybrid securities that are part bond and part equity, seemed unstoppable last year. When equity issuance stumbled, convertibles were used to fill corporate coffers with their low – and in the case of zero converts – nonexistent interest rates. Then when the debt piled up and companies needed to deleverage, a different brand of convertibles – mandatories -allowed them to do so. In 2001, U.S. convertibles accounted for a record $103 billion in issuance, almost double the $55.7 billion in 2000.

But that’s all over. Blame it on hedge funds shorting the stock, or on all those early redemptions that now loom for companies whose credit isn’t as good as it seemed a year ago. Whatever the reason, issuance volumes fell 22%, to $45.2 billion in the first half of 2002, from $57.9 billion in the same period in 2001.

Some companies haven’t exactly gone off cold turkey from their convertibles fix; they’ve just been cutting private deals instead. Called fixed convertible transactions, these have grown to 44% of the PIPEs market, from 39% last year, said Robert Kyle, executive vice president of Placement Tracker, which collects data on PIPEs.

Public companies that issue convertible bonds sold privately to investors are able to control the conditions surrounding the capital-raising process. For one, they have gotten rid of those pesky hedge funds. Although hedge funds are the biggest buyers of convertibles, they also tend to short the stock right before the deal is priced to hedge their holdings. This causes the issuer’s shares to decline, and at times forces the issuer to offer more securities because of the erosion in value.

Take what happened to energy trader Mirant Corp., which is suffering a credit crunch. On July 1 it said it would offer $370 million in convertible-debt securities to boost liquidity as it tries to renegotiate a $1.13 billion revolving credit facility that matures July 17. As soon as the news came out, Mirant’s already battered shares began to tumble, taking a hit of $1.01 to $6.29 as a result of short-selling by hedge funds.


The biggest players of the public convertibles market also have seen their offerings come back to haunt them as they have to come up with cash to redeem bondholders because of short-dated puts that were attached to the convertibles. Unfortunately, those puts are maturing at precisely the same time their stock is down and their business weak. Tyco, for example, issued in late 2000 and early 2001 nearly $6 billion in zero-coupon bonds. In February 2003, investors can redeem $2.3 billion in convertible bonds, followed by $3.6 billion in November.

The redemption can be in either stock or cash. But stock is out. With Tyco’s stock plunging more than 80% in the past year, the company would have to issue millions of dollars worth of shares to make up for the shortfall, which is practically impossible at this point. Tyco’s other option is to use cash, a difficult route for a company that has just sold its CIT unit for a depressed value of $4.6 billion in an IPO on July 1 just to keep up with debt payments.

With all these problems in the public market for convertibles, several companies already have tapped the private convertible PIPEs market. Some have been issuing them with private-equity firms and others with investment banks, including Lehman Brothers, which has arranged for a handful of such deals in the past six months or so.

“The private, negotiated market is going to become much more important for public companies going forward,” said Richard Biebel, who works with the Palladin Group, a private-equity firm that invests in such deals. “Companies are doing private financing because the public markets are unavailable to them,” Biebel said. “In the private market their deal is more discrete and their stock less affected. Private investors are less influenced by day-to-day market sentiment.”

In April, CTS Corp., which makes electronics components for the auto industry, raised $30 million with Palladin in a private deal. While this is a tiny deal, analysts say that the average size of convertible PIPEs is on the rise as more companies look for a less punishing environment.

No Easy Fix

However, private convertibles have their own problematic image to overcome. They got a bad name when now-bankrupt Internet companies such as eToys Inc. and At Home Corp. issued toxic convertibles with Promethean Capital, a private-equity firm, and others in 2000. Called “death spiral convertibles,” they are based on the assumption that the number of shares of stock into which they convert will be reset in the future. In the event the stock falls, the company has to issue more shares to the investors, who recoup their capital by shorting the stock. Ultimately, this type of financing can drive companies into bankruptcy.

The PIPEs that are becoming popular are a different kind of financing and carry no such onerous terms. “Some private converts, like the death spiral kind, got bad publicity,” said Venu Krishna, head of U.S. convertible research at Lehman Brothers. “It doesn’t have to be that way. Private convertibles can be structured to benefit both issuers and investors, allowing both sides to achieve their objectives-issuers getting the required funding with optimal terms and investors incorporating reasonable safeguards with regard to their investment.”

Unlike the public convertibles, no market is made in the private offerings. The securities typically stay with the investor until maturity, which is often between three to five years, or until the securities are converted, which can occur earlier. Terms are tailor-made to the deal and fees can vary as well. They are often a couple of points higher than the public underwriting fees, depending on the size of the deal and the company’s credit rating.

Contact Avital Hahn