Nobody is complaining yet about the IPO market. Up against recent history, the environment for new offerings can still be considered robust, especially when one considers that 19 buyout-backed companies priced IPOs on U.S. exchanges last quarter, corralling a combined $3.48 billion in capital (see Buyouts, July 4, 2005).
However, there have been signs of weakness, and for smaller businesses with public market aspirations, launching a successful IPO is no easy task. Perhaps that’s the spark behind the renewed interest in reverse merger/PIPES, which occur when private companies acquire a public shell to create a new public company, and alongside that a parallel PIPE investment is made that infuses capital into the newly public business.
Ronco Corp., best known for infomercials starring company Founder Ron Popeil, was the latest company to access the public market this way, when it merged with SEC reporting shell Fi-Tek, Inc. The company also raised total proceeds of $50 million through a PIPE, and now, after assuming the Ronco name and business plan, the “combined” company lists its shares on the Nasdaq Over-the-Counter Bulletin Board exchange.
The institutions that market these transactions cite a laundry list of benefits over a traditional IPO and even other alternatives, such as private equity or VC investments. For one, the process-generally between one to four months-is shorter and said to be relatively painless, without the length of an IPO roadshow or extended negotiations involved in an LBO. Moreover, they are less expensive than traditional IPOs (by several hundred thousand dollars), without the risk of having to be pulled due to unforeseen market fluctuations. There’s also no need to attract an underwriter to sell investors on the company, since having a sexy story isn’t necessary to do a reverse merger.
William Sprague, a managing director at Sanders Morris Harris, the placement agent on the Ronco transaction, describes that even as most companies seeking reverse merger/PIPES may not have the story of a Warner Music, it doesn’t mean this is an alternative for bad businesses. “From our standpoint, the companies we’re focusing on will be attractive public companies, with quality management teams, and a quality business. We’re less worried about whether there’s a hot story, and more concerned about the question, Is this a good long-term business?'” he says.
Sprague adds that he’s been in regular discussions with buyout groups interested in reverse/merger PIPES as a way to facilitate an eventual exit. However, Sprague would not name names, other than to say the interest is coming from “groups you’ve heard of.”
Flexpoint Partners Founder Donald Edwards is one buyout pro that has seen success with the reverse merger, albeit from the acquisition side. Upon leaving GTCR Golder Rauner, Edwards took over as the CEO of Liberte Investors, a public holding company with few assets. Under Edwards, the company sought out and acquired USAuto Holdings, which became the operating company of the merged entities. Edwards, with his Liberte experience in tote, told Buyouts in June that he had seen interest rising and was fielding a lot of calls from people looking to execute their own reverse merger transactions.
Sprague concedes that while reverse mergers could provide an outlet for buyout shop portfolio companies, they’re also sure to represent an alternative for middle market businesses that would otherwise seek a buyout. And further tweaking the hedge fund/private equity rivalry, he adds that the primary PIPE-investor base in these transactions is made up of the hedge funds.
Turning Over a New Leaf?
Reverse mergers are by no means novel, but after a period when the arrangement was generally considered as a transaction of last resort, companies that go through them are no longer viewed in a bad light. Part of that is because of increased regulation, and part is because better companies have raised the bar. Ronco, for instance, which has marketed such products as the Veg-O-Matic, the Pocket Fisherman and the Showtime Rotisserie, generates more than $100 million in annual revenues. It’s a business investors can trust, even if they don’t quite buy Ron Popeil’s pitch for Spray-On GLH (great looking hair).
However, Jocelyn Arel, a partner in Goodwin Procter’s Corporate and Technology Group, notes that there could still be some substance behind the ongoing suspicion of the regulators. “You have to be careful,” she says. “There are a number of legitimate players, but then you’ll also come across some people that aren’t so legitimate. You really have to do your due diligence… Oftentimes we’ll find that the people who are making their shell companies available have been suspended by the SEC, or there are also cases when the public shell can carry some liabilities that may not be visible at first glance.”
Then there’s the question about costs. While reverse mergers are typically cheaper than IPOs at the onset, at the end of the day, the difference may be negligible. “You have to pay something for the shell, usually warrant coverage and an equity kicker, and there’s the immediate dilution of company’s stock,” Arel notes, adding that legal fees are around the same range, and so are the costs of Sarbanes Oxley and 404 compliance, which are the most burdensome outlays of the entire process.
Another concern is the possibility that once a company executes a reverse merger it will only do so to wallow as an orphan stock. Without the investment banks’ marketing effort, and lacking the initial pop an IPO generally provides, there is the chance that research coverage will not materialize and the stock then falls victim to investor neglect. Also, given the past stigma of reverse mergers, companies that access the public markets this way could find themselves subject to more regulatory scrutiny than your standard IPO.
However, despite these misgivings, the popularity of reverse merger/PIPES continues to effervesce. Between 2001 and November 2004, Sanders Morris Harris identified 111 companies that had executed reverse mergers. Industry trade publication The Reverse Merger Report, meanwhile, has counted 162 of these transactions since the start of 2004, with 67 being executed in the first half of this year.
Brett Goetschius, the editor of the Reverse Merger Report cites, “There’s an increasing interest among small companies seeking access to capital… There’s also a growing interest from companies in China that want to access the U.S. capital markets. That’s where a lot of this [interest] is coming from. Recent changes in regulation, which should bring more in the way of disclosure, could also encourage investor interest.”
As more reputable companies seek out this transaction, the market for reverse mergers should continue to shed its stigma as a desperation move, and that, Sprague predicts, will only spur more deals in the future. He says, “If this structure continues to legitimize itself, it will only grow more attractive as an opportunity going forward.”