PIPEs are private investments made in public companies, with no shares offered on the open market. The recent SPAC boom saw many of these deals making headlines but PIPEs have been a mainstay in private equity for years. Private equity firms use this method opportunistically to invest in public companies, typically taking non-controlling stakes. Unlike in buyout deals, minority stakes limit two key return levers: leverage and operational control. From the private equiteer’s perspective, this means the focus shifts to other levers of generating returns: buying low, growth, and deal structuring. But before we dive into these considerations, it’s crucial to understand what sort of companies choose PIPEs in the first place.
Why Companies Do PIPE Deals
Public companies have several options for raising capital:
- Debt from direct lenders or issuing bonds
- Rights issues
- Secondary offerings
- And finally, PIPE deals
Debt is almost always cheaper than equity, and raising equity from the public is usually cheaper than dealing with sharps like hedge funds, PE, and Uncle Warren. So, when a CEO chooses to do a PIPE, it’s usually a sign that they’re in a tough spot and need to act quickly. PIPE investors offer a simple and fast solution to raise capital, avoiding the hassle of dealing with a large number of public investors. That’s why PIPE deals are common in distressed or struggling companies, small caps, and markets with low liquidity, such as during the 2008 GFC and the pandemic crash of 2020. They were also frequently used in SPACs to take advantage of retail mania. But that’s a story for another time.
The PIPE Dream: Why Private Equity Firms Do PIPEs
Private equiteers may seem to be giving up benefits of being private equity investors when they invest in public equities through PIPE deals. But the truth is that private equity is always on the lookout for the easiest return dollars, and PIPEs offer some risk-reward advantages.
The key to generating returns through PIPEs is buying low. Fortunately, if a company is resorting to a PIPE, you’re probably in a position to negotiate a discount. PIPE deals are usually priced at a discount to the prevailing stock price, which in times of turbulence is already cheap in the first place. And it doesn’t hurt that the burden of dilution falls on faceless shareholders rather than the executives across the negotiating table.
But things are cheap for a reason, and in potentially distressed situations, protecting the downside takes priority. That’s why the private equity approach relies on creative structuring to create upside with limited downside risk for the investor. Preferred stock, convertible debt, warrants and other similar tools allow private equity investors to get paid before common shareholders while still enjoying all the upside if things go well.
PIPEs also simplify the exit strategy for private equity investors. Having an active and liquid secondary market for shares that you own gives you much more flexibility in exit timing and broadens to universe of potential buyers. It is not uncommon for the narrative around a stock to improve sharply when private equity comes in and injects some confidence. This allows the private equity investor to de-risk his investment or realize the gain very quickly.
Risks and Challenges of PIPE Investments
All that said, PIPE deals make up a very small portion of private equity deals for a few reasons. First, the window to get good PIPE deals done is small and they don’t come often when markets are generally marching up. The opportunity set is limited except when markets are throwing the baby out with the bath water, like during the pandemic crash. Private equity investors only have a few years deploy each fund which makes it difficult to look at PIPEs as anything but a sideshow to the main investment strategy.
More importantly, LPs don’t invest in private equity funds to gain exposure to public markets. Private equity guys like to tout their value creation and financial engineering expertise, but the high fees we get to charge is mostly about providing access. From an LP’s perspective, why pay a 2 and 20 fee structure for the same exposure you can get for a fraction of the cost through simple market investments? Of course, private equity PIPE deals can offer unique structures and rights, but it’s hard to escape the reality that much of what you’re paying for is simply access.
It’s also no secret that private equity firms massage valuation marks of their portfolio companies in times of volatility to make things look a little better. Return smoothing is not so much to fool LPs, but rather as an added feature to institutional LPs who also need to manage return volatility for their own stakeholders; within reason, of course. This is more difficult with PIPE investments where there are daily publicly quoted prices.
Last but not least, PIPEs tend to be high probability and quick returns but with lower absolute upside. These deals can generate impressive IRRs, but when it comes to generating carry dollars for private equiteers, MOIC is the name of the game. After all, a 50% return in a year (1.5x MOIC) may be exciting, but if the capital can’t be reinvested, the opportunity cost of passing on a 3x MOIC investment that takes six years to realize (20% IRR) could be enormous. While the former deal may have a higher IRR, the latter could generate four times as much carry for the private equiteer. In private equity, it’s not just about hitting high returns – it’s about maximizing MOIC and generating the most carry possible.
It’s clear that PIPE investments can offer private equity investors an attractive risk-reward proposition. But because of the structural reasons discussed above, they will probably remain a niche / opportunistic part of private equity investing. Given the resurgence of PIPE opportunities with public markets in the doldrums, I’d love to hear from you if you have different thoughts or observations on them.