The millennial bust left many publicly held former venture capital deals in precarious condition. They need more money to survive. But, particularly in this post-SOX era, raising capital isn’t so easy for the riskiest firms, particularly in the public markets. So the market has responded with PIPEs – private investments in public equity. These offerings are structured to provide downside protection and upside opportunity commensurate with risk for the new investors without selling out the existing shareholders. See Chaplinsky, PIPES: Private Equity Investments In Distressed Firms.
Gretchen Morgenson is on the case, and this week's NYT column offers an interesting insight into how her mind, or at least her writing, works.
Where’s the story here? Could it be the dire straights of small public companies that leave them little option but to get money on the stringent terms that private financiers demand? Could it be the dynamism of our capital markets that has managed to meet the challenges of financing distressed small public companies?
No, of course not. It’s about conflicts of interest:
The close and profitable ties between hedge funds, famous for seeking outsize returns on behalf of their investors, and brokerage firms eager for the unusually rich commissions the funds pay them, are rife with potential conflicts.
The problem Gretchen sees is that because the deal may dilute the existing equity, someone with advance knowledge of the deal could make money by shorting that equity. So we can't miss her point, Morgenson opens with a quote from the Beatles’ “Do you want to know a secret.”
Even Morgenson has to admit that it’s not that simple. The point of the deal is often to save the firm and its existing equity from bankruptcy, which is positive for the common stock. Moreover, the offerors and their brokers have no incentive to sell the securities for less than the market will bear. If the stock is moving, it's probably not because of simple "dilution," but because of specific information about the company or the deal, which may be positive or negative. So Morgenson cites data showing that only half of PIPEs companies saw their shares drop in the pre-offering period, by an average of 8.6%, while about half rose, by an average of 20%. In other words, somebody who shorted all the PIPEs deals he found out about would lose money.
Morgenson’s analysis is as nuanced as it usually is, meaning not. She focuses on a specific deal in which the shares first rose, then declined, then rose. She notes that somebody who shorted the shares would have profited, while shareholders who sold would have lost. That’s a neat trick Gretchen – how do shorts win and sellers lose?
Assuming the market is moving because of inside information, which is actually a safe bet, what to do about it? Of course, readers of this space know that I don't think insider trading is much of a problem – it provides valuable information (particularly helpful for these sparsely followed companies) while the negative effects are elusive. And even assuming insider trading is bad, it may be an inevitable cost of these deals. As Morgenson notes, it is necessary to reveal information to sell the shares.
A reader of this column and its careless and incomplete analysis would come away with the conclusion that there’s a fundamental problem with these deals so they have to be regulated. And of course that’s the point Morgenson always wants to make. Yet these deals offer a tiny refuge from problems created by over-regulation. Maybe Morgenson should have started her column with “nowhere to run, nowhere to hide.”
Comments