The PIPEs, the PIPEs are falling

The history of the US private equity market's love affair with Private Investments in Public Equities is as short as it is sordid. David Snow looks at what's gone wrong.

Those crestfallen investors who, over the past two years, have lost money in the US stock markets can take solace in the fact that some of the mightiest private equity firms have also suffered greatly in the public markets, particularly with regard to a type of investment called a ?PIPE deal.?

Private equity firms' love affair with quoted companies began in late 1998, when major funds started to sink billions of dollars into publicly listed companies. It began to unravel early in 2000, when the stock markets began their long, excruciating meltdown, leaving in their wakes bankrupt companies and, for their private equity backers, spectacular losses.

During the second half of 1998, private equity professionals used this bit of jargon when describing the state of the private equity market: ?There's too much money chasing too few deals.? Firms that specialised in leveraged buyouts were finding leverage increasingly difficult to secure. In response to the financial crisis that began in Asia, rippled its way through Russia and, by the late summer of 1998, was affecting the US markets, banks severely curtailed their lending activities. This meant that less debt was available for buyouts, which diminished the return prospects for this particular type of investment.

At the same time, many established US private equity firms such as Kohlberg Kravis Roberts, Hicks, Muse, Tate & Furst and Forstmann Little were sitting on freshly raised mountains of dry powder. In other words, buyout firms had plenty of money, but nowhere to invest it.

A good idea at the time
These deal-starved GPs didn't have to look far to find companies in need of capital. The public market was filled with corporations that, thanks to the tight credit market, were more than willing to accept expensive money from private equity firms, usually in the form of convertible preferred shares. These shares typically, but not always, pay a small dividend, and are converted into common equity shares at a designated price. The conversion price is usually set at a premium to where the shares are trading when the PIPE transaction is made. As such, the investor can enjoy significant equity upside, but only if the company's shares appreciate in value following the investment.

At the time, PIPE deals seemed to make sense for private equity firms. Most investors agreed that the public markets were depressed, and therefore represented a buying opportunity. The deals allowed firms with large funds to ?put money to work? in a way that held forth the promise of tremendous profit, as opposed to the dim prospects then being offered by traditional leveraged buyouts. In addition, the debt-like nature of the PIPE securities offered a degree of stability – even if private equity houses were unable to lock in an equity gain for years, at least their convertible preferred shares paid a small dividend.

The deals represented a departure from the types of transactions normally pursued by private equity investors in that they did not give the firms control of the target companies. Another break with the private equity best practice was that PIPE deals left private equity firms to a large extent at the mercy of the public markets – whose cruel efficiency investors in private equity funds are typically trying to avoid. In addition, the deals put the investment performances of all the private equity firms that did PIPEs on a much more public stage than they would otherwise have appeared on.

Big headaches, no profits
Many of the first major PIPE deals were in longestablished industries. In December 1998, Apollo Advisors, The Thomas H. Lee Co. and Beacon Group invested $1bn in Wyndham International, a hotel group. At the time, Wyndham's share were trading for approximately $8, and the terms of the PIPE deal allowed the private equity investment group to convert to common shares at $8.59 or higher. Under an ideal scenario, the private equity group was to hold the security for two or three years, convert to equities, and sell when the shares were trading at, say, $18, or even $27, thereby locking in a nice profit for relatively little effort.

Today shares of Wyndham are trading near $0.50, meaning their value will have to increase by a factor of 18 before the private equity investment group can convert to equity. A more likely scenario is that the debt-laden hotel company will go bankrupt.

Other PIPE-backed companies are in similar trouble. Allied Waste, which received $1bn from Apollo and The Blackstone Group in 1998, is still below its conversion price. Financial services conglomerate Conseco, in which Thomas H. Lee invested $500m at the end of 1999, has since seen its price-per-share fall to $4 from $18, and recently received a rare ?sell? recommendation from Salomon Smith Barney equities analysts.

Some PIPEs are bigger than others
While ?old-economy? PIPEs have proved troublesome for private equity firms, the real doozies, if you will, have been the telecom investments. During the late 1990s, buyout GPs watched their venture capital counterparts make astonishing returns on investments in communications-related companies, and thought, ?I can play this game, too.? The attraction was mutual – telecom firms needed lots of money, and buyout firms had lots of money.

The type of company that needed the most capital was a relatively new species of telecommunications outfits called competitive local exchange carriers (CLECs). These groups were launched with the goal of competing directly with the family of former AT&T monopolies that operate telecom fiefdoms across the US. Establishing a CLEC is an expensive proposition that requires extensive infrastructure build-outs. Among the CLECs to receive PIPE backing were RCN Corp. (Hicks Muse, $250m), Winstar Communications (Credit Suisse First Boston, Welsh Carson Anderson & Stowe, Cascade, Microsoft, $900m), US LEC (Bain Capital, Tom Lee, $200m) and ICG Communications (Hicks Muse, Liberty Media, Gleacher Capital, $750m).

Of course, the PIPEs to dwarf all other PIPEs were Forstmann Little's $2.5bn commitments to two CLECs, XO Communications and McLeodUSA. While other private equity firms have allowed their struggling PIPEbacked telecom companies to declare bankruptcy, perhaps afraid of ?throwing good money after bad,? Forstmann Little stepped forward and provided XO and McLeod with additional capital infusions.

Some deals may still come good
While the additional investments gave the New York private equity firm greater ownership of the companies, the market for CLEC services has only gotten worse and worse, and the extra money failed to prop up XO and McLeod. On November 29, XO announced a restructuring plan by which Forstmann Little and Mexican telecom firm Telefonos de Mexico each committed $400m to XO, a transaction that wiped out Forstmann Little's previous $1.5bn worth of investments in the company. Meanwhile McLeod is searching for ways to avoid bankruptcy and has sold its telephone directories business to Yell, the UK company that is jointly owned by Apax Partners and Hicks Muse. Forstmann Little, which itself had put in a $535m bid for the business to get the auction going, will have greeted the news of the $600m deal with joy.

The PIPEs story may not be over. While many of these investments have ended in total losses for the firms that did them, others will eventually prove profitable, albeit after far more years than was originally anticipated. If the market for CLECs or broadband services takes off, one or two of the PIPE deals may even turn out to be homeruns.

As 2002 starts, publicly traded companies once again find themselves cash-strapped and unable to secure debt financing. Many of them have raised capital through private placements. But no one should be surprised to learn that major private equity firms have been conspicuously absent from this latest round of PIPE deals.

David Snow is the editor in chief of, a New York-based Web site providing news and information on the private equity industry.