The market for PIPEs keeps going mainstream. The news that buyout firm Kohlberg Kravis Roberts is doing a $700 million PIPE -- short for private investments in public equity -- with Sun Microsystems ( SUNW) is a big vote of confidence for the ailing tech giant. In the privately negotiated deal, Sun sold two convertible bonds to a European-based KKR fund. The bonds convert into shares if the computer hardware manufacturer's stock rises to $7.21. With shares of Sun most recently trading at $6, the private equity firm is clearly making a long-term bet on the company's prospects. But the KKR investment is more than just a bet on a turnaround in a single company. It's further evidence that PIPEs, once a prime source of funding for cash-strapped small-cap companies, are becoming a major financing vehicle for big companies as well. In fact, 2006 was the best year ever for the PIPEs market. In all, U.S. companies raised a little over $28 billion through 1,326 PIPE deals, besting the old record set in 2000 by some $4 billion, according to PlacementTracker. The PIPEs market keeps expanding despite a long-running regulatory investigation that has cracked down on abusive trading by hedge funds in shares of small companies doing PIPEs. Some had feared the investigation would be a death-knell for the PIPEs market.
But if anything, the inquiry may have invigorated the market by driving out some of the bad actors and forcing the Wall Street firms that arrange PIPE deals to clean up their practices. The list of most active PIPE investors continues to include familiar players such as Iroquois Capital, Cornell Capital, NIR Group and LH Financial -- outfits that invest exclusively in PIPEs of small-cap companies. But the list of frequent PIPE players, according to Placement Tracker, also includes some big Wall Street names -- most notably UBS ( UBS) and Lehman Brothers ( LEH). To some degree, the explosion in PIPE deals isn't surprising, given the willingness of Wall Street to lend money to companies. Last year was a banner year for the domestic IPO market and Wall Street firms sold a record amount of corporate bonds. The easy borrowing led to a frenzy of corporate mergers, including a record number of leveraged buyouts by KKR and its private equity peers. For a big company, a PIPE deal is an attractive way to raise money, especially when dealing with a handful of deep-pocketed investors: The negotiations tend to be quicker, and they all take place behind the scenes. PIPE deals also have been used as way to fund buyouts and partial buyouts. Indeed, the biggest single PIPE deal last year was a $2.4 billion financing transaction involving Sovereign Bancorp ( SOV). The Philadelphia-based lender structured its controversial sale of a 20% equity stake to Spain's Grupo Santander ( STD) as a PIPE.
To be sure, there's a big difference between the giant PIPE deals involving Santander and KKR and the far more modest-sized transactions that a hedge fund such as Cornell Capital or LH Financial tends to invest in. In the classic PIPE deal, a small company raises money by selling discounted stock, or a bond that converts into discounted shares, to hedge funds and other institutional investors. The hedge fund investors turn around and unload the shares as soon as they are registered, hoping to score a quick profit. Hedge fund investors also typically short the company's stock as a way to protect themselves against a decline in the share price. The stock of a company doing a PIPE typically falls after a deal is announced to the public, especially if the company is selling discounted shares. The regulatory investigation has focused on allegations of hedge funds trying to game this selloff by improperly shorting shares in advance of the PIPE being announced to the public. But when a KKR invests in a PIPE, it's not necessarily looking for a quick exit -- or cleaning up on the short side. In fact, as part of its investment, KKR is getting a seat on Sun's board. That's a sign it plans to play a role in the management of the company. In its deal with Sovereign, Santander also got board representation.
Fours years ago, private equity firm Silver Lake Partners negotiated a similar deal with Flextronics ( FLEX), when it invested $200 million in the electronics manufacturer via a PIPE deal. An investment banker who arranges PIPE deals but doesn't want to be identified says private equity firms increasingly are using PIPEs as another way of making a long-term bet on a company, short of an actual buyout. The banker says buyout firms -- unlike a hedge fund PIPE investor -- don't tend to go short because they typically get to take an in-depth look at a company's financial situation first. In a typical PIPE deal, the hedge fund investors don't get a similar open-door treatment. Then again, the investment by KKR could just be more evidence that buyout firms have raised so much money that they simply don't know what else do with it.