Financing Under Extreme Uncertainty: Evidence from Private Investments in Public Equities

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Abstract
This study examines the use of private investments in public equities (PIPEs), an increasingly common form of equity-based financing. From 1995-2000, a total of 1,466 firms raised more than $29 billion through 2,626 PIPE issues. We investigate the motivations and the returns to the firms and investors using PIPE financing. By all accounts, PIPE issuers are poorly performing firms, urgently in need of cash that, as a consequence, are without access to traditional forms of financing. Despite these uncertainties, PIPE investors make relatively large investments in these firms representing an average of 16 percent of the issuer's equity and more than 500 percent of the issuer's daily traded volume. The question is why investors would be motivated to fund these seemingly troubled firms. The contract terms and imbedded options within PIPEs allow investors to alter their exposure to the post-issue movements in the value of the issuer's equity. Price Protected PIPEs provide investors with significant protection against downward movements in an issuer's stock price following the issue. "Unprotected" PIPEs offer no downside protection but offer investors significantly higher returns in circumstances of positive post-issue stock performance. We find that shareholders earn average benchmark adjusted returns of -22 percent in protected PIPEs and -9 percent in unprotected PIPEs in the year following issue. Because of the structure and imbedded options employed in PIPEs, the returns earned by shareholders are not the returns earned by investors. We estimate that PIPE investors earn average benchmark adjusted returns of 52 percent for protected PIPEs and 78 percent for unprotected PIPEs in the year following issue. The difference between investors' and shareholders' returns is both economically and statistically significant. The results indicate that the contracting terms of PIPEs provide incentives for investors to take relatively large stakes in firms with substantial operating uncertainties, enabling companies barred from traditional capital markets to obtain much needed financing.

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