In the Catbird Seat

Private investors are starting to put their mountains of cash to work.

What’s more, private companies don’t have to make financial disclosures to the market, and can usually tailor the securities to their specific needs in terms of maturities and principal payment schedules. Private placements also provide a much-needed alternative to short-term bank debt, says Weaver. “In the 1990s, bank financing was cheap,” he says. “Now the banks are raising their prices and cutting their exposures.”

And the private placement market has become all the more important for midmarket companies. Jerry Whiteford, CFO of Elkhart, Indiana-based Nibco Inc., a privately held company in the flow-control industry, says that privately placed debt is a vital source of financing diversification for his company. “With all the bank consolidation, our syndicate financing options are fewer,” he says. Despite the fact that cheaper short-term bank credit is readily available, Whiteford has historically arranged 40 percent to 60 percent of his debt financing through private placements. “I look at private placements as a piece of our long-term capital,” he says.

The biggest investors in private placements — insurance companies and pension funds — typically hold the securities until maturity. But that isn’t always the case.

Choosing the right investors is key, says Hal Logan, CFO of TransMontaigne Inc., a refined-products distribution company based in Denver. “You want a long-term partner that will hold the securities for at least three to five years,” he says. Patient, long-term investors are also apt to commit to more funding if the company requires it down the road.

When it comes to private equity financing, finding good investors is all the more important. As Seth Lemler, managing director with Morgan Lewins & Co., a New York-based investment bank serving midmarket companies, puts it, “You’re going to be living with these people for a long time.”

For private companies, vetting potential investors amounts to determining what the company needs and whether or not the investor is a suitable fit. For public companies, the decision can be of much greater consequence.

Cleaning the Pipes

Mention the word PIPE (private investment in public equity) to a public company CFO, and he’s apt to recoil in horror. He’s sure to have had the idea pitched to him, and he’s also sure to have heard of companies that have spiraled into bankruptcy soon after arranging one. Dozens of floundering companies, including eToys, AtHome, and Winstar Communications, have slid into financial ruin in part because of PIPEs gone awry.

The favorite form of PIPE is the convertible preferred share, which gives holders the right to convert their shares into common stock, typically at a premium to the company’s share price at the time. As valuable as a long-term private investor can be for public companies, the private market also has predatory investors that, when they smell blood in the water, will move in for the kill.

Certain hedge funds and private equity groups have pushed more than a few companies into a “death spiral” with so-called toxic convertibles that have exercise prices that reset if the public stock price falls. However supportive a private investor might seem, a floating conversion rate provides incentive for an investor to work against a company–shorting the public stock to lower the conversion price of the preferred shares.

The result can be a snowballing dilution that swamps public shareholders. “You dance with the devil when you have to,” says Lemler.

Companies can and do set conditions that the investor cannot work against them. But that doesn’t stop other investors from selling stock short. The negative publicity surrounding toxic convertibles, however, has helped clean up the PIPE market. And with so much private capital looking for a home, growing numbers of public companies are tapping the market.

“Not all PIPEs are bad,” says Lemler, who helps public and private companies find suitable private investors. “People have wised up, and there are a lot fewer abuses in the market.”

When structured correctly, a PIPE can provide essential capital and a potentially valuable business partner for a public company. TransMontaigne’s Logan says several large private investors have remained shareholders since the company went public in 1997. “We look for investors who’ve been in hot kitchens and don’t get uncomfortable,” he says.

Very often, private investors can provide valuable management help and strategic support for a public company as well. Consider Salton Inc., headquartered in Lake Forest, Illinois, a maker of home and kitchenware products such as the George Foreman Grill. Three years ago, CEO and founder Leon Dreimann needed $80 million to buy back 6.5 million shares from another company, Windermere. Through boutique investment firm Barrington Research, Dreimann hooked up with New York-based private equity group Centre Partners. Centre came up with half the equity in the form of preferred shares, and the banks provided the rest.

Today, two Centre partners still serve on Salton’s board. “They’ve made a major contribution to our business,” says Dreimann.

With public stock prices the way they are, a lot of capital-strapped companies could use that kind of help.

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