A Pipe Dream Or Reality?

07 August 2008

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Andrew Carpenter and Mike Hinchliffe of Addleshaw Goddard on why PIPEs may make a lot of sense

In the current environment the UK’s private equity players will inevitably turn their attention to the public markets. Notwithstanding the current turbulence, a survey of CFOs carried out by Deloitte nearly a year after the credit crisis first erupted revealed that 49% of CFOs considered UK shares to be undervalued, with only 22% of the view that they are overvalued.

Nevertheless, there has been relatively little public-to-private (P2P) activity in the UK in the last 12 months. Some of this may be put down to time lag (given the time-consuming nature of P2Ps), but the word in the market suggests that institutional investors are still demanding significant premiums to reflect their perceived undervaluation.

The alternative of taking a strategic minority investment in a public entity (PIPE) generally meets resistance in the UK market. In the US they are relatively commonplace, making it unsurprising that the highest profile PIPE attempted in the UK in recent months (TPG’s aborted £180m investment in Bradford and Bingley) was originated by a US investor.

The pre-emption hurdle

In the US, companies are often free to issue public stock without first offering it to existing stockholders, making PIPEs far easier. In the UK, public companies will have a limited general authority to allot shares outside pre-emption of up to 5%, so a higher share subscription will generally need a shareholder approval, or an underwritten rights issue (creating uncertainty as to the exact equity stake the investor will hold at closing).

Given tighter credit conditions, public company targets may seem ripe for PE investors to fund value-enhancing bolt-on acquisitions. A few alternatives to the traditional convertible loan note PIPE or an underwritten rights issue are worth consideration here, such as a PE-backed vendor placing, or an offshore "cash box" deal. Both such transactions will mitigate the effects of the UK pre-emption rights regime, but without the uncertainty in the investor's final stake that is inherent in an underwritten rights issue.

In the absence of a listing rule requirement for shareholder approvals due to the size of any proposed acquisitions, it should be possible to structure a transaction via a vendor placing or “cash box” placing without shareholder approval. This provides greater deal certainty than a P2P or underwritten rights issue, and the transaction can be executed more quickly without the need for any circular, prospectus or other public document. Deal costs risk can also be placed more on the PLC than in a P2P deal.

The need to control

Many UK private equity investors, particularly mid-market, claim they are simply “not set up” for a PIPE. Whilst some investors always shun a minority deal, the majority still promote their ability to do them. The constitution of a fund will also often allow a holding of a certain proportion of the fund in public stocks (typically to facilitate exit by IPO).

The gut reaction of many such investors is that a minority holding in a public entity does not give the investor the control and influence it requires to effectively manage their investments. But how close to a typical PE minority deal could a PIPE get?

Investor Directors are common where a PE investor holds a stake of more than 5- 10% in a public entity. The circular from the aborted B&B rights issue revealed a Relationship Agreement whereby TPG would have the right to nominate two directors, so long as its stake was at least 15%, or one director at 5%.

Remuneration/Audit Committees are a requirement under the Combined Code, comprising solely of independent non-executive directors, and which by negotiation might include the nominee of an investor.

Management control and incentives can be obtained via a number of familiar mechanisms. Shareholdings (often subject to lock-in) might be combined with option schemes with appropriate performance conditions and leaver provisions. Restrictive covenants will be included in service agreements in the usual way. At least half the board should be comprised of non-executive directors under the Combined Code to keep the executive team in check, and where other institutional shareholders are aligned on non-performance only a majority vote would be needed for removal.

Warranties may be negotiable, subject to bargaining power, from the Company (or where funding a bolt-on, possibly from the vendor(s) of the acquisition target).

Shareholder protections exist under general law (Rule 9 of the Takeover Code provides a tag right on change of control, and the Companies Acts provide a pre-emption regime), and can be supplemented by a Relationship Agreement that might include information rights and investor consents, in addition to provisions concerning confidentiality and conflicts of interest.

Counting the cost?

It will be interesting to see if PIPEs do become more prominent in the UK. P2Ps can be time consuming, unpredictable, and very costly. The circular from the aborted B&B rights issue revealed that TPG was entitled to a 1% break fee on failure due to a takeover offer or other change of control transaction, and a right to participate in future fundraisings on like terms in the next 12 months if its own fundraising failed. As UK investors contemplate whether the main list and AIM markets are undervaluing companies where there is a buy-and-build opportunity, often combined with a significant part of the equity being held by a smaller number of significant stakeholders, perhaps the time has come to start challenging the assumptions of what a PIPE can deliver?