 a  future  public  registration  of  the  securitiesbeing filed, so they can be resold once they are declared effectivewith  the  SEC.  This  provides  liquidity  for  resale  of  the  privatesecurities in the public markets once the registration statementbecomes effective.
Because PIPEs are a private placement, they are regulated bythe guidelines found in Section 4-2 of the Securities Act of 1933.This act provides an exemption from registration for the transac-tion of an issuer that does not involve a public offering of securities.This is the private investment side of the PIPE transaction. In addi-tion, SEC Regulation D establishes a safe harbor for private offersand sales of securities that meet certain specific requirements
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when marketed to qualified investors. PIPE offerings are usuallyconducted using a Reg D qualified investor exemption. These aresophisticated investors who generally manage over $100 million forthemselves or others.
In many ways, PIPEs are the bridge between the public and pri-vate capital markets. In most respects, they are structured like aprivate-venture capital equity investment; however, the investmentis  directed  at  a  small  or  micro  cap  publicly  traded  company.  In the past 10 years PIPEs have grown to become a useful and attrac-tive source of capital for micro cap issuers, particularly during timeperiods  when  more  conventional  equity  market  financing  in  theform of public offerings may not be available due to market condi-tions. Because the investors who use PIPEs as a primary vehicle toinvest  in  public  companies  are  generally  sophisticated,  private-capital institutions, it is a sector that is certainly worth monitoringclosely for opportunities in the micro cap investment arena.
The PIPE market as an investment vehicle for capital forma-tion  began  approximately  20  years  ago,  when  micro  cap  com-panies,  which  faced  difficult  financing  constraints,  were  able to  secure  investment  capital  from  private  hedge  fund  investorsand  high-net-worth  individuals  and  family  offices.  These  were the  type  of  sophisticated  investors  who  qualified  for  the  Reg  Dexemption.
In  1990,  the  SEC  promulgated  Regulation  S,  which  allowedcompanies to sell unregistered securities to non-U.S. entities. Italso allowed for these securities to be resold into the public mar-kets after a 45-day holding period. Reg S allowed public compa-nies  to  structure  capital  market  transactions  in  the  form  ofconvertible  preferred  equity  or  convertible  debt  securities  withmultiple pricing features. Although these transactions sometimeshurt the valuation of the public equity of micro cap companies,they provided a valuable source of capital for small and micro capcompanies.
During the 1990s, transaction sizes in the PIPE market usingReg S typically ranged from $1 million to $10 million, and the totalsize of the PIPE market grew from several hundred million dol-lars in the early 1990s to several billion dollars in the late 1990s.
By the late 1990s, the PIPE market began to take shape as astable and viable capital market vehicle for small companies. Dur-ing this time, more and larger companies began to take advantage
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of the ease and relative certainty of financing provided throughPIPEs.  Also,  many  micro  cap  biotechnology  companies  foundadditional  ongoing  financing  via  the  use  of  PIPEs  because  of the  difficulties  of  raising  capital  in  the  public  equity  markets.Development-stage  pharmaceutical  companies  such  as  Pozen(see case study in Chapter 11) often used PIPE financing to con-tinue product development through the raising of capital duringperiods when the public capital markets were less than favorablefor them to issue equity.
In  the  past  five  years,  the  PIPE  market  has  generally  beenlegitimized among institutional investors. Since 1999, most largeinvestment  management  firms,  such  as  Fidelity,  Putnam,  and T.  Rowe  Price,  have  created  investment  affiliates  that  originateand invest in PIPE deals on behalf of their small and micro capinvestors. It is estimated that private placements in public equi-ties  during  2001  and  2002,  which  excluded  issuers  with  marketcapitalization of less than $25 million, had an approximate aver-age  transaction  size  of  $20  million,  and  common  equity  repre-sented the majority of PIPE deals during that time period.
PIPEs provide an excellent alternative financing vehicle for asmall public company that may not find the current environmentdesirable  for  raising  public  equity  in  the  capital  markets.  Thereare some key advantages for public companies when issuing orstructuring PIPE financing:
• It offers greater flexibility in the tailoring of structure in terms
of the offering.
• It  allows  the  issuer  to  avoid  the  SEC  registration  process, permitting  a  faster  time  to  market  with  regard  to  raising capital.
• Private  and  confidential  capital  raising  is  indicative  of  thePIPE  structure,  where  no  public  filings  are  made  until  afterthe transaction is executed.
• Smaller transactions in the $5 to $25 million range are avail-able at an effective cost to the issuer by avoiding the expenseof the public registration process.
• The equity base can be expanded to strong institutional share-
holders with long-term time horizons.
• It provides for access to capital when the public markets are
not favorably positioned for raising equity.
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• It allows micro cap companies that may be too small for anytype of public offering to successfully issue equity or equity-linked capital.
As mentioned, PIPEs are typically offered through a Reg D pri-vate placement to a limited number of qualified institutional buy-ers.  The  growing  number  of  mutual  funds,  investment  advisors,private  equity  sponsors,  hedge  funds,  and  other  financial  institu-tions  that  now  participate  in  the  PIPE  market  have  helped  tobroaden and deepen the size of the available capital pool for PIPEs.During  the  late  1990s  and  through  2002,  typical  issuers  of  PIPEswere companies in the technology, biotechnology, or pharmaceu-tical  sectors  looking  for  technology-based  investment  capital  to continue executing a business plan. However, PIPEs have gainedpopularity across all industry sectors of the public capital markets,and now deals are common outside of the technology area. In thePIPE  capital  markets,  the  universe  of  potential  investors  is  typi-cally divided into two groups: fundamental investors and technicalinvestors.
Fundamental  investors are  typically  long-term  equity  in-vestors who consider an investment in a company through PIPEsas they would consider any other equity investment. These funda-mental investors tend to conduct extensive due diligence of thecompany  over  and  above  what  is  usual  and  customary  throughregulatory  and  SEC  disclosures.  Fundamental  investors  tend  tohave a longer time period for their investment horizon and typi-cally  will  look  out  one  to  three  years,  or  in  some  cases  longer,when considering the opportunity to make an equity investmentthrough a PIPE.
Technical investors, which would include hedge funds, con-vertible arbitrage funds, and certain venture capital funds, tend totake a more short- to intermediate-term view of their investmentin a public company through PIPEs. In most instances, the tech-nical  investor  is  looking  for  some  near-term  catalyst  to  emergethat they feel will be perceived as beneficial by the public marketsand  as  such  propel  share  prices  higher.  Technical  investors  aremore  concerned  about  market  and  trading  characteristics  thanfundamental investors. Share-price volatility and overall and totalliquidity of an issuer’s stock are of primary concern to the techni-cal investor. Again, the time horizon varies but typically 6 to 24
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months is the spectrum in which technical investors are lookingat their investment horizon. In addition, hedge funds as technicalinvestors typically manage the risk of their investment positionsthrough using various hedging techniques to moderate volatilityand lock in certain returns.
Although  it  is  important  to  attempt  to  identify  what  type  ofinvestor has made a private investment in a public company, inorder to determine the potential time horizon on which you, as amicro cap investor, may want to consider investing, it is becomingmore and more routine to see syndicated PIPE deals that containboth fundamental and technical buyers of the same PIPE offering.And  both  fundamental  and  technical  investors  like  to  purchasePIPEs because they efficiently and seamlessly help them obtain alarge  position  in  a  small,  illiquid  stock  without  having  a  largeadverse impact on the market price. In addition, they allow themto leverage existing investment strategies and industry and sectorexpertise in smaller companies that may otherwise not present tothem an investment opportunity.
Because of the liquidity constraints, the inefficiencies of theprivate market allow for negotiation and customization of termsthat otherwise are not available in the public securities market. Inmost respects, these negotiated PIPE transactions represent theprincipal  agent  theory,  discussed  in  Chapter  5,  and  they  create a  real  and  tangible  pricing  mechanism  between  the  public  and private securities markets.
TRACKING PIPE TRANSACTIONS
Regulation FD, which is now known as Reg FD, was enacted in2000 in order to deal with the issue of selective disclosure of mate-rial nonpublic information by public issuers of securities. Reg FDwas designed to create a level playing field between institutionaland  individual  market  participants.  The  fair  disclosure  rules  ofReg  FD  prohibit  a  company  from  revealing  material  nonpublicinformation  to  selected  investors  without  disclosing  that  samematerial to the public at the same time. While material nonpublicinformation  does  not  have  an  exact  definition  under  the  regula-tions, most investment professionals would agree that corporate
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information can be viewed as material if there exists a substantialpossibility that a reasonable investor would consider the informa-tion as important in making an investment decision. Informationcan be viewed as nonpublic if it has not been disseminated in away that makes it available to all investors at the same time. Thus,a  private  placement  of  securities  by  an  issuer  in  most  instanceswould be a material fact.
Because the fair disclosure regulations would apply to publiccompanies conducting any type of private offering, the informationthat  companies  are  able  to  disclose  to  potential  investors  duringthe PIPE marketing process is restricted to publicly available infor-mation.  However,  through  the  use  of  confidentiality  agreements,potential investors at times expressly agree to keep the informationthat the issuer is considering an equity offering in confidence untilthe transaction has been publicly announced or terminated. So apotential investor in a private investment offering for a public com-pany would not be allowed to trade in the issuer’s securities priorto  such  an  announcement  or  termination  of  the  offering.  After  aPIPE  funding  has  been  agreed  to,  the  public  issuer  would  berequired  by  SEC  guidelines  and  fair  disclosure  regulations  to publicly disclose the transaction. Typically, an issuer would file a current  report  Form  8-K  and  issue  a  press  release  regarding  thefunding. It is the Form 8-K filings and press releases that provide afertile  opportunity  for  micro  cap  investors  to  discover  potentialcandidates in the micro cap arena. This is a very useful screeningtechnique when looking at micro cap opportunities.
As discussed in Chapter 5, private investments in public equi-ties would be considered smart-money transactions. The invest-ment professionals who are in a position to make a large privateinvestment  in  a  public  company  will  typically  have  extensiveindustry and investment knowledge and will see there an oppor-tunity that may not be apparent to the broader equity markets. Inaddition, because these investors may have a limited time frame,particularly in the case of technical investors, it is possible to con-struct a series of logical assumptions that would lead to an endpoint or exit strategy for a typical PIPE investor. There are severalgood  venues  for  obtaining  information  on  PIPES  and  privateequity deals. Of course, the SEC, in its daily filing reports, wouldallow an investor to download and review all 8-Ks filed by publiccompanies.  Although  this  is  a  cumbersome  process,  investors
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who monitor such activity on a daily basis become fairly efficientat weeding through 8-K filings. However, there are several privatedatabases  available  via  the  Internet  that  provide  informationabout equity private placements. PrivateRaise.com is a web sitethat compiles statistics about private investments in public equi-ties. The transactions on the web site are contained in a databasethat includes Rule 144A PIPE transactions, registered direct PIPEtransactions, and non–rule 144A transactions. The database alsodocuments the issuance of any equity or equity-linked security ofover $1 million in nominal value that has been executed by a pub-lic  company  domiciled  in  the  United  States  or  public  foreign-based company that has its primary trading listing or a significanttrading  presence  on  any  of  the  U.S.  stock  markets.  Equity  andequity-linked  security-type  structures  included  in  the  databaseare  common  stock,  convertible  preferred  stock,  nonconvertiblepreferred  stock  that  has  warrants  attached  for  common  stock,convertible debt and nonconvertible debt with warrants attachedfor common stock, prepaid warrants, and equity lines of credit.This is a useful resource if you are going to seriously consider afocus  on  PIPE  transactions  as  part  of  the  micro  cap  screeningprocess.
A BRIEF CASE STUDY OF A PIPE TRANSACTION: Ptek HOLDINGS
Ptek  Holdings  is  a  global  provider  of  business  communicationservices  to  large  and  medium-sized  corporate  customers.  Thecompany has two business units, Premier Conferencing and Xpe-dite. Premier Conferencing offers a variety of conferencing andWeb-based  data  collaboration  services,  and  Xpedite  offersenhanced  electronic  messaging  through  various  distributionchannels including e-mail, fax, wireless, and voice. The companyhas a global presence and an established customer base of over32,000  corporate  accounts,  including  a  majority  of  the  Fortune500 firms, spanning virtually every industry group.
A  large  number  of  businesses  rely  on  data,  audio,  and  webconferencing or electronic transactional messaging to manage awide variety of important communications. The growth of these
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communication  technologies  and  the  increasing  complexity  ofservice requirements have created a large market for companiesthat wish to outsource these group communication processes. Inaddition, the current geopolitical climate coupled with corporatecost-cutting trends have encouraged companies to replace busi-ness travel with more convenient, reliable, and economical com-munications such as teleconferencing and videoconferencing.
Ptek  went  public  in  1996  at  $25.00  per  share.  The  companyhad $52 million in revenue and was marginally profitable duringits first year of operation. The company began a rapid expansionprogram in 1997 that included deploying a large number of assetsinto  fixed  infrastructure  in  order  to  accommodate  the  growingvolume of conferencing activities. In addition, the company madea number of acquisitions of smaller enterprises and quickly grewsales from $52 million in 1996 to a peak of $458 million in 1999.However, the company was not able to execute this growth strat-egy at a profit. On a per-share basis, the company lost $.78 in 1997,$1.67 in 1998, $.72 in 1999, and $1.22 in 2000 as sales declined to$423 million in 2001. As a result of write-downs and charge-offs aswell as continuing losses on its operating business, the companyreported  a  loss  of  $4.84  per  share.  Although  the  company  waslargely unprofitable on a generally accepted accounting principle(GAAP) earnings basis, between 1998 and 2001 the company gen-erated large internal cash flow through depreciation and amorti-zation  of  capital  equipment.  So,  although  the  company  had  hadsignificant GAAP earnings losses, it managed to generally breakeven and even create positive cash flow during the period through2001. (See Figure 12.1.)
During 2001 and 2002, the company presented what seemedto be an interesting investment opportunity. Sales had stabilizedat  around  $425  million  and  the  company  was  trading  at  a  rela-tively low multiple of book value as well as a low multiple of cashflow. In fact, during 2000, 2001, and 2002, the company traded in arange as low as 1.0 times cash flow and as high as 6.4 times cashflow. On a cash flow basis, this was an extremely cheap company.Furthermore, in 2002 the company had created a stable EBITDAmargin  of  17.5  percent  and  a  net  profit  margin  of  4.2  percent,which created a return on equity of 17.7 percent. All these finan-cial metrics suggested that if the company could continue grow-ing,  it  would  present  a  fairly  attractive  investment  opportunity
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FIGURE 12.1 Ptek Holdings price chart.
and would ultimately show the ability to convert revenue to earn-ings and allow for expanding margins and growing profitability.
On August 7, 2003, Ptek Holdings announced the pricing of anoffering of $75 million of 5 percent five-year convertible subordi-nated notes due in 2008. The press release stated that the noteswere sold to qualified institutional buyers pursuant to Rule 144Aunder the Securities Act of 1933 as amended. In addition, certainpersons in offshore transactions relying on Regulation S also pur-chased the offering. In essence, that press release announced tothe world that the company had done a PIPE offering of convert-ible  subordinated  notes.  The  press  release  indicated  that  thenotes were convertible under certain circumstances into the com-pany’s  standard  stock  at  a  conversion  rate  of  149.4  shares  per$1,000  of  principal  amount.  That  equaled  a  conversion  price  ofapproximately $6.69 per share. At the time, the common stock ofthe company was trading at about $5.50 a share, so the $6.69 con-version  price  represented  a  conversion  premium  of  18  percent.This indicated that institutional investors believed that the poten-tial return on the common stock would be no less than 18 percent,based on the trading premium for which they negotiated upon thepricing of the securities. On August 21, the company filed a regis-tration rights agreement between Ptek Holdings and CIBC World
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Markets, an affiliate of UBS Securities, as the initial purchasers ofthe 5 percent convertible subordinated notes.
For purposes of micro cap analysis, UBS Securities would beconsidered a technical investor, and it’s likely that these convert-ible subordinated notes went into one of its hedge fund vehicles.It would also be safe to assume that at the time, the time horizonon these notes, although having a useful life through August 2008,would for practical purposes be shorter than the five years indi-cated by the registration rights agreement.
In part, the company used the proceeds to fund several acqui-sitions  of  complementary  business  lines  and  fund  several  jointventures  with  other  service  providers  that  would  provide  in-creased revenue for the company. The year 2003 was solidly prof-itable for the company, with the real profitability starting with theJune 2003 quarter. However, sales began to increase with the Sep-tember and December quarters, along with real net income, withthe company showing $.42 of adjusted gap earnings for the yearended December 2003.
Since  the  August  2003  offering  of  convertible  subordinateddebentures,  Ptek  Holding  stock  has  increased  in  value  fromapproximately $5.50 per share to approximately $11.00 per share,showing about 100 percent appreciation over the time period.
On June 14, 2004, Ptek Holdings announced that all outstand-ing 5 percent convertible subordinated notes due in 2008 wouldbe converted into approximately 12.7 million shares of commonstock,  all  of  which  had  been  included  in  the  company’s  dilutedshares outstanding. As a condition of the conversion, Ptek wouldpay  converting  note  holders  accrued  interest  of  approximately$1.4  million  and  also  pay  them  a  make-whole  provision,  essen-tially a prepayment penalty of approximately $16.3 million, whichrepresents the net present value of future interest payments onthe bonds.
During  the  first  quarter  of  2004,  Ptek  continued  to  performstrongly, with revenues increasing from $89 million in March 2003to $105 million in March 2004. The company earned $.13 per com-mon share on a fully diluted basis, an increase of 25 percent overthe  $.09  per  share  the  company  earned  for  the  quarter  endedMarch 2003. Since 2003, five well-known research organizationshave elected to begin coverage on Ptek Holdings, including CIBCWorld Markets, which were the initial issuers of the convertible
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subordinated  debt,  and  Morgan  Keegan,  a  well-known  regionalbrokerage firm. This is just a brief example of the private invest-ment and public equities transactional activity that takes place inthe capital markets. These types of transactions are worth scruti-nizing in order to determine whether there is an opportunity avail-able as a private micro cap investor. The addition of capital allowscompanies  like  Ptek  Holdings  to  continue  executing  their  busi-ness  plans,  along  with  increasing  equity  capitalization  throughongoing conversion of convertible securities, all of which pointsto positive future valuation potential for the company.
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CHAPTER 13
A Frameworkfor InvestorAction
This chapter will attempt to answer the following questions:
• How can you get started in micro cap investing?• What should you consider when looking for micro cap oppor-
tunities?
There  are  two  ways  that  investors  can  get  started  investing  inmicro caps. The simple and quickest way to get started is througha micro cap mutual fund or a money manager that specializes inmicro cap portfolios. (More on this subject later.) The other wayto get started is to analyze and select micro cap stocks for yourown  portfolio.  For  investors  with  the  time  and  patience,  thisactivity  can  be  a  rewarding  contributor  to  the  portfolio.  Let’srecap  some  important  items  to  keep  in  mind  when  consideringmicro caps.
As  Chapter  1  discussed,  micro  cap  companies  are  publiclytraded stocks with a market capitalization of $500 million or less.These companies have historically represented over 50 percent ofall  currently  reporting  publicly  traded  companies.  There  are  at present more than 4,100 companies that meet this simple criterion.The opportunity lies in the fact that very few of these companieshave any meaningful research coverage from Wall Street analystsor institutional investors. This allows you, as an individual investor,
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to  research  and  analyze  a  large  group  of  companies  that  are  notclosely monitored by large groups of investors. The opportunity isthat  a  diligent  analyst  can  discover  and  develop  an  informationadvantage over other investors. This can create the opportunity toinvest in small public companies well ahead of the time when theinformation is widely recognized by other investors. These are theemerging companies that will be of great interest to a vast legion ofprofessional small cap managers as they climb to market capital-izations that exceed $500 million. Companies such as Amazon.comstarted as micro cap opportunities.
The entire concept of an information advantage is discussedin Chapter 2. It revolves around the notion that markets are effi-cient. The chapter does not dispute the idea of the efficient mar-ket, which is well documented in academic literature. However, itdoes point to studies that suggest that in the short term, capitalmarkets can be somewhat inefficient. And the smaller the capital-ization of a company, the more likely it is that some level of mar-ket inefficiency exists. There is no unified theory to explain thisphenomenon,  but  it  can  be  partially  explained  by  the  principalagent problem that exists in private-venture capital transactions.This  book  concludes  that  micro  cap  stocks  have  some  uniquecharacteristics that are a result of their size. Like their larger cap-italization  publicly  traded  cousins,  micro  caps  live  within  theboundaries of efficient market theory but behave slightly differ-ently  than  their  larger  cousins.  When  compared  to  larger  capstocks, micro caps do not seem to reflect all available informationas  efficiently  as  larger  cap  public  companies.  This  results  inhigher  expected  returns  and  higher  volatility  than  large  stocks.But  the  higher  returns  more  than  compensate  for  the  addedvolatility.  This  leads  us  to  the  theory  that  there  can  be  an  in-formation  advantage  available  to  diligent  micro  cap  investorsbecause  the  micro  cap  sector  is  less  efficient  in  the  speed  atwhich  it  reflects  information.  If  this  were  true,  EMT  would  becalled into question.
However, when comparing the micro cap investment sector toventure  capital  investing,  the  EMT  inconsistencies  within  microcaps can be reconciled when considered in light of the principalagent  venture  capital  model.  This  suggests  that  micro  caps  are a  sector  unto  themselves.  The  sector  has  many  of  the  elements of larger capitalization stocks as well as many characteristics of 
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venture capital investments. In many ways, the micro cap sector isa bridge between the public equity markets and the private ven-ture  capital  markets,  and  it  displays  the  unified  characteristics of both.
These unified characteristics are discussed in more detail inChapter 3. There is no doubt that over time smaller stocks pro-vide larger investment returns than bigger stocks. This is a func-tion  of  the  capital  asset  pricing  model,  which  suggests  that  themore  risk  an  investor  undertakes,  the  more  potential  return  isrequired. In the framework of the CAPM, investors are more thanadequately  rewarded  for  risks  undertaken  in  micro  cap  stocks.This suggests that there is an opportunity to capture some excessreturn, or “alpha,” in the micro cap asset class.
The data suggest that micro caps behave in part like venturecapital investments