Outlook 2009: Market shrinks in 2008, outlook hazy; private equity, preferreds could play bigger role

By Kenneth Lim

Boston, Dec. 31 - The PIPEs market shrank in 2008 amid a freeze in the capital markets, and a quick recovery is not expected in 2009, market observers said.

Issuers will likely continue to struggle to find capital, but with equities trading near their lows and favorable interest rates, investors could find some bargains in the year ahead.

Volumes in 2008 fell as investors and issuers struggled through one of the biggest crises in the capital markets in years.

While a small number of very large offerings from financial issuers raised the dollar amount of U.S. PIPEs, the number of deals fell substantially. And Canada saw a significant reduction in both deals and dollar value.

"It's no surprise that raising any kind of money in 2008 was really hard," a New York-based investment banker said. "Stock prices were falling, there was a lot of concern about credit, investors were worried about losing money. Finding investors, especially for the smaller and less healthy companies, was really hard, because nobody wanted to make an investment."

Credit markets essentially closed for many companies, the banker said.

"It's not that you can't issue debt," the banker said. "The problem is that it's just very, very expensive for a company, especially the smaller companies, to issue debt. If you give a high enough coupon, people will lend you money, but it's not a viable option for many of the small companies to take on that kind of expense."

Issuing equity was a more acceptable option, the banker said.

"A lot more companies issued shares or preferred shares," the banker said. "Preferreds really had a much better year. The companies can't afford debt, the investors want something better than common stock, so preferreds kind of filled in the gap."

Issuers certainly felt the pain. Larry Froom, chief financial officer of H&R Real Estate Investment Trust, said his company's recent C$200 million sale of five-year 11.5% debentures was one of the most expensive financings for the Downsview, Ont.-based REIT.

"This was the best we could get in considering the market," he said.

Rise in private equity

Private equity came through for some companies, especially the capital-hungry energy juniors.

"The big thing that happened in '08 for energy companies is in '07, '06, '05, you used to be able to do $40 million to $50 million private placements as a publicly traded junior, and it would be bought by the traditional Toronto, New York, wherever money managers," said a Canada-based investment banker who focuses on the energy sector.

"In '08, almost all, or the vast, vast majority of private placements were private equity funded. The traditional buyers were not there at all. And they were doing deals of $300 million to $500 million at a time."

"It totally went away from the model where you raised a bit of capital then went back to the market," the banker said. "In 2008 that totally went away. The guys in the market were totally private equity guys. No interest from the traditional guys who did the financings along the way."

Despite the larger deal sizes, volumes fell by about half in 2008, the banker said.

"The market went from smaller tranche-by-tranche financing to much larger deals," the banker said. "There's a lot fewer of them...I'm not sure it's good for the industry overall, but we definitely had a good year."

The emergence of private equity has led to some changes in the way that investment bankers and issuer seek capital.

"It's not a complete change," the banker said. "It's nuances. It requires a lot more patience, longer timelines, because private equity tends to fund private companies and a lot of these are publicly listed...you're starting from a different level of disclosure. It lengthens the timeline and due diligence processes. It's also a different market."

Notable deals

Financials were some of the biggest PIPE issuers in 2008 as they sought to prop up their balance sheets amid the financial crisis.

"All the biggest deals were from the banks, Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley," the New York-based banker said. "Was there any bank that didn't raise any capital? Again, no surprise there. They were the ones which needed the most money."

Citigroup Inc. sold $12.5 billion of 7% perpetual convertible preferreds in January 2008, the largest single deal in 2008. Morgan Stanley raised $7.8 billion from a placement of 10% perpetual convertible preferreds, while Merrill Lynch & Co. Inc. sold $6.6 billion of 9% 33-month convertible preferreds. Goldman Sachs Group, Inc. raised $5 billion from a sale of 10% perpetual preferreds.

Equity financing facilities also had a good year, with several large deals arranged with investors like Kingsbridge Capital Ltd.

"There are only a few players in the market doing those kinds of deals," the banker said. "For the companies it's a way to secure longer-term financing down the road, and usually they only have to use it if they want to, so it's usually a good deal for the companies. But the investors are usually very selective, and it's not an option that's open to everyone."

Sizable deals included Jazz Pharmaceuticals Inc.'s three-year $75 million committed equity financing facility and Dyax Corp.'s 18-month $50 million facility.

Anther notable deal that was mentioned was Canada-based Crescent Point Energy Trust, which raised C$125 million through a sale of common units at the start of the year. It was offered publicly in Canada and under Rule 144A in the United States.

2009 still uncertain

The forecast for the coming year remains hazy.

Froom of H&R REIT said he did not know how 2009 would emerge in terms of capital raising.

"I don't know," he said. "I hope it does improve. We're not sure. We will see."

The New York-based banker said capital will likely remain tight in the first six months of 2009.

"I don't see it improving much at least for the first half," the banker said. "It's hard to predict much beyond that.

"I think there are still a lot of fundamental problems with the economy, and as we deal with those issues capital's going to be hard to find.

"Equities and preferreds will probably be easier for the smaller companies. Issuing debt, unless you're a larger, investment-grade type company, it's pretty much still out of reach for the smaller companies. The Federal Reserve rate cut will probably push some investors towards corporate bonds, but still, that's mostly going to be into investment-grade names. The bulk of the companies that are raising money through PIPEs won't find debt attractive."

The energy banker also noted that the traditional money managers are unlikely to return in 2009.

"Not this year," the energy banker said. "I would say we won't see this year that the traditional money managers will be back. But we'll probably see that the private equity type of capitalization will slow down...There's a logical limit to the number of those that should be out there."

2009 could also be a good year for bargains.

"Do I think everything is going to fix itself in 2009? No," the energy banker said. "Do I think there's room for money to be made in 2009? Yes. You look at a lot of these stocks, they're trading at 10 to 15 cents instead of a buck...they haven't really moved much. I think there will be great opportunities in 2009."

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