In Depth

Paragon Surges With PIPEs

Mar 11 2008 | 9:07am ET

Since 2005, New York-based Paragon Capital has been generating annual returns in excess of 70% by focusing on private investments in public entities.

We spoke with Paragon founder and portfolio manager Alan Donenfeld about the PIPE market, how his hedge fund makes investment decisions and why his strategy is on such a winning streak.

FINalternatives: Tell us about your background.

Donenfeld: Prior to starting Paragon Capital, I was a general partner of Whalehaven Capital, a PIPE fund which posted an audited net return of 135% in 2004. For over 10 years, I was president of Bristol Investment Group, an SEC-registered broker-dealer and member of FINRA. I’ve also worked for Bear Stearns, Shearson Lehman Hutton and SG Cowen, primarily in mergers and acquisitions. 

FINalternatives: What are the advantages of investing in PIPE hedge funds over other strategies?

Donenfeld: Within the hedge fund universe, PIPE funds are among the best performing hedge funds. According to HedgeFund.net, over the 12-year period from 1995 through 2006, PIPE funds produced a compounded annual return of 27% versus 10% for the Standard & Poor’s 500.

PIPE investments are attractive because we purchase a company’s common stock at a discount from the price that it is trading at in the public market. We may also invest in a convertible preferred or a convertible note, but the conversion price will be at a discount below the price at which the stock sells in the public market. Although we seek to make our return through the common, preferred or convertible instrument, we always receive warrants as a sweetener and these warrants have the potential to dramatically increase the rate of return on our investment.

FINalternatives: What motivates companies to utilize PIPEs?

Donenfeld: For a small-cap public company, PIPEs are the only way to raise capital. They can’t obtain bank financing, yet they need capital to grow. PIPE funds like ours are ready to invest on short notice and PIPE transactions are quicker and less expensive than secondary offerings.

Over the past decade PIPEs have become an institutionalized business adopted by the major firms on Wall Street as an important and flexible financial tool to finance public companies.  In recent years the PIPE market has been booming: according to PrivateRaise and Sagient Research Systems, over $80 billion was raised in more than 1,400 PIPE transactions last year, up from $28 billion in 2006. There also are anticipated changes in securities regulations that will make it easier for small-cap public companies to pursue PIPE transactions, which should significantly increase the number of PIPE deals done.  Given the huge number of companies seeking PIPE transactions, our fund can be highly selective and invest in the most advantageous PIPE deals.

FINalternatives: How do you choose which companies to invest in?

Donenfeld: We’re extremely selective–we source and evaluate more than 50 PIPE deals a month, but typically only invest in two of them a month. We like to focus on biotechnology and healthcare, technology, energy and communications. We also like companies in other sectors that have strong fundamentals that are overlooked by Wall Street in general but have excellent management and simply need capital to grow their businesses. 

In addition, although most of our investments have North American operations, we also invest in companies with overseas operations to take advantage of rapidly growing markets such as China. 

FINalternatives: Is there a particular sector you favor?

Donenfeld: Healthcare is a sector that we currently like a lot.  If we invest at the right stage of development, with the right technology niche and management, the company can exhibit exponential growth in valuation. It's one of the few areas where we can achieve very high rates of return by doing our due diligence and understanding where these companies are headed and what their growth cycles are. Biotech companies in Phase II, moving to Phase III, can really reward us if we're invested in the right ones.  When they hit their milestones, it can bring tremendous growth and stock appreciation.

FINalternatives: What is your due diligence process?

Donenfeld: To highlight a few areas of importance, it’s critical that a company’s management checks out. We want to ensure that they’re raising the right amount of capital, they have the knowledge and capability to execute, and their compensation is significantly tied to growth of their company’s stock price so that all of our interests are aligned.

It’s also critical that a company’s capital structure is optimal.  We want to make sure that there aren’t a lot of options and warrants that are struck below the price at which we’re purchasing a stock.  Deal terms also are important: We want to maximize our potential for returns while minimizing our risks. These risks include illiquidity, companies failing to perform, management failing to perform and just general risks associated with any investment opportunity. 

FINalternatives: How do you minimize the risks of investing in small-cap public companies?

Donenfeld: The fact that we’re buying stock or a convertible note at a price that’s at a discount to the market price is one way to mitigate risk. We also have the option to lock-in the gain created by the purchase of securities at a discount. In addition, we protect our investment and enhance its returns through warrants, conversion rights, repricing milestones, full ratchet anti-dilution provisions and rights of first refusal. We keep our portfolio diversified as well, and limit how much of our assets we invest in any one company.

FINalternatives: What are the advantages to investing in your PIPE fund instead of larger PIPE funds?

Donenfeld: First, we can invest in PIPE deals that are too small for larger funds to focus on. These deals often offer better terms and a significantly higher potential for tremendous gains. Second, larger funds may have so much capital to put to work that they’re compelled to invest in many of the deals that they see, including the less attractive ones. In contrast, we can be very selective in deciding which PIPE deals to invest in. 

Third, as a smaller investor in PIPE deals, it’s far easier for us to exit our investments. In contrast, larger funds may end up “stuck” in investments given the larger size of their investments and limited liquidity. In addition to investing in PIPE deals, we can invest in very appealing transactions called alternative public offerings, which are an inexpensive IPO substitute for attractive private companies seeking to become publicly traded. These transactions, which can produce significant returns, typically are too small for larger PIPE funds to focus on. For these reasons, we have far more flexibility and potential for higher returns than do larger PIPE funds.

FINalternatives: Can you further explain alternative public offerings?

Donenfeld: In an alternative public offering, an attractive company is merged into a public shell, often with a simultaneous or subsequent PIPE financing. We can produce attractive returns by investing in the public shells into which attractive private companies are merged to become more highly valued publicly traded companies. Our team’s expertise in alternative public offerings provides us with a huge edge over other funds that can’t capitalize on these lucrative deals.

FINalternatives: How has your PIPE fund performed?

Donenfeld: We have had tremendous results and generated a cumulative return of over 235% since inception in 2005.

By Hung Tran


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