Will the Private Public Joint Venture "PPJV" Reinvent the PIPE Market?

The Dow has been climbing at a breathtaking pace, reaching a record high of 22,000, a significant jump from 17,000 in 2016. Whatever the underlying assumptions driving this growth, it's clear that Keynes' "Animal Spirits" are running wild! This economic improvement has had an impactful cross over effect on the private equity markets, pushing valuations to sky high multiples and leverage ratios to levels unseen since the pre-crash hay days. Undeployed capital chasing investments in privately held companies has grown considerably. The question is, "Does this trend represent an opportunity for MicroCaps — traditionally limited to dilutive ATM and convertible debenture transactions — to change strategy and achieve significant high growth financing? And further, what are the best structures to consider?" We believe the Private Public Joint Venture, or PPJV, is the structure MicroCap CEOs and their Boards of Directors should explore.

Capital overhang in private equity is currently over $700 billion. Yes, that's correct $700 Billion. Based on recent PIPE (Private Investment in Public Equity) activity over the last six months, some PE money is crossing over into the public markets. And yet, MicroCaps are still struggling to attract capital at competitive terms.

According to Placement Tracker (PlacementTracker.com), PIPE deal volume is down 2.8% (469 deals in H1 2016) and dollar volume decreased a massive 44% ($27B in H1 2016). A logical analysis of these numbers infers that PE managers have two possible course of action: to start sending money back to investors, or get more creative.

PIPE activity was well distributed across sectors, with financials leading the way. Many of the sectors which are typical mainstays of private equity are showing considerable activity. That includes the energy and basic materials sectors, which typically represent a high concentration of MicroCaps.

Similar to 2016, the instrument types typically favored by PIPE investors have not changed. Registered common equity and ATM transactions have led the way. Both tend to favor more mature companies with market caps well in excess of $100M. These companies have the daily trading volume and VWAP profiles to allow companies to finance with these types of instruments without detrimental effect on share price. The reality is that unlike the larger Small Cap PIPE issuers, many MicroCap companies are limited to selling shares at discounted prices with warrant coverage, or selling convertible debentures that convert at discounts to market.

We picked a few random examples from 2017 to demonstrate the effect of each major transaction type on sub $10M issues. Where our analysis is not purported to be statistically accurate for each transaction type, we highlight the results using common examples of public issuers to examine the impact of certain structures. The companies selected were chosen randomly, and all information used was publicly available at the time. Our conclusions are not buy or sell recommendations, nor do we have any opinion on, or financial interest in, the specific issuers.

The first transaction type is a CMPO, or Confidentially Marketed Public Offering. Marrone Bio Innovations, Inc. Nasdaq CM: MBII announced a $9,200,001 offering on April 24, 2017. The offering was issued at a 20% discount to the company's share price which at the time was $1.75. By August the company's share price dropped to $1.11, a 37% decrease. Without delving into the specific operations of MBII, it is clear that the combination of discount to share price, and sudden increase in share volume created a negative impact on price. This is a very common story for MicroCap issuers.

In addition to CMPO's convertible debentures have been a mainstay of the PIPE market. We picked an offering that took place on the same day as the MBII offering in a different sector to demonstrate the effect. On April 24, 2017, Reed's, Inc. (NYSE MKT (AMEX):REED) announced that it raised $3,400,000 in a Convertible Secured Notes transaction. The fixed conversion price of the Convertible Secured Notes was $3.00 per share, an approximate 36.84% discount to the market price ($4.75 at the time) of the REED deal announcement. A series of 1,416,667 60-Month Warrants (125% Coverage) with an exercise price of $4.00 per share (8.05% discount) was issued to the investors in this transaction. As the chart indicates, on August 11th, the closing price of REED was $1.60, down 66%.

The two examples are representative of the broader experience of illiquid MicroCap issuers with traditional PIPE structures. Clearly there must be a more effective way for MicroCap issuers to raise growth capital. When the status quo cannot go on we must adapt, innovate or die. In this instance, we believe the solution may lie in a strategy wherein MicroCaps partner with private equity, opening up access to the current $700 billion private equity overhang. This strategy is particularly suited to companies pursuing an active M&A strategy such as data center roll ups or mining consolidations. Given the heavy commitment by PE to the E&P sector, energy companies are uniquely suited to the strategy.

This structure allows management teams to execute their business plans and create shareholder growth without excessive dilution or "technical" erosion of market cap due to oversupply of shares with insufficient liquidity. Over the years we have met hundreds of MicroCap CEOs and their management teams. In general, we see highly motivated managers that could execute exciting plans "if only they were adequately capitalized." We believe the market is ready for a new transaction type, the PPJV or Private Public Joint Venture. The PPJV brings both the public company issuer and the private equity investor together in a symbiotic relationship that meets the requirements of both worlds.

Let's examine the pros & cons for the MicroCap operator:

Pros for the MicroCap operator

• Non-dilutive — Pubco shareholders experience the benefit of pubco share of the JV cash flow without excess dilution.
• Acquisitions are accretive to pubco earnings.
• Financial stability — commitment of long term deep pockets of the PE company.
• Easier access to low interest leverage.
• Experience and expertise of PE management particularly in the M&A process.
• MicroCap management team can focus on building shareholder value, and spend less time raising money.
• Access to higher quality investors.
• Access to higher quality acquisition targets.

Cons for the MicroCap operator

• Non-consolidation of assets. Generally speaking, the pubco initially has a minority position, and may not have board control. However, this is not always the case.
• Potential double cost of management between Pubco and JV management.

Pros for the PE investor

• Built in exit option — by electing to convert JV equity interest into shares of the Pubco, or through phased divestiture, the PE investor has a built in public exit which can be phased over time.
• Higher exit value — since the PE company is converting, they are eliminating the illiquidity spread between private company and public company valuations.
• Greater financing flexibility — a properly executed pubco listed on a major exchange offers cheaper equity financing opportunities, particularly in difficult credit market cycles. Access to S3 shelf registrations can be a tremendous value.

Cons for the PE investor

• Transparency — depending on structure of the JV, the PE company could end up with unwanted transparency.
• Higher costs — depending on how pubco costs are allocated, this could reduce earnings at the JV level.

We believe that the pros of the PPJV structure significantly outweigh the cons for both issuer and investor alike. And this structure could quite possibly become the next major trend in MicroCap investment as the concept gains popularity. With possible elimination of dilution, which has a detrimental impact on public shareholders, we believe the PPJV is a far more productive approach for raising capital.

PPMT Capital recently attended the Planet MicroCap conference in Las Vegas in April and test marketed the concept with attendees, including representatives from the mining and energy sectors. We sat down with Chris Jones, CEO of Uranium Resources, Inc, (NASDAQ CM: URRE). Uranium Resources, Inc. operates as an energy metals exploration and development company and is developing lithium brine basins in Nevada and Utah for exploration and potential development of lithium resources. Chris felt that the PPJV would be an interesting way to accelerate transition to production of some of the company's larger reserves.

Jericho Oil Corporation, (OTC: JROOF) is developing E&P reserves in one of the most exciting basins in the US, the "Stack" in Oklahoma. We were intrigued by the knowledge that Jericho was already leveraging the PPJV strategy with a strategic family office relationship. As a prime example of an early adopter, we'll be tracking Jericho to see how the impact of the PPJV impacts their development longer term.