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2019-08-14 22:17:48

PIPE Deals Are Always and By Definition Very Expensive

Insight Enterprises (NSIT) has to raise between $500 and $600 million to pay for the $581 million acquisition of PCM, Inc. (PCMI). I have written several articles about the virtues of this deal in Seeking Alpha, including Insight Updates Its Forecast With PCM Acquisition on August 8, 2019. The issue I left out is that NSIT only has $112.8 million in cash as of June 30, 2019.

I took NSIT at its word in its presentation that the acquisition would be financed with cash on hand and borrowings under a new credit facility - taken from page 4 of its presentation on the deal - see below:

Source: June 24, 2019 presentation by Insight Enterprises

Note there is no mention here of a $350 million convertible note arrangement with a bunch of hedge funds on Wall Street. That is essentially what this deal will amount to.

I am been involved with and analyzed a good number of these kinds of PIPE deals (Private Investment in Public Equities). The bottom line is they are always very expensive, both in terms of fees and potential dilution to existing shareholders.

One of the main tricks that Wall Street firms use in these deals is to make them complicated and highly dilutive. Just as I was writing this article NSIT posted an announcement on its site about the conversion price:

Source: August 13, 2019 Announcement on Pricing of Convertible Senior Notes

Here is how I look at the deal: NSIT has to pay a bunch of Wall Street firms about 12.5% dilution of its stock just to borrow $340 million. Here is how I calculated that figure:

Source: Hake estimates

NSIT will likely disagree with me on this. For example, they have entered into some anti-dilution transactions. Those seem to cost $27.8 million. That represents about 8.15% cost on the $341 million borrowed. And there is no guarantee that the shares will be converted, so it is a sunk cost. Moreover, there are warrants and options that the buyers have been granted on top of the deal. These are priced at a 100% premium to today's stock price, but they still represent dilution to existing shareholders.

I never understand why middle-market firms like NSIT get caught up in these Wall Street schemes. What they don't realize is that the hedge funds themselves are borrowing the money that they lend in the PIPE deals - often with the same underwriting bank, in this case, JPMorgan. Why can't NSIT just borrow the money it needs from JPMorgan without all these fees, warrants, options and hidden issues. One of the hidden issues is how do the hedge funds lay off their risk in this deal. Often they will short the stock, sell derivative calls instruments with the underwriting bank as the counterparty, etc. This tends to put pressure on the stock price.

My original question stands - why didn't NSIT stick to what it said it would do and borrow the money under a revolving credit facility? Here is probably one reason it didn't do it: JPMorgan is the senior lender for the facility (and the remaining amount of money needed to close the PCM deal) and also the underwriter/agent for the Senior Secured Convertible Notes.

Note also that no one will know who the hedge funds are that are doing the investment in the secured notes. There is a whole cadre of funds that make a living on these dequity PIPE deals (i.e. a mixture of debt and equity, designed to guarantee a minimum 20-25% annualized return on investment largely due to the fees, options and warrants that are associated with the deal). They don't have to issue Form 4's with the SEC about their ownership interests in NSIT, even though it will be over 10% of the company on a combined basis, because of the derivative and convertible structure.

Why Can't NSIT Just Use Debt?

Isn't that what their presentation said? A new revolver. Well, I guess it wasn't possible. Or maybe NSIT just didn't want to put together a lending syndicate to raise $600 million in revolving credit. I suggest that this would be much less expensive for shareholders.

NSIT can't recall these senior convertible notes for three years, and even then the stock price has to be at a 30% premium to the conversion price, which is already at $68.32 per share is already at a 32.5% premium to today's price. In other words, NSIT cannot repay the convertible notes unless the stock price after three years is above $88.82 per share or 72.2% above today's price. That represents a compounded return of 19.87% gain the stock price (remember how I said dequity firms need to make a 20% return).

Here is the problem with that situation. First of all, you will find that the stock will be magically stuck below that magic $88.82 price around the time that NSIT would be able to begin redeeming the notes in August of 2022. The hedge funds have 2 more years after that until June 2024 to convert their stock. So, in effect, they get a 5-year warrant at 20% or better return, with a lot of fees, and 0.75% interest paid while they are waiting.

I have shown in my previous article that with the deal NSIT will easily be able to pay down the debt associated with the PCM acquisition within three years. But that is when I thought the deal would be financed with a revolver AS MANAGEMENT SAID. In addition, in my previous article, I wrote that NSIT is worth at least $95.14 per share. I am actually being conservative with that target. That is well above the $88.92 trigger price for the redemption of the notes.

Conclusion

NSIT is probably stuck with this deal now. If they have any chance of getting out of it and doing what they originally said they would do and use a revolving credit facility for 100% of the deal, they should attempt to keep their word. Mark one up for Wall Street banks on this deal. Someone is getting a bonus. It won't be NSIT shareholders.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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