The Case for Registered Direct Offerings

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 |  Includes: GNVC, GSI
by: Kevin Pollack

The basic premise behind Paragon Capital’s registered direct offering investment strategy is simple – why buy a company’s stock in the open market when you can buy that company’s stock at a significant discount to the market price and also receive warrants for extra upside?

What exactly are registered direct offerings (RDOs)?

In an RDO, a public company sells investors securities that have been previously registered pursuant to an effective shelf registration statement. For a company hungry to raise capital, RDOs are quicker and less expensive than a secondary offering. RDOs typically involve a company selling registered stock to investors at a below market price, with warrants as a sweetener.

According to PrivateRaise, in 2009 companies raised a total of $5.87 billion from 267 RDOs, 92 of which were in the fourth quarter. Given the sizable number of companies currently looking to raise capital, it’s an investors market, and investors can pick and choose to invest in the most attractive companies with the most attractive investment terms.

How can an investor profit from RDOs?

You can profit from an RDO whether you’re a very short-term investor or a longer-term investor:

What if you could buy stock at a significant discount to the market price, sell that stock promptly for a quick profit and also receive long-term warrants for free additional upside? If you’re a very short-term investor, RDOs can provide you with exactly that – an opportunity to have no net investment risk and obtain warrant upside for “free.”

If you’re a longer-term investor, RDOs offer an excellent value proposition, too – they can provide you with stock in a company that you already like at a cheaper price than the market price, and with the bonus of a warrant kicker for additional upside.

If you invest in a company’s RDO, how much higher of a return can you realize than if you were to buy that company’s stock in the open market?

Your return will vary based on a number of factors, including the RDO investment terms, the attractiveness of the company and your holding period. However, in any event, you can realize a far higher return by investing in a company’s RDO than if you were to merely buy that company’s stock in the open market.

For example, let’s take a look at a recent $25 million RDO completed in late December 2009 by the NYSE-listed General Steel Holdings, Inc. (NYSE:GSI). GSI is a Beijing-based company operating a portfolio of Chinese steel companies.

On December 23, 2009, the day before GSI’s RDO was announced, GSI stock was trading as high as $5.84 – yet if you were an investor in GSI’s RDO you bought shares at just $4.50, a more than 20% discount to both the market high and the closing price the previous day. In addition, for every two shares of GSI that you bought at $4.50, you also received a 2½ year warrant to buy a share of GSI at an exercise price of $5.00 per share.

So, if you’d invested $100,000 in GSI’s RDO, then you would’ve received 22,222 shares of GSI stock and warrants to buy 11,111 shares. In contract, if instead of participating in the RDO you’d bought GSI stock in the open market at $5.84 the day before GSI’s RDO was announced, you would’ve received just 17,123 shares of stock and no warrants. Effectively, for the same exact investment amount of $100,000, if you were an investor in GSI’s RDO you would’ve received 30% more shares of GSI than if you were a buyer of GSI stock in the open market, not even including the warrants. That’s a huge difference, reflecting the significant advantage of being an RDO investor.

So, how did investors in GSI fare? Let’s take a look at three scenarios:

1) If you were an investor in GSI’s RDO who promptly sold your stock

2) If you were an investor in GSI’s RDO who held onto your stock

3) If you were a buyer of GSI stock in the open market

In many RDOs, some investors promptly sell their stock to lock in a quick gain, which appears to be the case with GSI’s RDO. Once GSI’s RDO was announced on December 24, GSI’s price temporarily dropped to just above the $4.50 RDO purchase price on unusually very high volume of almost 9,000,000 shares. If you were an investor in GSI’s RDO and sold your GSI stock at $5.06, the high on the day that the deal was announced, that represents a quick profit of more than 12%, not even including the potential upside on your 2½ year $5.00 warrants.

If you were in an investor in GSI’s RDO who believed in the future of the company and held onto your GSI stock after the RDO, your immediate gain on the stock was temporarily reduced when GSI’s stock price hovered in the $4.50 range just after GSI’s RDO was announced. However, the very next trading day, December 28, GSI’s price was at a high of $4.79, more than 6% above your $4.50 RDO purchase price. If you fast forward, you would’ve done very well – every single trading day from December 24, the day that GSI’s RDO was announced, through January 22, the high of the day was above $4.50, and the stock reached a high of $5.13 on January 11. If you’d sold your position at $5.13, then you would’ve gained 14% in just a few weeks plus be in the money on your 2½ year $5.00 warrants.

Now, if you didn’t invest in GSI’s RDO and instead were a buyer of GSI stock in the open market at the high of $5.84 just before the RDO, you would’ve taken a huge short-term bath when GSI’s price dropped to around $4.50. Even worse, the stock has yet to reach $5.84 again. Irrespective of the merits of the GSI and its future prospects, GSI’s RDO was a better risk/return play for an investor.

The moral of the story is that investors in RDOs, regardless of whether they are very short-term investors or longer-term investors, can fare far better than buyers of stock in the open market.

Are there specific industries where investors in RDOs have realized higher returns?

Recently, biotech and healthcare RDOs have been particularly attractive to investors. Since the second half of 2009, many biotech and healthcare companies have been especially eager to pursue RDOs. During the 2008-2009 market meltdown, many of their stock prices took huge beatings – for some of these companies it was a very difficult time to raise capital and it was uncertain whether they could raise capital at all. The market doesn’t like uncertainty and for some of these companies their depressed stock prices reflected the possibility that they could run out of cash before they could raise the capital that they needed to survive and thrive.

The RDO has been a saving grace for these companies. Even though raising more capital may be dilutive to these companies, their stock prices typically have gone up after pursuing a financing via an RDO. Why? Raising capital through an RDO signaled to investors that these companies were going to survive for awhile, have enough cash to make it to that next key milestone and be able to raise capital again in the future, if necessary.

For example, let’s take a look at GenVec, Inc. (NASDAQ:GNVC), a Nasdaq U.S.-based biopharmaceutical company developing gene-based therapeutic drugs and vaccines. GNVC raised capital through 2 RDOs, an August 2009 $6 million RDO and a January 2010 $28 million RDO.

If you’d invested in GNVC’s August 2009 RDO, you would’ve bought shares at $.75, a more than 15% discount to GNVC’s high the previous day and a more than 8% discount to GNVC’s closing price the previous day. In addition, for every two shares you bought in GNVC’s RDO you would’ve received a 5 year warrant to buy a share of GNVC at an exercise price of $.828 per share.

If you were an investor in GNVC’s RDO and promptly sold your stock at $.80, GNVC’s high on August 27, the day that the RDO deal was announced, that represents a quick profit of more than 6%, not even including the potential upside remaining on your 5 year $.828 warrants.

If you were in an investor in GNVC’s RDO who believed in the future of the company and held onto your stock after the RDO, your immediate gain on the stock was temporarily reduced when GNVC’s price hovered in the $.75 range after the RDO deal was announced. However, in the more than five months since the day that GNVC’s RDO was announced, on every single trading day except for September 3, GNVC’s high of the day was not below your purchase price of $.75.

Since GNVC’s RDO, the stock reached a high of $3.34 on January 25. If you’d sold your position at $3.34, then you would’ve gained over 345% in less than half a year plus be deep in the money on your 5 year $.828 warrants. Although with GNVC you would’ve realized a good return had you bought the stock in the open market instead of participating in the RDO, you would’ve made a far higher return from investing in the RDO, especially given the warrant upside.

How can investors access RDOs?

The easiest way to access RDOs is to either contact your broker or invest in an investment fund with an RDO specialization. However, keep in mind that because a broker often has incentives to push firm product and generate commissions from raising money for an RDO, you should do your own analysis on those deals. In contrast, an investment fund is rewarded for good performance and thus has every incentive to invest in the best RDOs. Investment funds also see a far wider range of RDOs than brokers.

You also need to recognize that not all RDOs are created equal. A specialized investment fund has the expertise and “special sauce” to know which RDOs offer the best risk/return characteristics and whether a very short-term or longer-term holding period is appropriate.

Regardless of whether you rely on a broker or an investment fund, assuming that you qualify to invest in RDOs, it’s highly advisable to consider allocating some of your investment capital to RDOs. After all, who doesn’t like getting a below market price?

Disclosure
: Paragon Capital LP holds no positions in GSI or GNVC.