Private placement pitfalls / Pinetree post-mortem

Some publicly-traded companies regularly participate in private placements.  One subtlety about private placements is that the buyer receives shares at a discount to the market price.  Participating in private placements can generate immediate mark-to-market gains.  This can make short-term performance appear better than it actually is.

In the long run, I think that private placements are a bad idea for investors for the same reason that secondary offerings are a bad idea.  It is difficult for the incoming shareholders to make money given the conflicts of interests (existing shareholders prefer to sell shares at inflated prices) and the extreme fees (typically several percent or higher).  An alternative to a private placement is a rights offering.  Rights offerings are considered to be fair to all shareholders and can potentially have very low fees.  However, very few Canadian juniors actually go that route.  Most companies choose to dilute shareholders and to generate massive fees for brokers, underwriters, lawyers, accountants, etc.

Pinetree Capital is an example of a company that has constantly participated in private placements.  Currently the company is in bad shape due to its investment losses.  Shockingly enough, I have made money going long this company thinking that it traded at a discount to its liquidation value.  In hindsight, it is easy to see that its liquidation value was bound to drop given how awful junior exploration stocks are.  Currently, debentureholders have some control of the company and will likely look at selling off assets to de-leverage the company.  It will be interesting to see if there is liquidity for the shares that Pinetree acquired in private placements.

Value traps

What I’m slowly starting to learn is that I should stay away from cheap stocks with bad management teams.  That being said, I still have positions in Northfield Capital (bought into multiple private placements) and Kobex Capital (bought into a single private placement).  Knowing what I know now, I would not invest in Northfield.

*Disclosure:  No position in Pinetree stock or debt.

Flipping

The parties buying into a private placement will be unhappy if the market price falls below the price they paid.  The brokers want to keep their clients happy.  Typically, the underwriters and brokers behind a private placement will promote the stock and try to keep its share price up.  Some market participants will try to immediately sell shares that they acquired in a private placement, locking in their profits and getting a free ride on the brokers’ stock promotion efforts.  This hurts the brokers as it makes it difficult for them to maintain a high market price for the shares.  While the brokers try to discourage or prevent such behaviour, I believe there are ways around it.

Brokers love funds that never flip their shares.  They might provide subtle kickbacks to the managers behind these funds.  For example, a broker could give kickbacks by giving individuals shares of heavily oversubscribed IPOs to flip in their personal accounts.  For this reason, I am extremely skeptical about funds and companies that consistently participate in private placements.  While the money managers may simply be stupid rather than crooked, both scenarios often end poorly for shareholders.

Doubling down

A manager can keep a (bad) investment going by repeatedly injecting more and more capital into that investment.  The constant injections of capital can create accounting profits if the assets are marked to market or to fair value.  However, it is likely that these gains will be ephemeral if the investment does not create anything of value.

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