Regulation D Strategies

Regulation D of the U.S. Securities Act of 1933 allows public companies to raise capital through private placements of unregistered securities. Private placements are cheaper and less time consuming than public issuances of securities and are thus an attractive alternative. In a Regulation D strategy, a hedge fund manager takes a long position in privately placed unregistered securities (stocks, convertibles, options, or warrants) issued by a publicly traded small or micro capitalization company.

Convertible or debenture securities with high coupons and short maturities (1.5 to 5 years) are the most commonly used investment in a Regulation D strategy. Conversion features allow the manager to obtain an equity position in the issuer at a discounted price (often 15% to 40% below the market price) after registering the securities with the SEC. Once converted, the shares can be sold on an exchange after an agreed-upon holding period has lapsed. Conversion prices in a Regulation D strategy are often negotiated to be floating, which effectively maintains the conversion spread and hedges price exposure. Issuers are often required to register the private securities within 60 to 120 days after the transaction or pay a penalty to the investor. The key component in structuring the convertible transaction is the choice of conversion price (i.e., fixed or floating). In some instances, the manager may short the issuer's common stock (and depress its price) to protect the investment until conversion is viable. The effects of shorting and dilution from conversion can create a "death spiral" (i.e., the stock price falls, greater dilution occurs, the stock price falls again, and so on).

Regulation D strategies require bottom-up analysis of the issuer before capital is committed. The analysis should center on the issuer's financial condition, strengths and. weaknesses of the issuer's management team, the liquidity associated with the issuer's stock, and a thorough assessment of the business environment of the issuer.

Risk and Return for a Regulation D Strategy

Hedge fund managers pursuing Regulation D strategies utilize their specialized knowledge of Regulation D issuances in conjunction with their ability to negotiate and successfully manage the private placement to generate alpha for investors. Since Regulation D strategies involve small and micro capitalization companies and private securities, information inefficiencies exist that allow for potentially high returns from mispricings. However, a portion of the returns to Regulation D strategies comes from premia associated with exposure to systematic risks including credit risk (e.g., issuers have relatively low credit ratings) and liquidity risk (e.g., unregistered issues from small-cap companies).

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