By Richard Hefter, Editor, Small Cap Manager

In its three years of operation, Bristol Investment Fund has navigated through some historical extremes in market sell-offs and rallies, and the fund, true to what its charter purports (to be non-correlated to the direction of the market) has managed steady, robust returns of 19%, 36% and 34%, respectively, in 2001, 2002, and 2003 -- net of fees. The Los Angeles-based hedge fund, with $21 million now under management, garnered these returns investing in PIPES -- private investments in public entities -- and its co-founder and co-manager Paul Kessler, together with Mark Tunney, an advisor to the fund, describe why this strategy is on such a win streak.

Q: Would you describe your fund's strategy?

To identify emerging small-cap and middle-market growth companies that we believe are trading at a discount to their peer group, and then make investments through negotiated PIPE structures.

Q: What are PIPES?

PIPEs are private investments in public entities. Investments can be in the form of convertible debentures, convertible preferreds, or straight common stock, and most of the structures carry warrants. Although we seek to make our return through the common, preferred or convertible instrument, the warrants have the potential to increase the rate of return in our investment.

Q: What is the advantage of this kind of investment?

Over the last 12-13 years PIPEs have become an institutionalized business adopted by the major firms on Wall Street as an important and flexible financial tool to finance public companies. It became very popular especially after the crash of technology or Internet companies in the spring of 2000 when the investment banks were not getting secondaries and/or IPOs done. So, many of the companies that were public needed to raise capital in some manner and they turned to the PIPE funds like us for that capital.

From our perspective, it's a unique opportunity, as we focus in on market sectors that have high rates of return. We like to focus on biotech, medical devices, life sciences, technology, service industries -- sometimes special situations and companies that really have strong fundamentals that are overlooked by the Street in general but have excellent management and simply need capital to grow their businesses. We find those opportunities and structure what we believe to be an appropriate investment deal.

Q: How do you minimize the risks of investing in what are often young, speculative companies?

I think one of the differentiating factors is we mitigate much of our risk by the way we invest. We're not necessarily buying common stock as a common investor would in the stock market, but rather we're trying to structure instruments that provide us protection.

Q: Do you mean because you're buying at a discount?

We're buying it at a discount, so that's one way to mitigate risk. In some structures we get coupons and/or dividends. And then, of course, we're also complementing that with warrant coverage.

Q: How do you identify these opportunities?

The good news is the companies find us, and they come from a variety of relationships that we have developed over the last decade and a half. We see a significant deal flow -- we're probably looking at anywhere from 35-50 opportunities a month coming from the investment banks, both large and small, as well as from SEC lawyers and accountants that specialize in this area. So we have a tremendous referral source.

Q: How many companies are you invested in?

We currently average four investments per month, and we probably have interests in about 40 companies.

Q: That's quite a lot considering the work involved in each deal.

We're pretty diversified and that's the way we like it. We don't want to be heavily weighted in any one sector nor heavily weighted in any one company, so we try to take a diversified approach.

Q: Can you talk about a couple of companies?

We don't normally comment on our portfolio.

Q: What's your typical holding time?

When we make an investment decision, we're basing that decision on numerous factors. We're looking at analysis the companies provided. We're looking at our internal analysis based on that. We're looking at factors that are inherent to the market price of the security, the quality of management, the products and services the companies are involved in, the sector they may be involved in, and we're really trying to identify undervalued companies that will give us high growth potential. When those companies start hitting milestones, we're more likely to become longer-term investors. Conversely, though, if companies fail to perform and don't hit the projections and milestones they set out, we may take a shorter-term view of the companies.

Q: Can you talk a little about biotech and what you like about the industry and how much of your portfolio is invested in it?

First and foremost it's a sector we like a lot. Life science, biotech and medical device companies account for approximately 40-45% of our investments at any given time. That's true in large measure by the fact that biotech companies are the largest issuers of PIPEs, largely because they consume a tremendous amount of cash. There really hasn't been a secondary market in recent years to assist these companies in raising the capital they need to grow. Life sciences represented approximately 19% of total PIPE transactions in 2003, which was an increase from the prior year. The PIPE industry raised just under $19 billion in 2003. Of that, biotechnology/pharma accounted for 257 PIPE transactions, representing $3.2 billion.

Q: What do you like about being in the biotech sector?

I think it's one of the few areas where you can achieve some very high rates of return, by doing your due diligence and understanding where these companies are headed and what their growth cycles are. Biotech companies in Phase II moving to Phase III can really reward you if you're invested in the right ones. They offer you tremendous blue sky potential seldom seen in other sectors. Also, it's a robust market. Biotech stocks by and large have strong liquidity and broad shareholder bases. When they hit their milestones, it can bring tremendous growth and stock appreciation.

Q: Anything you'd like to add?

I think the advantages again are that we really strive to achieve consistent and above average rates of return in any market environment, whether it be a market we've seen in the last eight months, where the Dow and the underlying sectors have really performed quite well, or one where the market turns sour. We still believe based on our investment philosophy and approach that we'll have the ability to achieve a higher rate of return, uncorrelated to anything that goes on within the market or the general economic picture.

I would also add we're very big supporters of the PIPE financing structure. We feel they offer the issuers significant advantages over traditional IPOs and secondary offerings simply because they're so flexible and thus tend to be more cost effective. Traditional offerings require you to spend half a million dollars preparing a registration statement over the course of 3-4 months and hoping that the capital markets window will be open four months down the road. PIPEs, on the other hand, are very efficient and can be negotiated, structured and closed within two weeks using an instrument that's appropriate for each company. So a very healthy company may be financed with common stock at the market price, whereas companies that may not be quite as healthy might utilize convertible preferred or debenture structures at a discount to market.

Q: It doesn't sound like something individuals could simply invest in on their own.

Not a chance. It's far too technical. There are obviously barriers -- for example, you have to qualify as an accredited investor or be a qualified institutional buyer. The deal flow is very complex. My wife and partner who I co-manage the fund with is a securities lawyer, and we have another securities lawyer who works as well within our group, and a full-time analyst. So it's very heavy on the legal, very complex, very technical in terms of managing the process both prior to and post investment. There's a tremendous amount of work that goes into every facet of what we do.

© 2004, Small Cap Manager, published by AdviceTrade, Inc., sponsored by JM Dutton & Associates.