If you’re not a SPAC or Visa Inc., the initial public offering market is pretty much dead.  The shell merger market is holding up relatively well, however, and may even be poised to produce a surge in completed deals in the second and third quarters, industry insiders say.

To be sure, reverse merger activity has not been immune from market woes.  Deal totals are down 41% from the fourth quarter and 24% from the year-earlier quarter.  But reverse merger deal flow has weathered the downturn better than the IPO market, which is down 83% since last quarter and 73% year over year.

There were 45 reverse mergers during the first quarter valued at $1.3 billion in market cap, for an average deal size of $35.9 million.  In the fourth quarter 2007, there were 76 reverse mergers, valued at $1.75 billion.  For comparison, there were only 12 IPOs in the first quarter, according to Hoover’s IPO Scorecard.  They raised a total of $18.9 billion, but $17.9 billion of that was from Visa’s mammoth offering.

Meanwhile, cash-hungry businesses that previously would not have considered a reverse merger are said now to be clamoring for shell companies to facilitate transactions, fattening the deal pipeline for future quarters.

Rule 415 Hampers APOs

The total amount of proceeds raised in private placements subsequent to reverse mergers, commonly known as alternative public offerings, dropped by more than half in the first quarter compared with the fourth quarter.  That may be partly because of more aggressive enforcement by the Securities and Exchange Commission of Rule 415 of the Securities Act.

Some industry watchers have reported that a growing number of stock registrations are being delayed as SEC staff raise concerns about compliance with Rule 415. 

Rule 415 limits the amount of stock a company can register relative to its market float.

The heightened focus on Rule 415 in the first quarter is a reversal for the SEC, which in 2007, had adopted a loosened interpretation of the rule.  The move last year had given companies more leeway in the amount of stock they could register in a reverse merger that included a concurrent PIPE.

During the first quarter, 36% of reverse mergers included a private placement, raising total proceeds of about $89 million, or an average of $5.5 million per placement.  In the fourth quarter of 2007, one-third of APOs raised $190 million, or more than twice as much.

APO investment may also be slowing because a lot of funds are suffering liquidity problems, said Christopher Casey, a managing partner at Intaglio Partners in New York.

“I am hearing from some funds that they are rebalancing their portfolios and not making new investments for the next 30 to 60 days,” he said.  “Some funds that committed to investments a couple of months ago aren’t returning calls now.”

Of those funds that are still investing in APOs, few are interested in straight common share deals, Casey said.  Most favor convertibles instead.

“The market was terrible and investors were more focused on salvaging what they owned rather than new opportunities,” in the first quarter, said Mark Elenowitz, chief executive of boutique investment bank TriPoint Global Equities.  “And there are some deals out there that are having huge 415 issues.”

Elenowitz said that TriPoint has been hired by several companies to help them with placements arranged by other agents, that are now delayed by issues relating to Rule 415.

“Some investors and placement agents aren’t looking ahead to the potential problems that large warrant positions can cause with Rule 415,” he said.  “But what can happen when the registration doesn’t go effective because of Rule 415?  The warrants become cashless a year later and a financing done at $2 becomes readjusted to 50 or 75 cents.”

TriPoint was the placement agent on one of the largest APOs of the first quarter.  In that deal, Chinese drug maker Tianyin Pharmaceutical Co. raised $15.2 million in an oversubscribed placement originally intended to bring in about $12 million.  Pope Asset Management and Vision Capital Advisors were among the investors in the offering.

Tianyin issued 152 units, each including a $100,000 convertible exchangeable note and 62,500 common share purchase warrants.  The notes were convertible at $1.60 per share.  Tianyin issued two types of warrants:  five-year warrants exercisable at $2.50, and seven-year warrants exercisable at $3.  Tianyin’s shares have traded between $2.55 and $3.50 since the Jan. 16 merger, closing on April 8 at $2.70.  The registration statement for shares issued in the APO is not yet effective.

Elenowitz remains upbeat about the APO market.  He said that his firm has about $100 million in deals planned through the end of the summer.

“I am finding that some of the bigger players that haven’t typically participated in this market are now coming to us and asking to participate because it’s the small-cap companies that are still growing 30% to 50%,” he said.

Offshore Strong Source of Deals

More than one-quarter of reverse mergers in the first quarter involved private Chinese companies.  Such deals created $210 million in market cap value.  The average Chinese merger during the quarter was worth $17.5 million, about half the size of a typical first-quarter merger.

The number of Chinese deals decreased by more than half compared with the fourth quarter 2007, when there were 30 closed mergers valued at $555 million.  About 40% of fourth-quarter mergers involved a Chinese operating company.  In the first quarter 2007, there were 15 Chinese mergers that raised $247.9 million, or an average of $17.7 million.

Chinese companies have largely driven growth in the reverse merger market, but other overseas locales also piqued the interest of U.S. dealmakers in the first quarter of 2008.  Companies with operations in Argentina, Cameroon, Canada, Greece, Korea, and Panama also completed reverse mergers with U.S. shell companies.  These mergers were about 23% smaller on average than Chinese mergers, and created companies with market caps ranging from $330,000 to $49.1 million.

Halter Financial Group, which specializes in advising on Chinese transactions, is among the firms expanding their global reach.  “We have a pretty full pipeline at the moment, with several non-U.S., non-China deals in the mix,” founder Tim Halter said in an e-mail.  Those include deals involving operating companies in Eastern Europe, Latin American and India, he said.

Halter said his firm closed four deals in the first quarter, including two APOs and two reverse mergers without PIPEs.  All four were with Chinese companies.

The largest Chinese reverse merger of the first quarter was done by a company that manages a major toll expressway in China.  Pingdingshan Pinglin Expressway, owned by a group of British Virgin Island companies, acquired 68% of shell Learning Quest Technologies, creating a public company with a market cap of $129.9 million.  Pingdingshan’s revenue grew about ninefold to $38.5 million in the company’s 2007 fiscal year.  The company’s stock has risen about 8% since its Feb. 8 merger, closing at $4.95 on April 3. 

SEC Drops SB Forms

The pace of new Form-10 shell filings slowed slightly at the end of the quarter.  That may have been because of the SEC’s abandoning of “SB” forms, which had been reserved for small business issuers.  David Feldman, a founding partner with New York based law firm Feldman Weinstein & Smith, said that many companies rushed to get their filings in before the somewhat simpler 10-SB forms were discontinued on Feb. 4.

Feldman said that he is creating 19 shells for seven different issuers that will be filed with the SEC in the next 30 to 60 days, and has another 11 shells on the back burner.

Feldman said he expects the reverse merger market to soon see a dramatic increase in its number of players.

“I’m meeting with people interested in reverse mergers daily that I never though would be interested,” he said.  “I am even getting interest from private equity firms—the last holdouts.”