December 2015 Issue
Having previously disappeared into the folder marked ‘Inactive’ in the years following the 2007/08 financial crisis, the special purpose acquisition company (SPAC) collective investment structure has now returned to add a certain frisson to an often staid corporate landscape.
An intermittent presence in the US since the 1990s, and less well-known in Europe, a SPAC, for those unfamiliar with the concept, has been defined by the US Securities and Exchange Commission (SEC) as a “development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person”.
In other words, a SPAC is a means by which funds can be raised via public investors, investment opportunities identified and a purchase made with the potential for large rewards. That said, although attractive in that they offer investors a largely guaranteed return, SPAC participation is by no means a foolproof undertaking.
According to SPAC analytics, in 2014/2015 there were 30 SPACs registered as a means of executing a deal. This activity includes the recent conversion to the acquisition company model by a number of US private equity firms, such as TPG Capital which raised $460m in August 2015 through the use of a SPAC, Avenue Capital Group which raised $220.5m via its SPAC, and WL Ross’ SPAC success to the tune of $435m.
Furthermore, over the past five years, average deal sizes have risen in value from $36m to over $200m, with gross proceeds increasing substantially from $36m to $3.5bn – a further indication of how SPACs are once again a viable investment option.
Once the weapon of choice among sophisticated investors, the SPAC seems to be back in favour and once again an attractive proposition for both investors and potential business combination counterparties alike.
Recent activity in the SPAC space
The financial crisis weakened overall IPO market activity, with a knock-on effect for the SPAC market, only really recovering in 2013. Following this period of inactivity, SPACs are currently undergoing something of a renaissance, a scenario that has been assisted by a number of factors, including low worldwide interest rates that have led to a search for yield, an increased risk appetite among investors, and the increase in importance of emerging markets where SPACs can be a very effective instrument in getting exposure.
Recent regulatory changes in the US have also served to make SPACs a more attractive investment proposition, with NASDAQ making changes to its listing rules so that the requirement for SPAC acquisitions to be subject to prior shareholder approval is no longer necessary. The uncertainty of the shareholder vote had proven to be a deterrent to sellers of high quality companies who became wary of entering into transactions with SPACs. Douglas Ellenoff, business law attorney at Ellenoff Grossman & Schole LLP, observes that because there are fewer ‘regulatory frictions’ persisting at the time of the IPO, the result is that the quality of the groups involved have risen to encompass the most respected private equity firms in the US. “These sponsors have not only successfully completed SPAC IPOs, but also have business combinations executed via SPACs which have performed well operationally and in the markets on a post business combination basis,” says Mr Ellenoff.
“SPACs are usually more liquid than traditional PE investments.”
Like NASDAQ, NYSE Amex has similarly amended its listing rules, which again resulted in a boost to the attractiveness of SPACs to investors. “There have been some recent SPACs that have executed deals that have gone on to trade well in the market, which has further eliminated some of the reputational taint previously associated with ‘blank cheque’ companies generally,” says Carol Anne Huff, a partner at Kirkland & Ellis LLP. “Larger investment banks have also increasingly acted as underwriters in SPAC IPOs, increasing the familiarity of investment professionals with this structure. As a result of this increased familiarity, sponsors with established track records in completing deals, including several large PE firms, have entered the space. All of these factors make sellers of target companies more willing to engage with SPACs,” she adds.
Omer Abdullah, co-founder and managing director of The Smart Cube, attributes the recent upsurge in SPAC activity in the US to the improvement in investor confidence seen since the financial crisis. “As the stock market’s performance improved, it became relatively easier for SPACs to get required funding by selling shares and using own shares to acquire businesses,” he explains. “And the fact that SPACs offer an alternative way for private equity firms to raise capital and provide viable exit opportunities makes them popular among the investor community.”
SPAC structures
Whilst the SPAC investment vehicle lay in a dormant state for a number of years between 2008 and 2013, numerous changes to its structure and investment terms were underway – alterations that subsequently have had a major impact on investor appetite and challenged the perceived wisdom around how SPACs are best utilised.
In addition to the NASDAQ/NYSE Amex reconfigurations, amendments made to SPACs securities have also proved significant. “Typically, SPACs offer units, consisting of one share and one warrant to purchase a share,” explains Simon Schilder, a partner at Ogier. “Historically, the warrant strike price was set significantly below the IPO price of the units, risking a potential significant dilution for shareholders from ‘in the money’ warrants, which put downward pressure on the trading prices of SPAC shares. By contrast, the strike price of SPAC warrants now tends to be set above the IPO price.”
A further change in SPAC structures is the reduction in the number of warrants issued by the SPAC as part of the IPO units from two warrants to one, and, more recently, a further drop to one-half or even one-third of a warrant. “The potential overhang of the warrants had been viewed as a negative factor by target companies and by investors purchasing the SPAC’s stock in anticipation of the closing of a business combination,” points out Ms Huff.
In recent years there has been the shift in focus towards niche sectors, with shareholder voting features being modified to increase the redemption threshold and provide shareholders with the option of getting their money back even after voting in favour of the business combination. A tender offer option is also included in the agreement, wherein stockholders can redeem stocks for cash upon consummation of the business combination. In addition, the conversion threshold which dictates the power of SPAC investors to veto a specific acquisition proposed by SPAC management has also increased. “These changes help fix the issue of hedge funds and activist investors misusing stockholder voting requirements to obtain additional consideration, reduce hurdles in completing business acquisition, thereby, helping renew interest in SPACs,” says Mr Abdullah.
SPACs: reward and risk
In the rarefied world of the SPAC, the chances of an investment resulting in a healthy return and one that bottoms out can often be marginal. For the private equity firm looking to execute a deal utilising a SPAC, reward and risk are but two sides of the same coin.
In terms of reward, because the sponsor is issued 20 percent of the pre-business combination equity for a nominal price, SPACs have always presented great upside potential for sponsors that are successful in executing a business combination. “This is more favourable than a ‘carried interest’ to a private equity fund’s manager in that carried interest is an interest only in appreciation, while the ‘founder shares’ are an interest in the SPAC’s capital as well as appreciation,” says Ms Huff.
The view that SPACs represent an attractive alternative mechanism for private equity firms executing deals has been bolstered by SEC regulations that purport to provide transparency and confidence for investors. The SEC regulations, notes Dr Lars Helge Hass, associate professor of finance and accounting at Lancaster University, reduce the expert knowledge requirements of investors, making SPACs attractive for a broader group of investors. As an additional inducement, SPACs are usually more liquid than traditional PE investments.
In terms of risk, a lack of transparency, lack of a focused business plan, and high dependence on the trustworthiness of the sponsors are often cited as the main reasons why SPACs make for a risky investment. “Unlike private equity firms, a SPAC means an investment in one company, not a portfolio of companies, so the risk of loss is increased,” points out Mr Abdullah. “With up to two years in hand to identify a target company for acquisition, SPACs may rush to complete an acquisition, which may sometimes lead to bad choices.”
Illustrating the potential consequences of a ‘bad choice’, according to SPAC Analytics, during the 2003 to 2015 period, 76 out of 228 SPACs liquidated, earning no return for investors. Furthermore, 127 SPACs that did complete an acquisition witnessed a -12.1 percent annualised return.
SPAC: the participation decision
The expression ‘timing is everything’ is universally understood and relevant to the question of when and if a potential investor should get involved with a SPAC. “At the time of the IPO, it is all about whether the sponsors can identify and secure a quality target so that the IPO warrants have value. After the announcement and closing of the business combination, it is all about the quality of the acquisition,” declares Mr Ellenoff.
Of course, whilst participating in a SPAC, investors should always be focusing on the quality of the entity that will be making the investment. As a rule, this should include an evaluation of the SPAC’s management team’s experience and track record, their ability to execute the acquisition, and the proposed investment strategy and business plan. “At the time of the SPAC IPO, the investor should opt for SPACs that offer a focused statement of purpose, which throw light on the defined idea or strategy of acquisition,” suggests Mr Abdullah. “During the time of target search, investors should keep track of the sponsors’ activity through news and market speculation. Once the target is spotted, they should verify the target’s fundamentals and market position before voting.”
For Dr Hass, the expertise of the management team and close adherence to a coherent incentive structure are the key determinants in the success of a SPAC investment. “Investors should pay careful attention to the experience and connections management team members provide,” he says. By way of an additional safeguard, he believes that investors should monitor the share price movements and block holder structure of the SPAC before proxy votes, as this is a good predictor of SPAC success.
SPAC to the future
Over the last year or two, the reputation of SPACs has been augmented by the success of deals executed by the likes of TPG Capital through the IPO of its Pace Holdings SPAC, Avenue Capital’s Boulevard Acquisition SPAC and the WL Ross Holding SPAC instigated by Wilbur Ross Jr, an investor well known for turning around troubled companies in private equity deals.
So, are we looking at a genuine resurgence in this type of transaction? Are SPACs the real deal once more? In 2015, 15 SPACs have been registered to date, with 10 others currently in the pipeline, highlighting the future viability of the SPAC. “The successful completion of a business combination utilising the SPAC structure by a sponsor that is affiliated with a top private equity firm will certainly increase interest among investment professionals in SPACs as an alternative investment vehicle,” says Ms Huff. “Sponsors affiliated with private equity firms may view this structure as an opportunity to leverage their resources and experience in identifying and completing deals.”
Underlining this seeming rebirth of the SPAC is the propensity for private equity firms to increasingly undertake such deals primarily to make investment outside of their main buyout fund. Prime examples of these are Pace Holdings, which raised $460m in April 2015, the $435m raised by WL Ross Holding in June 2014 and the $220.5m raised by Boulevard Acquisition in February 2014. “The improvement of investor confidence, strong stock market performance and recent changes in SPAC structure are likely to support the resurgence of this type of deal,” says Mr Abdullah.
Conclusion
Although recent activity appears to suggest that a SPAC as a viable investment vehicle is back in favour, the reception from the investor community has been somewhat mixed and it would take a brave character to suggest that SPACs are back for good.
They are certainly an attractive proposition in times when investor appetite is high and firms are looking to capitalise on attractive opportunities. But whether they are a go-to option when appetite is low and uncertainty pervades the stock market is less clear. This time around, it very much remains to be seen whether their recent re-emergence will ultimately result in SPACs entering the investment mainstream.
© Financier Worldwide
BY
Fraser Tennant