THE PREVIOUSLY red-hot market for special purpose acquisition companies, or SPACs, succumbed to the general market malaise in the second quarter of 2008. This was in sharp contrast to the first quarter, which saw 12 SPACs successfully raise over $3 billion and approximately 30 new SPACs filed with the SEC.
In the few weeks prior to presstime, however, there have been encouraging signs that some life may be returning to the SPAC market. A new SPAC—formed by a promoter with significant experience in that SPAC’s target industry—priced during late June 2008 and raised $220 million. Three other new SPACs filed registration statements during that month. In addition, the last few months saw announcements of several initial business combinations that the SPAC sponsors hope will have sufficiently attractive economics to win shareholder approval. Industry watchers expect that a string of successful initial business combinations will help to break the logjam in new SPAC issuances.
In anticipation of a turnaround in the SPAC new-issuance market, many of our institutional manager clients are using the current market lull to get up to speed on the product and build the necessary infrastructure to add a SPAC to their product platform once the market rebounds. Institutional managers must be sensitive to several important structural considerations not faced by, or of secondary importance to, other SPAC promoters.
Determining the Focus
Notwithstanding the flexibility built into the product structure, many SPACs, whether or not institutionally sponsored, opt to focus on a specific industry or geographic area of the world. By adopting a targeted approach, the SPAC is able to leverage the promoter’s particular expertise and contact base. A SPAC that capitalizes on the promoter’s strengths is substantially more likely to get done, as prospective SPAC investors in recent transactions have become much more focused on the sponsor’s ability to source and evaluate a quality initial business combination.
The institutional promoter must be especially sensitive to the SPAC’s investment mandate. To the extent possible, it will want the SPAC to dovetail with its other activities without raising investor consent issues or potential conflicts. If the promoter has expertise in multiple industries or geographic areas of the world, it also may wish to give the SPAC a fairly narrow focus to enable the promoter potentially to have more than one SPAC in the market at the same time.
Building the Management Team
As the number of SPACs and their size has increased, investors have become more discerning. There has been a movement to proven management teams with relevant industry and deal experience. SPAC investors have become focused on the ability of the promoter to complete an initial business combination. Furthermore, once an initial business combination has been announced, before buying the SPAC equity, fundamental investors will require a management team that they believe can continue to grow the target and enhance equity value.
Hedge fund promoters in particular often need to round out the SPAC deal team prior to launch. In many cases, the fund has industry or geographic experience, but lacks private equity experience. There are two approaches to building the SPAC team. One approach is to partner with an external team with acquisition experience. The team is not employed by the promoter, but instead participates in a piece of the promote and the promoter investment, with some agreement between the parties regarding the amount of time and resources that each will devote to the SPAC. The second approach is to hire additional management company personnel. Compensation arrangements vary widely in terms of both equity and cash, as well as other retention terms. With either approach, however, this tends to be a significant lead-time item. In addition, as a public company, a SPAC is subject to periodic public company reporting. Although the reporting regimen is not as complicated as for an operating company, many institutional promoters need to build out their financial reporting and/or legal compliance function to adequately handle both the initial offering and ongoing public company compliance for the SPAC.
Addressing Potential Conflicts
SPACs are structured to mitigate some conflicts. The SPAC usually may not enter into an initial business combination with a target in which any of its affiliates has a financial interest. In addition, prior to the completion of the SPAC’s initial business combination, the promoter generally must give the SPAC the first opportunity to pursue any acquisition opportunities that meet the SPAC’s investment parameters.
In the case of institutionally sponsored SPACs, greater sensitivity to conflicts of interest is required due to the possibility that one or more of the promoter’s other vehicles may overlap with the SPAC. For example, the promoter may have an existing private equity fund, own an operating business that may seek similar acquisition opportunities, manage a business development company and/or make illiquid investments through a hedge fund-type vehicle. There also may be potential conflicts with future activities.
Some promoters seek to minimize conflicts with existing vehicles by giving the SPAC a different focus. For example, the SPAC may pursue deals that are significantly larger than those done through the promoter’s other vehicles. However, even where there is little overlap, a promoter with an existing fund business may, depending upon the contractual rights of its existing investors, need to obtain investor consent to create the SPAC. Even where consent is not required, disclosure to existing investors still may be prudent. In some cases, to eliminate conflicts, the promoter may opt to make the SPAC investment through an existing investment vehicle or to offer existing investors the opportunity to participate in the SPAC. To the extent that the promoter establishes other vehicles after the SPAC IPO, it also must be sensitive to the need to disclose SPAC-related conflicts to potential investors in those vehicles, as well as the allocation of investment opportunities.
The Promoter’s Equity Investment
The promoter’s equity investment takes the form of promote shares and privately placed securities.
The promote shares are purchased for a nominal purchase price. Until recently, a 20% promote was the market standard. The most recent deal to price featured a 20% promote. However, one recent deal that did not price went to market with a 7.5% promote. Another deal that had not gone to market by press time filed with a 10% promote. Many SPAC watchers expect that there will be significant downward pressure on the historical 20% promote in many future deals. The privately placed securities purchased by the promoter take the form of either privately placed units or warrants. The size of the private placement investment depends on the size of the SPAC, but it is usually between 2% and 5% of the size of the public offering and can therefore be several million dollars or more. This investment helps to fund the trust account, while also giving the promoter the opportunity for additional upside.
An institutional promoter must decide how it wants to hold and fund its SPAC investment at inception, before it makes its nominal promote equity purchase. It may hold the promote and private placement investment directly, including in one or more of its funds, or through a pass-through holding company, which typically is structured as a limited liability company. In many cases, institutional promoters opt for a holding company structure, since it affords them more flexibility as well as the ability to control the monetization of the promote shares and privately placed equity to the extent that the promoter has co-investors.
Another consideration for institutional promoters, given their often significant cash resources, is whether to include a Rule 10b5-1 repurchase component as part of the SPAC. This feature requires the promoter to place limit orders for up to a specified amount of common stock during a buyback period that commences after the filing of the preliminary proxy statement for the SPAC’s initial business combination. The limit order requires the promoter to purchase any shares of common stock offered for sale at or below a price equal to the per share amount held in the trust account, to the extent not purchased by another investor. From the promoter’s standpoint, Rule 10b5-1 repurchases may help to stabilize the share price and increase the likelihood of completing the initial business combination.
Completing an Acquisition
The acquisition approval process is the single biggest drawback to the SPAC structure for most institutional promoters.
A SPAC is nowhere near as nimble as a private equity or hedge fund. To complete its initial business combination, the SPAC must receive shareholder approval via a proxy solicitation. Two other significant requirements also must be satisfied.
First, the target business must have an aggregate fair market value equal to a stated percentage of the balance in the trust account, typically 80%.
Second, public stockholders owning not more than a stated percentage of the shares sold in the IPO, typically between 30% and 40%, must not have voted against the initial business combination and exercised the right to convert their shares to cash, which entitles them to a pro rata share of the trust account. In order to reduce conversion risk, recent SPACs have capped the conversion right of a stockholder or group at 10% of the IPO shares. As discussed above, some recent institutional promoters also have incorporated Rule 10b5-1 repurchase components into their SPACs.
In addition, the SPAC has a fixed amount of time following the IPO to complete an initial business combination, typically two years, although some recent deals provide for an extension to 30 or even 36 months under certain circumstances. If the SPAC does not complete an initial business combination within the requisite time frame, it liquidates and the trust proceeds are paid to the public investors. However, institutional SPAC promoters tend to be more concerned about the uncertainty of obtaining shareholder approval than with their ability to source deals on a timely basis, given their infrastructure and experience.
The Road Forward
Notwithstanding current market conditions, most SPAC watchers believe that the institutionally sponsored SPAC is here to stay and is likely to capture an expanding portion of new issuances. Even with the recent pressure on promoter economics, the conventional wisdom is that in a larger SPAC the return profile will remain attractive to many institutional promoters, especially those requiring little additional infrastructure to launch a SPAC.
For many managers, a SPAC will fit nicely within the manager’s existing product platform. The SPAC may enable the manager to pursue opportunities that are not appropriate for its existing funds or to develop a nascent private equity strategy. A SPAC also may enable the manager to capitalize on acquisition opportunities that are not as well-suited to its existing private equity vehicles. For example, as a publicly traded vehicle, a SPAC may be a more attractive merger candidate for a seller that wishes to retain a significant equity stake or a target seeking to become a public company. A SPAC also may be more advantageous for pursuing a roll-up strategy.
On the investor side, anecdotal evidence indicates that hedge funds still have substantial interest in SPACs as a product, although the market has been migrating to more experienced promoters. As SPACs have become larger and the promoters more well-known, underwriters also have begun to actively court fundamental investors, although with limited success thus far. Both of these trends favor institutional managers.
From initial consideration until completion of a SPAC IPO, an institutional manager is looking at a process that usually takes from four to six months and, in some cases, longer. Therefore, now is the time to consider whether a SPAC should be part of your platform.