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Private Equity

SPACs may give traditional PEs a run for their money

Special Purpose Acquisition Companies (or SPAC) appear to be in vogue for corporate acquisitions. Also described as “blind pool”, “blank-check” or “development stage companies”, a SPAC, without any assets, revenue or operational history, raises money through an initial public offering (IPO), based on the strength of its management team, industry and geographic focus, with the intention of merging with or acquiring an unknown company or asset in the future. Some recent India specific SPACs include Indian Globalisation Capital Inc; Phoenix India Acquisition Corporation; and Millennium India Acquisition Company.

This article describes the evolution and structure of SPACs, the trust arrangements that SPACs undertake to protect IPO proceeds and also explains the potential risks and advantages associated with an acquisition through a SPAC.

Fashionable in the United States in early 1990’s, SPACs faded away because of their unpopularity with regulators. However, the last decade has witnessed a revival in the number of SPAC filings with the United States Securities and Exchange Commission (SEC). This new wave of SPACs are an improvisation on “blank check companies” since these they issue units that are not “penny stock” i.e. the stock is priced above $5. One of the other distinctions is that current SPACs, upon completion of its IPO, usually have tangible assets in excess of $5 million and are hence exempt from the provisions of US securities laws.

The organizational structures of SPACs are fairly standard, with most being organized as “C” corporations (a corporation whose profits are taxed separate from its owners under chapter C of the US Internal Revenue Service) under the Delaware state laws. The management team and founding shareholders make the initial investment into the company and as part of such investment purchase, for a nominal amount, common stock. Immediately upon incorporation, the management team appoints an investment bank to assist the SPAC raise money either through a PIPE (private investment in public equity) transaction or otherwise. In return for the investment, the SPAC issues units typically priced at $6/unit, consisting of one common stock and two warrants exercisable at a later date, all of which are eventually individually publicly traded. Thus, upon conclusion of its IPO, the management would typically control 20 per cent of the share capital and 80 per cent would be with the public shareholders. The management’s 20 per cent is typically locked-in for between 2-3 years after the proposed future acquisition.

Once the IPO is completed, SPACs normally deposit almost 90 per cent of the IPO proceeds (net of expenses) into a trust, to be used as consideration for the acquisition of a target or for distribution to the public shareholders if an acquisition if not affected within the stipulated time, resulting in the SPACs liquidation. In some recent SPACs, even the trust deposit is further invested into short-term government securities and the interest derived is used to meet the company expenses. It is standard to stipulate a period of 18-24 months for consummation of most SPAC transactions. However, such time periods may be extended (by public shareholders approval) where the management has entered into definitive agreements but when the transaction is still to be consummated. Typically, for a SPAC to consummate an acquisition the fair market value of the target must equal a minimum of 80 per cent of the SPAC net assets and given that the SPAC is public company, the proposed acquisition must be approved by a majority of its public shareholders. If approval is not obtained the management either, has the right to buy from such disapproving shareholders the units they hold, or the SPAC would be liquidated and the money from the trust account would be distributed to public shareholders. On such liquidation, the management team would continue with its initial locked-in units which may no longer be fungible, but at least the public shareholders money is returned.

Although the SPAC structure is approved by the SEC, it is not without some risks. Foremost among them is that even after placing the funds in a trust, potential third parties or even a prospective target can bring claims against the SPAC and seek to have the trust funds attached or applied to their claims. Also, there is pressure on the management team to consummate acquisitions within the timeframe of 18-24 months and this pressure could lead to the company making hasty acquisitions of overvalued targets. Additionally, given the IPO is completed when the company has no assets or track record, public shareholders are making investments largely on the basis of their faith in the management’s ability to create value based on their industry expertise.

On the flip side, SPACs can and do enter into agreements with all prospective targets and other entities, protecting the money deposited in trust, in principle, leaving them out of the reach of potential creditors. The risk of overvaluation is reduced, given that a public shareholders’ vote is necessary to effect acquisitions, and they largely employ objective criteria when selecting transactions. Amongst its advantages, SPACs afford the flexibility both to the management team for selecting acquisitions and to the investor, since the shares and the attached warrants are publicly traded. But its greatest advantage is that SPACs allow small companies and individual’s access to capital, which they otherwise may not have. Furthermore, it allows individuals to formulate the business case for corporate acquisitions, making them feel that besides their monetary contribution, they add value.

In the long run, SPACs will compete with PE players and when investment opportunities become scarce, there could potentially be a struggle between them to grab the best deals. But unlike traditional PE funds, where management fees are high, SPACs maintain low operating costs. While most PE funds have an operating history and raise money against a clear strategy for identified targets, SPACs offer a more flexible approach to acquisition risk. What remains to be seen is the ability of SPACs to sustain the returns they promise which will determine whether they are here to stay or are yet again a passing fad.

First Published in the Business Standard on September 10, 2007

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