What was largely a niche product is now starting to draw significant interest from mainstream buyout firms as an alternative vehicle for acquiring portfolio companies. However, buyout shops must be sensitive to several important structural considerations not faced by, or of secondary importance to, other sponsors, or so-called promoters, of special purpose acquistion corporations (SPACs).
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 more targeted approach, the SPAC is able to leverage off of the promoter’s particular expertise and contact base. It also has a better story to market, enhancing the likelihood of a successful offering.
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 it 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, and there has been a movement toward proven management teams with relevant industry experience.
Hedge fund promoters in particular often need to round out the SPAC deal team prior to launch. In many cases, the hedge fund has industry or country 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 they 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 require significant lead time.
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 in order 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 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.
Institutionally-sponsored SPACs require even greater sensitivity to conflicts of interest, since some of the promoter’s other vehicles may overlap with the SPAC. For example, the promoter may have an existing private equity fund, manage a business development company, or make illiquid investments through a hedge fund. 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 that those done through the promoter’s other vehicles. However, even where there is little overlap, the promoter may need investor consent to do the SPAC, depending upon the contractual rights of its existing fund investors. 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 disclosure of SPAC-related conflicts to potential investors in those vehicles, as well as 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. A 20 percent promote was the market standard until this year. However, investors have begun to push back on the promote in some recent deals. In addition, in mid-March, Goldman Sachs announced that it intends to enter the market with a structure contemplating a management promote of 7.5 percent. Downward pressure on the size of the promote is likely to continue.
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 percent and 5 percent of the size of the public offering and can therefore be several million dollars or more. This investment helps to fund the trust, 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 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, 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 no where near as nimble as a private equity or hedge fund. It must receive shareholder approval, via a proxy solicitation, in order to complete its initial business combination. 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 percent. Second, public stockholders owning not more than a stated percentage, typically 30 percent, of the shares sold in the IPO 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 percent of the IPO shares. As discussed above, some recent institutional promoters also have incorporated 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. If the SPAC does not complete an initial business combination within this 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 deal infrastructure and experience.
The Road Forward
During the first part of 2008, SPAC deal terms have moved further in the direction of the investor. In addition to downward pressure on the promote, there has in recent months been upward pressure on the percentage of cash placed in trust at closing. In addition, warrant exercise prices have trended down and exercise periods have lengthened.
Furthermore, as of late March, the new issuance market for SPACs had slowed substantially, with many of the traditional hedge fund buyers looking to monetize some of their existing SPAC positions before making new investments. Investors also have been concerned about the completion of initial business combinations.
Despite 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 SPAC 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 with its existing product platform. It may enable the manager to pursue opportunities that are not appropriate for its existing funds or to develop a nascent private equity strategy. 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 a more advantageous structure for pursuing a roll-up strategy.
On the demand side, anecdotal evidence indicates that hedge funds still have substantial interest in investing in SPACs sponsored by more experienced promoters. Underwriters also have begun to actively court fundamental investors as SPACs have become larger and the promoters more well-known. Both of these trends favor institutional SPAC promoters.
From initial consideration until completion of a SPAC IPO is often a four to six month process for an institutional manager and, in some cases, longer. Therefore, now is the time to consider whether a SPAC should be part of your platform.
Michael R. Littenberg is actively involved in representing alternative asset manager issuers, underwriters, promoters and investors in SPAC transactions, and has represented parties in capital markets transactions and ongoing securities law matters for almost 20 years. He can be contacted at michael.littenberg@srz.com.
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