The market is driving change in the SPAC world

Carlos Lobo
Hughes Hubbard & Reed, New York
carlos.lobo@hugheshubbard.com

Gerold Niggemann
Hughes Hubbard & Reed, New York
​​​​​​​gerold.niggemann@hugheshubbard.com

The pandemic has kickstarted a tremendous growth of the special purpose acquisition company (SPAC) industry. 2020 was a record year for SPAC IPOs in every respect: according to Pitchbook, 2020 saw 276 SPAC IPOs, representing a 330 per cent increase over 2019. The first quarter of 2021 saw 329 SPAC IPOs – more than all of 2020 combined.

Despite a recent slowdown in new SPAC IPOs, SPACs continue to be a powerful deal-making force in the United States, and are increasingly embarking on cross-border business combinations and leading the way to the emergence of SPACs incorporated in different jurisdictions.

In simple terms, SPACs are shell companies that are incorporated by a sponsor and then raise capital in an IPO. A SPAC’s goal is to acquire a business in a stock-for-stock merger, making the combined company a listed company with the SPAC’s IPO proceeds at its disposal. This process of taking a target company public via a business combination with a SPAC is referred to as ‘de-SPACing.’ Due to the relative valuations of the SPAC and the target, the target’s stockholders typically hold a majority of the shares of the combined company after the de-SPACing transaction, often 80–90 per cent. Hence, from the target’s perspective, being acquired by a SPAC is akin to, as well as an alternative to, consummating an IPO.

However, there are significant differences between an IPO and a de-SPACing transaction. There are advantages and disadvantages: target companies and SPAC investors alike should carefully analyse the specific terms of the SPAC and the proposed de-SPACing transaction. One key advantage of de-SPACing is that the valuation of the target is locked in at the very outset of the process in the business combination agreement between the SPAC and the target – ie before the transaction is publicly announced and before any information on the target is publicly filed with the US Securities Exchange Commission (SEC) in a proxy/registration statement. This gives the target much more control over the process. By contrast, a company seeking to go public via a traditional IPO has to prepare and file the registration statement first in an extensive process with the SEC, then do a roadshow. Only at the very end of the process, when the underwriters have completed the book-building process, will the target know the IPO price.

In volatile markets, the extended timeline of a traditional IPO is suboptimal and IPO candidates risk missing their window of opportunity. Also, if the target is exploring multiple strategic alternatives such as selling itself or raising capital from private investors, the lack of visibility on the outcome of an IPO process many months in the future deprives the target’s board of directors of crucial data points. If, for instance, a private equity sponsor presents a term sheet for an acquisition of the company, the company’s board will not always be in a position to put those negotiations on hold until the company knows its IPO valuation. It thus cannot evaluate that alternative. Going public via a SPAC flips this timeline around and offers the board a clear choice from the beginning.

Finally, being able to show financial projections of the business to potential private investment in public equity (PIPE) investors, which is not possible in the context of an IPO, is also perceived as an advantage of the de-SPACing process – especially for fast-growing companies, which may be able to extract a more favourable valuation based on the expected future results. Note, however, the SEC has signalled it is considering revising the disclosure rules in that respect.

A disadvantage of going public via a SPAC is the potentially greater dilution that the target’s stockholders may suffer. There are unique mechanics at work in de-SPACing deals that can have a tremendous impact on the economics of the deal. This article describes some of these mechanics and how the market is addressing issues and driving change.

When sponsors incorporate a SPAC, the traditional arrangement was that they purchase shares at nominal value (ie, essentially for free), usually representing 20 per cent of the SPAC after its IPO. This 20 per cent stake is referred to as the ‘sponsor promote’. It is the compensation for finding a suitable target for a business combination. Sponsors also purchase a significant number of warrants, exercisable for more shares if the stock price hits certain thresholds after the de-SPACing transaction.

Investors in the SPAC’s IPO purchase units (typically $10 per share) consisting of a share and a (portion of a) warrant. Like the sponsor warrants, these warrants are exercisable for more shares if the stock price hits certain thresholds after the de-SPACing transaction. If the SPAC does not find a target company to acquire within a defined period, often 24 months from its IPO, the SPAC has to return the IPO proceeds to the stockholders. The IPO investors also have the right to redeem their shares in connection with the de-SPACing transaction if they do not like the target chosen by the sponsor. As such redemptions reduce the growth capital available to the combined company, target companies typically insist on a closing condition in the business combination agreement to the effect that, at the closing of the de-SPACing transaction, the SPAC must have a minimum level of cash after giving effect to any redemptions. Redemptions are en vogue: an average of 58 per cent of shares were redeemed in SPAC mergers that closed in August 2021, according to SPAC Research. To satisfy the minimum cash condition (amongst other reasons), SPACs often sell additional shares in a PIPE investment alongside negotiating the business combination. These PIPE shares cannot be redeemed in the business combination, but the closing of the PIPE is conditioned upon the closing of the de-SPACing transaction.

For the target’s stockholders, all of this means imminent dilution, especially from the sponsor promote and the PIPE (balanced by redemptions of shares issued in the SPACs IPO), as well as future and potentially significant dilution from the warrants.

Critics have taken issue with the sponsor promote for a long time. Since these shares are essentially free for the sponsor, the sponsor earns a return even if the stock of the combined company trades at less than $10 – which is what the investors paid in the SPAC’s IPO. The sponsor earns no return if the SPAC does not find a target within 24 months from its IPO and has to return the IPO proceeds to its stockholders. Note that retail investors can buy SPAC shares between the IPO and the de-SPACing transaction, and many SPAC stocks have traded above $10 in expectation of a successful de-SPACing transaction – some significantly above. In short, critics have argued that the sponsor’s compensation is excessive and the incentives are not aligned with those of the other SPAC stockholders because, from the sponsor’s perspective, any deal is better than no deal.

The market has developed solutions for this issue. Since early in the current SPAC boom, target companies wooed by SPACs started pushing back against the sponsor promote. For example, they required that (a portion) of the sponsor promote would be forfeited if the SPAC wouldn’t achieve a certain minimum valuation of the combined company in the PIPE fundraising (a lower valuation means greater dilution for the target’s stockholders) or if the stock price of the combined company failed to hit certain thresholds for a certain minimum period of time (to ensure that the sponsor only earns a return if the investors also earn a return).

In other deals, the SPAC sponsors were asked to backstop any redemptions by SPAC stockholders in connection with the business combination, thereby putting the sponsors’ own capital at risk and reducing the uncertainty for the target about the capital available at the end of the transaction. Such asks are a matter of leverage and negotiation. Increasingly, target companies subject the sponsors’ shares to a contractual lock-up (we have seen up to three years after the business combination), as that means such sponsors are utterly convinced of the long-term prospects of the combined company and are willing to tie up their capital for an extensive period of time. In the current market, where a record number of SPACs are looking for suitable targets, the targets often run competitive processes and have the leverage to insist on such terms.

On a different front, the PIPE investors have recently become a driving force in the SPAC world. Both SPACs and targets are keen to raise funds in a PIPE from highly regarded institutional investors – partly to satisfy the minimum cash closing condition (to counter any potential redemptions by SPAC stockholders) and partly to validate with outside investors the valuation that the SPAC and the target have bilaterally agreed on. Just as with the IPO investors, the PIPE investors subscribe for SPAC shares at $10 per share. The key adjustment for their economics is the valuation of the combined company, as that number defines which proportion of the combined company the PIPE investors will own (all else being equal). Since the second half of 2020, the market has seen a number of cases where the PIPE investors have found the valuation agreed by the SPAC and the target too lofty and have signalled that they would invest only if that valuation was lowered. Occasionally, PIPE investors have even sought downside protection, such as ratchet-like features (if the SPAC’s stock traded below $10 between the announcement of the de-SPACing merger and the effectiveness of the registration statement, the PIPE investors would receive additional shares). The market seems somewhat saturated since the second quarter of 2021, after a record number of de-SPACing deals. There are cases where there is simply no PIPE interest in the target company’s business proposition at all, no matter the valuation. These developments help address the criticism that any deal is better than no deal – because without a PIPE, there is often no deal in the de-SPACing context.

All this shows that the SPAC market is alive, well and maturing quickly. Market participants are addressing market imperfections. Yet, de-SPACing transactions are not without risk. All those involved should seek competent advice to understand the market and what solutions have been tested for specific issues.