Merger, Acquisition & Transaction Consultants

King & Associates, P.C.

 

 

SPACs

Special Purpose Acquisition Corporations

 

2100 Fort Worth Highway

Weatherford, TX 76086

To contact us:

Phone: 817-598-1007

Fax: 208-693-3007

E-mail: Doug@ReverseMergersHome.com

(C) Copyright 2006-08

Special Purpose Acquisition Corporations (SPACs) are investment vehicles that allow public investors to invest in areas sought by private equity firms. SPACs are shell or blank-check companies that have no operations but that go public with the intention of merging with or acquiring a company with the proceeds of an initial public offering (IPO).

 

CHARACTERICS

SPACs were traditionally sold via an initial public offering (IPO) in $6 units consisting of one common share and two "in the money" warrants to purchase common shares at $5 a common share at a future date usually within four years of the offering. Today, SPAC offerings are more commonly sold in $8 units which consist of one common share and one warrant or $10 units with one common share and one warrant. SPACs trade as units and/or as separate common shares and warrants on the OTC Bulletin Board and/or the American Stock Exchange (both the Nasdaq and the New York Stock Exchange have announced plans to list SPACs in 2008) once the public offering has been declared effective by the SEC, distinguishing the SPAC from a blank check company formed under SEC Rule 419. Trading liquidity of the SPAC's securities provide investors with a flexible exit strategy. In addition, the public currency enhances the position of the SPAC when negotiating a business combination with a potential merger or acquisition target. The common share price must be added to the trading price of the warrants to get an accurate picture of the SPAC's performance.

By market convention, 85% to 100% of the proceeds raised in the IPO for the SPAC are held in trust to be used at a later date for the merger or acquisition. Today, the percentage of gross proceeds held in trust pending consummation of a business combination has increased to 98% to 100%. The SPAC must sign a letter of intent for a merger or an acquisition within 12/18 months of the IPO. Otherwise it will be forced to dissolve and return the assets held in the trust to the public stockholders. However, if a letter of intent is signed within 12/18 months, the SPAC can close the transaction within 24 months. Today, SPACs are incorporated with 24-month limited life charters that require the SPAC to automatically dissolve should it be unsuccessful in merging with or acquiring a target prior to the 24 month anniversary of its offering. Emerging market focused SPACs, particularly those seeking to consummate a business combination in China have been incorporating a 30/36 month timeline to account for the additional time that it has taken previous similar transactions to successfully close their business combinations. In addition, the target of the acquisition must have a fair market value that is equal to at least 80% of the SPAC’s net assets at the time of acquisition and a majority of shareholders voting must approve this combination with usually no more than 20% to 40% of the shareholders voting against the acquisition and requesting their money back. In order to allow stockholders of the SPAC to make an informed decision on whether or not they wish to approve the business combination, full disclosure of the target business including complete audited financials and terms of the proposed business combination via an SEC merger proxy statement is provided to all stockholders. All common share stockholders of the SPAC are granted voting rights at a shareholder meeting to approve or reject the proposed business combination. A number of SPACs have also been placed on the London Stock Exchange AIM exchange which do not have the aforementioned voting thresholds. In July 2007, Pan-European Hotel Acquisition Company N.V. was the first SPAC offering listed on the Euronext Amsterdam exchange raising approximately €100 million.

As a result of the voting and conversion rights held by SPAC shareholders, only well-received transactions are typically approved by the shareholders. When a deal is proposed, a shareholder has three options. The shareholder can approve the transaction by voting in favor of it, elect to sell their shares in the open market, or vote against the transaction and redeem their shares for a pro-rata share of the trust account. (This is significantly different from the blind pool - blank check companies of the 80’s, which were a form of limited partnership that do not specify what investment opportunities the company plans to pursue.) The assets of the trust are only released if a business combination is approved by the voting shareholders, or a business combination is not consummated within 24 months of the initial offering. This guarantees a minimum liquidation value per share in the event that a business combination is not effected.

The SPAC is usually led by an experienced management team composed of three or more members with prior M&A and/or operating experience. Management teams typically have developed a network of relationships in the investment community and have demonstrated an ability to create value for their shareholders. The management team of a SPAC typically receives 20% of the equity in the vehicle at the time of offering, exclusive of the value of the warrants. The equity is usually held in escrow for 2-3 years and management normally agrees to purchase warrants or units from the company in a private placement immediately prior to the offering. The proceeds from this sponsor investment (usually equal to between 3% to 5% of the amount being raised in the public offering) are placed in the trust and distributed to public stockholders in the event of liquidation. No salaries, finder's fees or other cash compensation are paid to the management team prior to the business combination and the management team does not participate in a liquidating distribution if it fails to consummate a successful business combination. In many cases, management teams agrees to pay for the expenses in excess of the trusts if there is a liquidation of the SPAC because no target has been found. Conflicts of interest are minimized within the SPAC structure because all management teams agree to offer suitable prospective target businesses to the SPAC before any other acquisition fund, subject to pre-existing fiduciary duties. The SPAC is further prohibited from consummating a business combination with any entity which is affiliated with an insider, unless a fairness opinion from an independent investment banking firm states that the combination is fair to the shareholders.

Since the 1990s, SPACs have existed in the technology, healthcare, logistics, media, retail and telecommunications industries. However since 2003, when SPACs experienced their most recent resurgence, SPAC public offerings have sprung up in a myriad of industries such as the public sector, mainly looking to consummate deals in homeland security and government contracting markets, consumer goods, energy, energy & construction, financial services, services, media, sports & entertainment and in high growth emerging markets such as China and India.

 

SPACs AND REVERSE MERGERS

A SPAC is similar to a reverse merger. However, unlike reverse mergers, SPACs come with a clean public shell company, better economics for the management teams and sponsors, certainty of financing/growth capital in place, a built-in institutional investor base and an experienced management team. SPACs are essentially set up with a clean slate where the management team searches for a target to acquire. This is contrary to pre-existing companies in reverse mergers.

SPACs typically raise more money than reverse mergers at the time of their IPO. The average SPAC raises about $115 million through its IPO compared to $5.24 million raised through reverse mergers in the months immediately preceding and following the completion of their IPOs. SPACs also raise money faster than private equity funds. The liquidity of SPACs also attracts more investors as they are offered in the open market.

Hedge funds and investment banks are very interested in SPACs because the risk factors seem to be lower than standard reverse mergers. SPACs allow the targeted company’s management to continue running the business, sit on the board of directors and benefit from future growth or upside as the business continues to expand and grow with the public company structure and access to expansion capital. The management team members of the SPAC will typically take seats on the board of directors and continue to add value to the firm as advisors or liaisons to the company's investors. After the completion of a transaction, the company usually retains the target name and registers to trade on the NASDAQ or the New York Stock Exchange.

 

REGULATION

The SPAC public offering structure is governed by the Securities and Exchange Commission (SEC). A public offering for a SPAC is typically filed with the SEC under an S-1 registration statement (or an F-1 for a foreign private issuer) and is classified by the SEC under SIC code 6770 - Blank Checks. Full disclosure of the SPAC structure, target industries or geographic regions, management team biographies, share ownership, potential conflicts of interest and risk factors are standard topics included in the S-1 registration statement. It is believed that the SEC has studied SPACs to determine whether they require special regulations to ensure that these vehicles are not abused like blind pool trusts and blank-check corporations have been over the years. Many believe that SPACs do have corporate governance mechanisms in place to protect shareholders. SPACs listed on the American Stock Exchange are required to be Sarbanes-Oxley compliant at the time of the offering including such mandatory requirements as a majority of the board of directors being independent and audit and compensation committees.

The Nasdaq Stock Market announced February 2008 that it would propose new rules permitting special purpose acquisition companies, or SPACs, to list on its market.

The move was inevitable. Last year, according to Dealogic, there were 66 SPAC initial public offerings raising $12.02 billion. SPAC I.P.O.s comprised 25 percent of all I.P.O.s in the nation in 2007 and 20 percent of the aggregate money raised. So far this year, the figures in the United States are running at 53 percent of all I.P.O.s and 75 percent of aggregate money raised. That is serious money.

Previously, only the American Stock Exchange permitted SPACs to list, so all of those listing fees and trading went to that exchange. Nasdaq and the New York Stock Exchange refused to list them because they had a poor reputation.

But money is money and SPACs are continuing to dominate the initial public offering market. The Nasdaq has taken the plunge first but expect the N.Y.S.E. to follow suit shortly.

The details of the news release are telling. Nasdaq asserted that “Nasdaq will introduce more stringent listing standards to this burgeoning market segment for the benefit of investors and issuers.” That is heartening – DealBook has recently documented the potential problems with SPACs.

Then you read the remainder of the press release. It outlines three of these “stringent” terms. Nasdaq intends to promulgate listing rules requiring the following:

- Proceeds of the SPAC offering be deposited in an insured bank or in a separate bank held by a broker or dealer

 - The SPAC has a 36-month deadline to complete an acquisition or acquisitions equal to at least 80 percent of the value of the escrow account at the time of the initial combination

 - The SPACs acquisition must be approved by the SPACs shareholders and by a majority of the company’s independent directors

Observers of SPACs will be scratching their head at this point. Initially, SPACs followed the terms of Rule 419 of the Securities Act, which was promulgated in the early 1990s in an attempt to regulate these entities. The SPACs sidestepped the application of this rule through a loophole but still largely followed its terms.

Accordingly, when they first appeared back on the scene in 2003, SPACs put an 18-month time limit on their acquisition and largely required that the value had to be 80 percent of the buyer’s net assets.

But as SPACs become more popular, adherence to the Rule 419 guidelines is slipping. For example, Delos Acquisition filed a registration statement on Feb. 20, 2008 for an offering to raise $150 million. It intends to give itself 24 months for an acquisition and use Nasdaq’s test for 80 percent of the value rather than Rule 419’s traditional net asset test.

The Nasdaq is thus allowing for even further market creep in its rules.

This is not to say that the rule changes are not appropriate. The timing deadline on SPACs in particular has resulted in some seemingly hasty acquisition decisions. Endeavor Acquisition justified increasing the consideration it paid for American Apparel because of the looming 18-month deadline on that SPAC to complete an acquisition.

Still, in setting these rules the Nasdaq will set a standard for SPACs, which will likely follow any looser terms. Given the flood of SPACs one would also hope the remainder of the Nasdaq’s rules address many of the problems with these vehicles. Perhaps the specter of a Securities and Exchange Commission review of any rules will temper any such temptation.

Of course, the S.E.C. may use this occasion to attempt to implement its own regulation of SPACs, but more likely given that the Amex permits these listings, the S.E.C. will move quickly to approve any rules Nasdaq proposes.

But perhaps it will trigger a subsequent longer public review of SPACs by the S.E.C. If so, such a review will come late in the stage of the SPAC boom.

Meanwhile, if the N.Y.S.E. proposes its own listing rules, it will leave only Goldman Sachs refusing to play the SPAC game. Remember how right they were in predicting the collapse of the last market frenzy: subprime mortgages.

 

ADVANTAGES

SPACs are more transparent than private equity as they are registered offerings regulated by certain SEC rules, including filing their financial statements and full disclosure of any material events affecting the company. Since SPACs are publicly traded, they provide liquidity to an investor (i.e. investment comes in the form of common shares and warrants which can be traded). Further, the unit structure, the ability to decouple the units and trade separately the common shares and the warrants, allows investors to correspondingly increase or decrease their risk return profiles. The unique benefits are the special rights of shareholders to vote in approval or rejection of the deal and the ability for investors to regain most of their funds, typically greater than 98%, if the SPAC fails to generate an acquisition within a 24 month period or should they vote against the deal and convert their shares for cash. In addition, it is an opportunity for individuals not qualified to buy into hedge or private-equity funds to participate in the takeovers of private operating companies that those funds typically do. Additionally, the SPAC vehicle for the target company is the opportunity to effect a reverse merger that yields more capital.

 

DISADVANTAGES

Other than the risks normally associated with IPOs, SPACs public shareholders' risks may include:

limited liquidity of their securities

low visibility on future acquisition(s) at the time of the SPAC public offering

dilution due to management and sponsor shares (20%)

public shareholder approval contingency may make SPAC unattractive to sellers

potential for uncertainty associated with the SEC merger/acquisition proxy process

There is also potential for delay and expense attributable to the public shareholders' special rights and the costs of functioning as a registered public company.

 

HISTORICAL AND RECENT DEVELOPEMENTS

David Nussbaum of boutique investment banking firm EarlyBirdCapital, Inc. is essentially credited as the founder of the SPAC movement in the 1990s. Nussbaum identified an opportunity in the capital markets because of an absence of a true market for IPOs in the mid-1990s depriving growth-oriented and emerging market investors of a new supply of public companies. Nussbaum identified an exemption in SEC Rule 419 providing that any company with $5 million in assets, or that seeks to raise $5 million in a public offering, need not comply with any of the restrictions of Rule 419. But rather than being free of Rule 419 restrictions, Nussbaum created a structure which voluntarily adopted the restrictions to attract investors to the SPAC structure such as putting all the money raised in escrow, except a small percentage for operating expenses and commissions paid to the investment bankers. He also required investor confirmation with a full disclosure document approved by the SEC and a time limit on finding a merger partner. But most important, Nussbaum arranged for a trading market for the stock of a SPAC, as well as for the warrants sold to the investors in the IPO. Trading of securities sold under Rule 419 are not permitted. As an extra twist for marketing, Nussbaum declared that each SPAC would specify a industry or geographic focus. Wrapped around this structure was a well-qualified and experienced management team that would be compensated with stock, but their experience and eye for deals would be valuable to the investors. Investors quickly snapped up SPAC offerings because 90% or more of their investment was invested in government securities while the SPAC searched for a merger target. If they did not like the proposed deal, they would likely receive 92% to 95% of their original investment back. Or when a deal was announced, if the price of the stock moved up, they could sell their shares in the open market. Although the investment was in a "blank check" the money was protected and investors had a legitimate means to opt out when a deal was announced. Companies liked the SPAC as a way to go public. In general, a company that might have considered a smaller IPO saw the SPAC as guaranteed cash, less risky than an IPO. All in all, the companies that merged with the initial SPACs in the 1990s generally fared well and the technique worked. SPACs in the 1990s tended to move counter cyclical to the micro and small cap public markets and when the IPO market heated up in the late 1990s, Nussbaum retreated from the SPAC market and began to work on more traditional investment banking and asset management businesses.

In 2003, the lack of opportunities for mid-market public investors to "back" experienced managers combined with the trend of upsizing private equity funds pushed entrepreneurs to directly seek alternative means of securing equity capital and growth financing. At the same time, the rapid growth of hedge funds and assets under management and the lack of compelling returns available in traditional asset classes led institutional investors to popularize the SPAC structure given its relatively attractive risk reward profile. SEC governance of the SPAC structure and the increased involvement of the bulge bracket investment banking firms such as Citigroup, Merrill Lynch and Deutsche Bank has further served to legitimize this product and perhaps a greater sense that this technique will be useful over the long term.

SPACs are forming in many different industries and are also being used for companies that wish to go public but otherwise cannot. They are also used in areas where financing is scarce. Some SPACs go public with a target industry in mind while others do not have preset criteria. With SPACs, investors are betting on management’s ability to succeed. SPACs compete directly with the private equity groups and strategic buyers for acquisition candidates. The tightening of competition between these three groups could result in a bid for the best company and possibly increase valuations.

 

IDEPENDENT RESEARCH COVERGE

Research coverage of SPACs has been limited. This is due to conflicts that discourage underwriters from covering the companies they are most familiar with. In addition, traditional sell side coverage is hesitant to allocate time and effort to research a company when certainty of deal completion is not known. SPAC Analytics provides analysis of all SPACs.

 

SELL SIDE RESEARCH

Maxim Group publishes a weekly piece called Carte Blanche. Morgan Joseph created the Morgan Joseph Acquisition Company Index (MJACI) which is quoted on Bloomberg. The MJACI is a total SPAC market index that measures the daily market performance of all publicly traded SPACs formed since August 2003.