SPACs the new trend?

SPACs come and go in popularity. In markets where trust is widespread and anyone can do a deal, they do well. In markets like the one it looks like is coming, you need more then a street rep to raise public equity in a SPAC on the promise that you will buy something.

All SPACs are is an agreement between an existing manager/M&A person that they will acquire a specified type of company and get returns from it. Personally, I believe that the trend will slow down through the choppy markets.

Basically, capital for a SPAC is raised in very like fashion to a  traditional IPO.  Investors or organizations with longer and better track records will be able to raise more equity in the offering.  The steps are very similar if not abbreviated - drafting the S-1, comments from the SEC (perhaps multiple rounds, but with how SPACs are so easily packaged these days, coupled with the fact that there is no company underlying the equity, just a shell acquisition company, not likely), final 424B and then an abbreviated roadshow (oftentimes, just domestic).  The basic premise of the SPAC is that over the course of two years the investors must find and make an acquisition, comprising of at least 80% of the capital raised in the public markets.  Once the SPAC acquires a company, it effectively creates a publicly traded entity.  If the SPAC cannot find a suitable acquisition within two years, the capital is returned to investors.  If the company being acquired by the SPAC only comprises 80% of the equity in the SPAC, the remainder is returned to investors. 
 
While SPACs have historically been used by individual investors, financial institutions (Lazard), former PE guys (Tom Hicks), and management teams alike, I see the SPAC market growing significantly in the next year.  The first reason being that PE players will find fundraising difficult in a market where making new acquisitions is near impossible without favorable leverage terms, and existing portfolio companies will have a difficult time exiting in both the private, public and strategic markets.  PE players may raise SPACs with specific investment intentions and find it easy to raise capital to make a single acquisition while the market recovers, and their successful track records will allow for a significant raise (Tom Hicks raised $500mm, a significant chunk of equity for just one acquisition - you figure at least $400 must be used, that's easily a $1 billion dollar buy with leverage).  The second reason SPACs will flourish is because it's HUGE fees for the banks underwriting them.  They are getting the traditional 7% IPO fee (which one would argue is a little steep given that there is significantly less work involved than a traditional IPO) on hundreds of millions of dollars.  To use Hicks as an example again, his $500mm raise netted $35 million in fees for the underwriters.  Not too shabby for three months work.  In addition, banks continue to hold shares in the SPAC so they are reputationally and financially incentivized to bring deals to the SPAC (complete with staples and leverage terms).  On top of that, of the $35 million in fees, half is deferred until the SPAC makes an acquisition - even more incentive for the bank to bring deals.  Furthermore, the acquired company has to float as a public entity, so you won't be seeing leverage greater than 4 or 5x (if that) on these companies.  So acquisitions will be easier since the equity checks will be larger.
 
Why don't all PE firms do SPACs instead of traditional LP funds or even pledge funds?  There's no fees involved (minus up front fees for overhead expenses), so it's not quite as lucrative for the players from the onset.  You can only raise one fund at a time to make one acquisition at a time, a pain in the ass if you plan to make a string of acquisitions.  Everytime you want to make an acquisition, you're subject to a shareholder vote, so there's always risk that you spend a lot of time on diligence and valuation and things blow up at the very end.  But if you're willing to put in the time and effort, and don't mind going fee-less for at least a while, the way the warrants are structured in the SPAC can make it extremely lucrative for the investors EVEN IF the stock does nothing during the lock up period after the acquisition is made, due to the promote structure. 
 
There you go.  Probably more than you ever wanted to know about SPACs and more...

Thanks for taking the time to explain it in great details. I learned a lot.

Excellent post, Game Theory. Thanks for the info.

SPACs may indeed get more popular this year with traditional LBOs all but dead, but for a number of reasons I don't think they're going to become the new hot thing in 2008.  Probably most important is that the elections are going to shut down capital markets for awhile in the second half, making new SPACs less likely.

Banks do like them because of the fees involved, but many buyside places actually make more from management fees vs. carry (maybe not true with PEs, more so with HFs).  So it's not quite as good a deal.

http://www.mergersandinquisitions.com/
Mergers & Inquisitions

You might find this post I wrote on SPAC's helpful and maybe even interesting.

http://www.princeofwallstreet.com/2007/12/24/spac-private-equity-without...

The Prince of Wall Street
http://www.princeofwallstreet.com

GameTheory's,

My group recently IPO'd a SPAC and I have been intimately involved in the process (roadshow, crafting the S-1, filing docs with the SEC, etc). I disagree with you on several points:

1) The initial business combination must meet the 80% threshold of the amount held in the trust. After the acquisition the remaining cash balance is used by the company to pay down debt, make operating improvements, acquire tag-along targets, etc. The money is not returned to the shareholders.

2) Our SPAC offering was slightly smaller than Hicks and the fees were about half of what you stated (1/2 at the beginning and 1/2 upon completion of the IBC).

Also, just a little bit about the growth of the vehicle
2004: 12 SPAC, $482M
2005: 28 SPACs,$2.1B
2006: 37 SPACs,$3.4B
2007: Almost a double

To date approximately 5 SPACs have been forced to liquidate (out of about a total of 110)
Upon liquidation (after 2 years and no IBC) all of the money held in the trust (including earned interest less expenses) is given back to the shareholders

Thanks for all of the insight GameTheory, your post was very concise.

Thanks for the clarification. Just regurgitating what the bankers have told me, since almost every bulge bracket has come pitching SPACs lately. It's quite probably that the fees are negotiated downwards (the traditional 7% IPO economics seem insane for the amount of work involved vis a vis coprorate IPO, I worked on a few IPOs while in banking).

Gametheory - could you elaborate more on the warrants? How would investors do extremely well with poor stock performance?

"But if you're willing to put in the time and effort, and don't mind going fee-less for at least a while, the way the warrants are structured in the SPAC can make it extremely lucrative for the investors EVEN IF the stock does nothing during the lock up period after the acquisition is made, due to the promote structure."

Each unit in the SPAC comes with one part common stock and one part warrant. So each investor's warrant is tied to a strike price of the common. The investors (and by investors I mean management team, sponsor, etc.) have a certain amount of allocated "at-risk" capital. So for example, for a $350 million dollar offering, that at-risk capital may be about 5 or 6 million dollars. If no deal is done within the set time period, all that at-risk capital is lost (hence the name). However, if a deal is done and approved, the investors have a promote structure within the agreement that allows them to have 20% of the outstanding stock (of the original offering). Obviously this is incredibly dilutive to the institutional unit holders, as their common stock will be diluted and their warrant strike price will be that much harder to hit. As a result, the institutional investors have demanded that transaction sizes actually be more in the range of 3-4x that of your original raise (so for example, if you raise a $100mm SPAC, your target TEV should be more like $300-500 million) thereby necessitating the need for an additional follow-on of capital. Since the investor promote does not carry forward to follow-on offerings, their 20% promote will dilute the original raise of capital but the pro-rata share of the follow-on offered to the institutional holders will minimize the overall dilution. And of course, the institutional investors have every incentive to buy up shares in the follow-on offering because that would only occur if a deal was close to being struck.

So to answer your question, if your original investment was your 5 million dollars of at-risk capital, and you received 20% of an original raise of say, $100 million, you invested $5 million and received $20 million just for doing the deal. Even if the stock price halves, you're still left with double your money in about 2 years. Not bad.

Of course there are other factors at play here. Oftentimes in order to actually complete a deal investors will give up promote - but from a strictly theoretical perspective, it's a great deal for the investors.

Gametheory - you are a genious, thanks for that well written, easy to understand write-up.

Guess I'm not clear why the heck Spac holder would agree to a 20% promote. Shouldn't they earn this "upside" by managing and improving the acquired company to increase value, not simply for executing a transaction? Is the 20% promote like a reward for finding a viable target company and executing on it?

Interesting that this thread has come back to life...

The SPAC upside is essentially a challenge by the markets "I dare you to create and unlock value" and thus surmount the dilution that is inherent in the SPAC structure.

As previously stated, it becomes significantly easier to surmount the dilution as you begin to consider companies that have larger EVs.

We have actually done some pretty interesting internal analysis that outlines what would happen to a portfolio holding only the warrants, only the shares, and a unit (common and warrant) or a combination.

Yield compression and trust investment restrictions have had a negative impact on the attractiveness of SPACs and that is one reason why their popularity has again begun to wane. GS pulled the plug on their first attempt I believe (Daily Deal about 3 months ago).

The main problem with the GS structure in the SPAC was that with only 10% promote, there's no incentive for the sponsor to give in to a lower promote in order to get a deal done. In a perfect theoretical world, the deal being brought to the shareholders would be exactly the right size and make perfect sense (you have to remember, the company should be private and fit your TEV requirements, as well as have a good reason why they aren't IPOing under regular circumstances but through a SPAC). Then the investor could keep all 20% promote and the shareholders would experience gains through both gains in the common stock and warrants that hit the strike price. However, it's incredibly difficult to find a private company that fits your criteria. A perfect example would be a reverse-Morris trust spin-off from a larger corporation (for example, Folgers probably would have made a decent SPAC).

In reality, the 20% promote often gets negotiated down to 15 or 10% in order to appease your shareholders. And the shareholders are in a great position, too. If they don't find the deal to make sense economically, they can always vote "no" on the deal. If a deal doesn't get done within the time period, the shareholders will get almost all, if not all of their money back (depending on the terms of the SPAC, it could be anywhere from 97% to 100% cash in trust).

junkbondswap brings up a good point about portfolios designed to only hold the warrants. What alot of the bigger institutional players will do to decrease their risk on the onset is sell the warrant peice of their units at around 65 cents on the dollar. That way they make an immediate return on their investment and hedge their downside. And it makes sense for the portfolio (in theory anyways, junkbondswap can probably tell you for sure) to hold only the warrants because at 65 cents on the dollar, if only a fraction of the SPACs in your portfolio ever hit the strike price, you make multiples on your money.

Out of curiousity, does anyone know how the Nelson Peltz Trian SPAC is doing? My assumption was that Nelson would use his activist fund to force Cadbury to spin-off a large portion into his SPAC, but that seems less likely given the Snapple Dr. Pepper spin-off.