SPACs gain in popularity
By Trevor Pinkerton
Some renewable energy companies are thinking about special-purpose acquisition companies — called SPACs — as a possible means to access the public equity markets.
Through September, at least 16 investment groups have formed SPACs listed on the New York Stock Exchange or NASDAQ that are aimed at the energy transition, primarily in the clean tech and electric vehicle industries. Of these SPACs, at least four that have filed since August are specifically aimed at the renewable energy industry.
There have been more than 130 initial public offerings of SPACs this year that have together raised more than $50 billion in gross proceeds.
A SPAC is a company formed to raise capital with the aim of merging eventually with another company, thereby converting the target company into one that is publicly traded. The sponsor group forming the SPAC usually includes a management team with public company experience in a particular industry. Investors in the SPAC know the industry in which the SPAC plans to invest, but not the particular company. After raising capital this way, the sponsor begins the hunt for acquisition targets in that industry.
US Securities and Exchange Commission Chairman Jay Clayton said in September that the SEC and other regulators are taking a closer look at SPAC transactions and the quality of SPAC disclosures, including disclosures about the interests that the sponsor group will have in the combined company at closing and the group’s incentives and motivations.
Most SPAC transactions follow a similar timetable.
The SPAC goes through an initial public offering process where a prospectus is prepared, an underwritten offering is conducted, and then shares in the SPAC are sold on a stock exchange. Because the SPAC has nominal assets, the process is much more streamlined than for an operating business.
The SPAC commits to a deadline during the initial public offering by which it must find a company to acquire, ideally in the target industry. It must not have already identified the company it plans to acquire (or else substantive disclosures would be required about the potential transaction, including target company financials).
The prospectus will explain what happens if the SPAC needs more time to conclude a transaction. The SPAC will probably have to redeem any shareholders who want out when the extension is granted.
The actual acquisition is called a “de-SPAC” transaction and is usually effected through a merger of the SPAC or its subsidiary with the operating company. The operating company shareholders exchange their shares for shares in the SPAC. The funds raised through the IPO remain in the combined company or are distributed to the existing shareholders of the target company as part of the consideration for their shares. Additional cash may be raised by bringing in PIPE investors.
PIPE offerings are a relatively fast way for public companies to raise capital in a private placement without the cost and delay of an underwritten public offering. “PIPE” stands for “private investment in public equity.” (For more information, see “PIPEs clogged” in the January 2007 NewsWire.)
The SEC must approve a registration statement for the stock consideration issued to the operating company shareholders, and issuance of additional SPAC shares to effect the merger must be approved by the SPAC’s shareholders at a special shareholder meeting via a publically filed proxy statement.
Certain SEC filings are required in connection with the closing.
There are several important nuances common to SPAC transactions.
At the time of the IPO, the SPAC issues units (combining one share and a fraction of a warrant to purchase a share of common stock), generally at a per-unit price of $10.
The warrants are usually exercisable for $11.50 shortly after the de-SPAC transaction or one year after the IPO, whichever is later.
The funds received in the IPO are placed in a trust account, managed by a trustee and subject to a trust agreement. These funds are used to pay SPAC expenses and to fund the acquisition of an operating business.
The sponsor group also receives equity in the SPAC and usually holds a significant minority stake in the company after the de-SPAC transaction. The sponsor group holds common equity with special rights called “founder shares” that, after the de-SPAC transaction, usually leave the sponsors holding 20% of the company on a fully diluted basis. This is called the sponsor’s “promote.” The sponsors also receive founder warrants that typically have a cashless exercise feature and are not redeemable, but otherwise have terms similar to any warrants issued to the IPO investors. Warrants are options to buy (or take, in the case of cashless exercise) more shares.
The SPAC shareholders must approve the de-SPAC transaction at a special shareholder meeting. They have the option at that time to cause the SPAC to redeem their shares in the SPAC for a specified value (the original share price), which is paid with funds from the trust account.
The redemptions that occur in connection with the de-SPAC transaction can tap into anywhere from 0% to 100% of the funds in the trust account. Average redemptions historically have laid claimed to around 50%.
These redemptions can significantly deplete the trust account that was meant to provide cash at closing to the combined entity and possibly also to the operating company shareholders. This often necessitates an investment by a PIPE investor, as well as potential backstop obligations from the sponsor group or other third-party investors. Examples of backstop efforts are an additional equity investment by the sponsor group or others to cover any shortfall in cash needed to make the full payments promised to the existing shareholders of the target company, transferring founder shares or warrants to the target company owners or to PIPE investors, having the sponsor group or other investors pay transaction costs or commit to buy SPAC shares in the open market.
The redemption offer does not apply to the public warrants issued to the SPAC investors in the IPO. These warrants remain outstanding even if SPAC shareholders cause the SPAC to redeem their shares instead of staying in through the de-SPAC transaction.
The sponsor group and other directors and officers typically waive any right to have their founder shares redeemed by the SPAC.
The ability of the SPAC shareholders to cause the SPAC to redeem their shares gives them essentially two decision points. They make an initial decision to invest based on the management team put together by the SPAC and then to confirm the decision when that team identifies the operating company to be acquired.
The de-SPAC transaction must be completed within a specified time after the IPO (often 18 to 24 months). However, some SPACs have automatic extension provisions if the SPAC has entered into a letter of intent or acquisition agreement with a qualified target, even if the transaction is not yet closed. However, if the deadline is reached, the SPAC will be forced to seek an extension by shareholder vote and will also risk losing SPAC shareholders who choose to redeem their shares through a tender offer process in connection with each extension. Each round of extensions and redemptions effectively reduces the cash available at closing.
SPACs have become a popular method of going public. While the structure has been around for decades, the number of SPAC IPOs has increased in each of the last four years. More than $50 billion has been raised in SPAC IPOs in 2020 through early October, including a large amount during August, a traditionally slow period for the capital markets.
While the SPAC structure obviously has benefits for the sponsors (the 20% fully-diluted ownership of a successful operating business for minimal investment of capital), it has also become popular with both the investing public and private operating companies looking to go public.
This popularity is due to several factors.
Operating company CFOs like it because it avoids the protracted process and uncertainty around a traditional IPO, especially during the COVID-19 pandemic.
It takes less time to turn a private company into a publicly traded company. The de-SPAC transaction often takes only six months from the initial letter of intent between the target and the SPAC through closing of the de-SPAC transaction. Taking a company public through an IPO normally takes a full year.
Another attraction is the combination for the operating company of a cash payout to its private shareholders at closing (through a portion of the trust account funds and PIPE) and access to the liquidity of the capital markets after closing through the public equity issued in the acquisition.
SPAC investors like it because of the unique optionality built into the structure. They have extra upside through warrants and can walk away from an undesired acquisition by forcing a redemption. An investor is basically buying a “look-and-see” opportunity with an experienced management team actively searching for viable M&A candidates.
Common Issues for SPAC Targets
At the same time, de-SPAC targets and their management need to approach SPAC transactions with their eyes wide open to some of the risks and uncertainties associated with SPACs.
When assessing the pro forma ownership of the combined company and the pricing of the de-SPAC transaction, the target should consider the likely event that some significant portion (or all) of the trust account that the sponsor group is bringing to the table could walk out the door through redemptions of SPAC shares.
Consider that in light of those redemptions, there may be significant renegotiation of the deal terms after execution of the acquisition agreement, which may require “backstop” agreements with the sponsor and other parties, including the PIPE investors, to put in more money, sell additional equity or reallocate founder shares, and these efforts can suck up management time of the target company before closing.
The SPAC sponsor group will probably own 20% of the combined entity on a fully diluted basis (through their founder shares), have warrants that are exercisable after closing if the stock price rises to $11.50 and negotiate for significant board representation, and it may hold certain approval rights and downside protection, and yet the sponsors may not show up with any cash left in the trust account. This risk is often mitigated to a degree by forcing the sponsor group to forfeit founder shares to cover redemptions by SPAC IPO investors, which helps pro forma ownership but does not address the depleted cash.
Due to redemptions, it is not unusual for a large portion of the deal consideration to end up coming from PIPE investors, and they may request board representation and require broad registration rights.
The target operating company may not have effective recourse against the SPAC to enforce pre-closing rights in the acquisition agreement (including the obligation to close) because of required protections surrounding the trust account and its cash.
Among the issues the target company will have to negotiate with the SPAC include what role the target’s management will play in the combined company and how many board seats of the combined entity will be held by board members of the target. Major shareholders of the target will want to retain their existing board representation. The existing target board members may or may not be considered independent directors after the de-SPAC transaction under the relevant exchange or SEC regulations. Exchange rules and SEC regulations require at least a majority of board seats in publicly traded companies be held by independent directors.
The target will need to have financial statements that comply with PCAOB (Public Company Accounting Oversight Board) standards and will need to work with its auditor (or find an appropriate auditor) to produce these financial statements, which can be an item with significant lead time.
The parties need to have a plan for practical liquidity in the equity markets after the transaction because the lack of underwriting by investment banks (a key element of the traditional IPO) means that the combined company will have less analyst coverage and trading volume than a company going public through a traditional IPO.
The SEC still views some SPACs with a wary eye, due to their history as a means around the traditional IPO process and a way to invest in speculative target companies that have not undergone the traditional vetting involved in an IPO.