SPAC to basics (IV): Sponsor Perspective

Fred Halbhuber

SPACto basics (IV): sponsor perspective

 

We turn now to the final ‘perspective’ analysis in this series.[1] Ironically, it is with this last actor—the sponsor—where the SPAC lifecycle begins.[2] The present installment is split into five parts, largely following the role of the sponsor through the lifecycle of the SPAC. First, the role of the sponsor will be considered leading up to the SPAC’s formation and its IPO; the incentives to sponsor a SPAC will be enumerated and evaluated. Second, the sponsor’s responsibilities will be considered at the point of the IPO and immediately thereafter. Third, the involvement of the sponsor will be considered during the24-month target search and time leading up to the merger. Fourth, the position—both payout and continuing risks—will be considered at the closing of the merger and thereafter. Finally, the overall importance of the sponsor will be evaluated by exploring the extent of the differences in SPAC performance between SPACs sponsored by PE companies, seasoned executives and novice managers.

 

Pre-formation and pre-IPO

Before addressing the role of the sponsor in setting up the SPAC and preparing it for an IPO, a necessary prior question is who the sponsor typically is. For SPAC IPOs between 1 January, 2014and 30 November, 2017 PE and hedge fund-sponsored SPACs represented 51% of the market share by gross proceeds.[3]These types of sponsors are particularly prominent in larger SPACs, sponsoring the vast majority of SPACs with an IPO larger than $300 million.[4]

 

The sponsor starts the SPAC life-cycle by funding the SPAC leading up to the IPO, primarily filing costs and limited operational expenses. What does the sponsor get out of the arrangement?For nominal consideration[5] the sponsor acquires a number of special “founder shares”[6] amounting to 25% of those being offered at IPO (therefore, a 20% stake in the post-IPO SPAC).[7]These founder shares automatically convert to shares in the target at a 1:1conversion rate at the closing of the De-SPAC.[8]

 

At the IPO

At the point of the IPO, and in exchange for 2% of IPO proceeds and (typically) a flat $2 million to fund theSPAC’s operating expenses going forward, the sponsor further purchases founder warrants.[9] The price of the founder warrants depends on how large a fraction of a warrant is included in the units at IPO: where each unit contains one warrant, the sponsor acquires warrants more cheaply at $0.50 each; where each unit contains merely a third of a warrant, the sponsor pays triple as much.[10]

 

Why do the SPAC management team and sponsor resign themselves to hold the funds raised through the SPAC IPO in treasury bonds or cash? Surely it would make more sense to invest in equity markets (with average annual return of over 10%[11]) than treasury bonds (with yields under 0.1%[12])?There are a number of reasons that the capital held in the trust is only invested in treasury bonds.

 

First, liquidity is a major concern of the SPAC sponsor and management team. The SPAC (typically) only has 24months[13] to complete its merger with a target company and must therefore be ready to jump when a valuable opportunity presents itself.[14] Equity markets are prone to swings and spells of illiquidity.[15] TheSPAC risks passing up on a valuable target if its IPO capital is exposed to normal market forces.

 

Second, SPACs are limited by theInvestment Company Act of 1940 (the “1940 Act”). SPACs seek to avoid being classified as an “investment company” under the 1940 Act to avoid its accompanying disclosure requirements.[16] While the escrow account set up by the SPAC would prima facie constitute an investment company under the1940 Act, the adopting release for Rule 419 of the Securities Exchange Act of1933[17]held that the trust account would not constitute an investment company so long as it meets the Rule 419 requirements.[18] This means that the IPO proceeds must be invested only into direct obligations of, or obligations guaranteed by, the United States government, with a maturity of 180 days or less or in money mutual funds meeting specific conditions.[19]

 

Third, tax considerations apply. So long as SPACs hold only treasuries and cash, the Internal Revenue Service (IRS)treats them as “startup” companies, significantly lowering the tax requirements of the SPAC.

 

Of course, that SPACs only invest inT-bills has the unfortunate consequence that capital raised in the SPAC IPO is parked inefficiently in the 24 months in which the SPAC searches for a target.Since few investors would be willing to buy into a less liquid asset class with no additional return, SPACs must offer alternative enticements. This comes inthe possibility to acquire shares in the target and in the warranties (or fractions thereof) offered as part of the SPAC unit at IPO. As shall be seen, however, these warranties are a double-edged sword for the sponsor: although they play a key role in attracting investors to the SPAC (particularly at IPO),their exercise dilutes the stock and thereby undermines the sponsor’s return by reducing their share of the target company.

 

Target search

The capital raised in the SPAC IPO is unavailable to fund the SPAC’s operating expenses in searching for potential targets. Indeed, the capital held on trust may only be removed for four reasons: (i) to merge with a target; (ii) to contribute to the capital of the target company; (iii) to distribute to shareholders in liquidation if the SPAC fails to close a merger; or (iv) to redeem shares on a request for an extension or a proposal to merge. Therefore, the burden falls on the sponsor to fund the operation of the SPAC during its target search and through the merger process to follow. On average, a SPAC takes 15.5 months to complete the search (i.e. to sign with a target and announce the commencement of the De-SPAC process).[20]

 

What happens if the SPAC is unable to find a target in 24 months? The SPAC has the option either to return the capital held on trust to the public shareholders (resulting in a complete loss of the sponsor’s initial investments) or to seek an extension of its lifespan.While the latter option might appear to be clearly preferable for the SPAC sponsor, this is not necessarily so. For one, as long as the SPAC survives, theSPAC sponsor will have to continue to pay its operating costs of the SPAC as it searches for a target. The sponsor may be better off electing to cut their losses in an oversaturated SPAC market, especially if there does not yet appear to be a deal in sight. Moreover, whenever a shareholder vote is held on whether the search period should be extended, the SPAC is obligated to make redemption available to public shareholders.[21]Therefore, requesting an extension runs the risk of sapping capital ultimately needed for the merger.[22] In order to avoid this, SPACs often offer an incentive to not redeem; this usually comes in the form of a minor cash contribution to the SPAC’s trust account, typically in the area of $0.033 per share per month. These monthly injections partially compensate investors for the longer illiquidity of their SPAC shares.However, it is typically the sponsor who bears the cost of these payments.Assuming the average 2020 IPO size of $337.0 million[23] and the typical listing price of $10 per unit, this amounts to a monthly expense of $1.1 million for the SPAC sponsor.

 

In relation to SPACs listed on theNASDAQ, the further question arises whether the SPAC lifespan can be extended by shareholder vote beyond the 36 months set out in the listing rules.[24] The exact wording of the listing rules is as follows:

 

“[I]n the case of a Company whose business plan is to complete an initial public offering and engage in a merger or acquisition with one or more unidentified companies within a specific period of time [i.e. a SPAC], Nasdaq will permit the listing if the Company meets all…conditions described below.

 

[…]

 

(b) Within36 months of the effectiveness of its IPO registration statement, or such shorter period that the company specifies in its registration statement, theCompany must complete one or more business combinations…”[25](emphasis added)

 

Winston & Strawn LLP have interpreted this listing requirement as limiting shareholder ability to extend the lifespan of the SPAC to a maximum of 36 months.[26] Therefore, where a SPAC’s registration statement sets the SPAC’s lifespan at 24 months (the typical length), shareholders could only elect to extend this by a further 12 months.

 

The interpretation offered byWinston & Strawn LLP[27]prima facie flows naturally from the rule. The SPAC must complete the necessary combination(s) within 36 months or any “shorter period” specified in its registration statement; if the lifespan set out in the SPAC registration statement is longer than 36 months, the lifespan in the registration statement is ineffective and the maximum 36month period would instead apply.[28]Similarly, the argument seems to go, where the lifespan is amended by anSEC-compliant proxy process and extended to more than 36 months post-IPO, this would fail to meet the “shorter period” restriction and be ineffective: again, the 36 month cap would apply.

 

It is suggested, however, that an alternative reading is possible. The reading offered by Winston & Strawn LLP overlooks relevant differences between registration and later shareholder alteration. First, NASDAQ Rule IM-5101-2(b) refers explicitly to a “shorter period” in the company’s “registration statement”.[29] When the lifespan of theSPAC is extended it is not the registration statement[30] which is amended, but rather the SPAC’s charter (included as an exhibit in the registration statement).[31] It is suggested that the reference in Rule IM-5101-2(b) solely to the company’s registration statement and not the company charter leaves open the possibility that the SPAC charter, if amended post-IPO with shareholder approval, could provide for a longer lifespan. What then, it may be asked, is the purpose of the NASDAQ 36-month restriction? The interpretation advanced in this article would surely strip the Rule of all meaning if the lifespan of the SPAC could be extended (presumably indefinitely) the day after the IPO? This, it is argued, is not so, since there is an important practical distinction between a lifespan cap at the time of the IPO and lifespan cap thereafter. The NASDAQ 36-month restriction still offers confirmation to all investors buying SPAC units at theSPAC IPO that they will have the chance to redeem their shares within 36 months or earlier. This is because, as discussed earlier, any request for extension must make redemption available to shareholders. Therefore, were the SPAC to seek a ten-year extension the day after its IPO, all investors who bought atIPO would still be given the chance to get their full investment back withinterest (an opportunity which, it is presumed, the vast majority of shareholders would take).

 

Market practice may appear to align better with the view taken by Winston & Strawn LLP: this author has been unable to find any precedent for NASDAQ-listed SPACs that have extended their lifespan beyond 36 months. However, this may be explained on the basis that there is very little investor appetite for a SPAC with such a long lifespan, and even less so when the SPAC originally has a lifespan of only 24 months.[32]Indeed, the 40% redemption rate on extension proposals[33] illustrates the lack of investor enthusiasm for extensions in general.[34] Therefore, although a SPAC lifespan may legally be extended beyond 36 months, investor incentive to get in and out quickly suggests that practical (rather than legal restrictions) may curtail the sponsor’s freedom to extend as they see fit.

 

Given this lack of investor enthusiasm, when should a sponsor seek investor extension? Seeking an extension is most desirable—and carries the least risk for the sponsor—where the SPAC has already found a target and only needs a few more months to close the merger(which typically takes 4–5 months). A proposal for extension in such a situation does not risk the same high redemption rates since investors may wish to hold onto their shares to sell their shares in the hot pre-merger market.With a shorter extension with a clear deadline in sight, investors are likely also less concerned about locking up their capital since they will be given ther edemption option again in just a few months at the merger proposal. Where the extension is proposed to finalise a merger there is also less risk involved forthe sponsor. Not only will there be no operating costs involved with finding a target (only with closing the deal), but there will also be a clear payout insight, since the value of the sponsor’s shares are wholly dependent on a successful merger.

 

De-SPAC and consequences

When a suitable target is found and announced, the SPAC shareholders vote on whether to merge. The sponsor, however, typically commits themselves to vote in favour of the merger; immediately, therefore, 20% of SPAC shares are committed in favour of any proposed merger.[35] As such, only another 37.5% of public shareholders need to approve the merger to meet the 50% threshold.

 

However, following the shareholder vote approving the merger (assuming it is successful) the share of equity held by the sponsor is whittled down. This is a result of new PIPE investments necessary to inject new cash into the SPAC, as a result of forfeitures by the sponsor themselves in order to encourage shareholders not to redeem[36] and incorporation of the target’s equity.

 

To illustrate this, this article will walk through a hypothetical De-SPAC process for a SPAC with the average2020 IPO size of $337.0 million[37] and the typical listing price of $10 per unit. In our hypothetical SPAC, there area total of 33.7 million shares to begin with. Immediately post-IPO, the sponsor’s share is 6.74 million shares, or 20% of total SPAC shares.[38] The typical 58% redemption rate results in the redemption of 19.55 million shares, reducing the total number of shares to 14.15 million shares. This increases the sponsor’s share to 48% (though the number of sponsor shares remains unchanged from 6.74 million). However, following forfeiture and PIPE financing,[39] the sponsor’s share is reduced to 31.30% pre-merger. Upon inclusion of the target equity, the sponsor’s share is further diluted to 11.7% of the final company.[40] It is important to note, however, that warrants typically expire only five years after the conclusion of the De-SPAC transaction. As such, the sponsor’s stake is always subject to potential further dilution up to five years following the merger.[41]

 

The initial 20/80 split therefore both overstates and understates the sponsor’s actual stake in the SPAC and target company. It overstates the sponsor’s average 11.7% stake in the target company post De-SPAC. This, however, should come as no surprise: shareholders in the SPAC—both public shareholders and the sponsor—were always going to have their shares diluted by the merger with the target. More revealing is that the20/80 split understates the sponsor’s share by failing to reflect that the median sponsor’s net promote is is 31.30% of the cash delivered in the merger,[42]representing a far higher share in the pre-merger SPAC than is originally evident.

 

When can the SPAC sponsor liquidate their share? The sponsor usually signs a one year lock-up agreement from the closing of the merger (De-SPAC process).[43] However, the agreement is often subject to early termination by the sponsor where the share price of the target crosses a certain threshold (typically $12.00) for 20 of 30 trading days after 150 days post-merger.[44]This acts as an incentive for the sponsor to set up the target for success post-merger.

 

Sponsor impact: from weathered professionals to inexperienced celebrities

We turn now to consider the difference which a sponsor might make to the success of a SPAC and, ultimately, of the target. The sponsor’s quality is important to finding, negotiating with and ultimately merging with the right target: market knowledge, experience and connections are therefore valuable asserts. However, the quality of the sponsor is also important to building investor confidence and thereby reducing redemptions. During the IPO process and subsequent target search, investors are given the chance to “gauge the quality” of sponsors and the SPAC management team.[45]Confidence in the management team is especially important in SPACs because information on the target is often not as extensive as may be hoped: investors must therefore feel confident putting their faith in the sponsor and their team to make the right decision. More competent sponsors are also able to attract more favourable PIPE investments for the SPAC; this helps to ensure that the target company has access to sufficient capital to operate upon going public.

 

A study by Michael Klausner andMichael Ohlrogge analyses the impact which the quality of sponsor has on target stock performance. Klausner and Ohlrogge found that post-merger returns in SPACs with “high quality sponsors”[46] was 31.5% (compared to-2.9% for post-merger returns on the SPAC market overall).[47] This difference is even more pronounced when compared solely against those companies deemed to have“non-high quality sponsors”, which averaged -38.9% returns three months post-merger.[48] The quality of the sponsor therefore remains has lasting effects on the stock performance of the ultimate target; finding an experienced sponsor should be a key priority to those companies looking to go public via a SPAC.


[1] Although this is the final analysis of SPACs from aspecific actor’s perspective, this is not the final installment in the series.Stay tuned for upcoming installments: ‘SPAC to basics (V): calls for reform’and ‘SPAC to basics (VI): UK potential’.

[2] This order was chosen because it is believed thatunderstanding the role and goals of the SPAC’s shareholders—and the operationof the redemption clause—is essential to fully appreciating the functioning ofthe SPAC. For more detail on the SPAC lifecycle, see the first installment inthis series: ’SPAC to basics (I): structure and timeline’.

[3] Ramey Layne and Brenda Lenahan, “Special PurposeAcquisition Companies: An Introduction”, Harvard Law School Forum on CorporateGovernance, 6 July, 2018, available at:https://corpgov.law.harvard.edu/2018/07/06/special-purpose-acquisition-companies-an-introduction/.

[4] Ibid. an important post-2017 trend in SPACsponsors merits mention: an increasing share of SPACs are sponsored by industryexecutives. The share of industry executive-sponsored SPACs more than doubledfrom 2017 to 2018 from 32% to 65% and increased a further 11% to 76% in 2019: “AI: Increasing Number of SPAC Founding Sponsors areIndustry Executives”, Jefferies, available at:https://www.jefferies.com/OurFirm/2/1616.

[5] Typically $25,000: Layne and Lenahan, “Special PurposeAcquisition Companies: An Introduction”.

[6] Purchase pre-IPO ensures that gains are taxed as capitalgains taxes.

[7] Layne and Lenahan, “Special Purpose Acquisition Companies:An Introduction”.

[8] Ibid.

[9] Finding, negotiating with and (hopefully) merging with atarget

[10] Layne and Lenahan, “Special Purpose Acquisition Companies:An Introduction”.

[11] The average annual return of the S&P 500 over the lastdecade has been 13.6%: Liz Kneuven, “The average stock market return over thepast 10 years”, Business Insider, 24 August, 2020, available at:https://www.businessinsider.com/personal-finance/average-stock-market-return#:~:text=Between%202010%20and%202020%2C%20however,in%20the%20past%2010%20years.

[12] The annual yield of a 26-week T-bill (in which IPO capitalis typically invested) is 0.08% (as of 15 December, 2020). See current data ontreasury yields: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2020

[13] See below for an in-depth discussion of the possibility ofextending the SPAC’s lifespan by a shareholder vote.

[14] This is also one of the reasons why SPACs typically onlyhold T-bills with a maturity of 180 days or less rather than full two-yearmaturity bonds.

[15] See, for example, the markets this year (2020) in Februaryand March.

[16] The 1940 is the framework used toregulate mutual funds and requires regular disclosure of investment objectives,amongst other things: see SEC overview of the Investment Company Act of 1940and legislation itself;https://www.sec.gov/investment/laws-and-rules#:~:text=Investment%20Company%20Act%20of%201940,offered%20to%20the%20investing%20public.

[17] Which mandates, inter alia, that blank check companiesoffering penny stocks must hold 80% of IPO proceeds on trust for investors andoffer them a redemption option for a pro rata share of the account. For furtherinformation on Rule 419 and its impact on modern SPACs stay tuned for the fifthinstallment in this series: ‘SPAC to basics (V): calls for reform’.

[18] SEC Release No. IC-18651 (Apr. 13, 1992).

[19] See Rule 2a–7 of the Investment Company Act of 1940.

[20] Ramey Layne, Brenda Lenahan and Sarah Morgan, “Update onSpecial Purpose Acquisition Companies”, 17 August, 2020, available at:https://corpgov.law.harvard.edu/2020/08/17/update-on-special-purpose-acquisition-companies/.

[21] The redemption rate at the point of extension, at around40%, is very similar to that at the merger proposal. See Ramey Layne, BrendaLenahan and Sarah Morgan, “Update on Special Purpose Acquisition Companies”, 17August, 2020, available at: https://corpgov.law.harvard.edu/2020/08/17/update-on-special-purpose-acquisition-companies/.

[22] Although, note the disconnect between capital raised in theSPAC IPO and the capital ultimately employed in the merger: see ‘SPAC to basics(II): investor perspective’. Even so, the difference between IPO capital andcapital needed for the merger is compensated for by PIPE deals which are oftenfunded by the sponsor. It is therefore in the sponsor’s interest to avoid highredemption rates.

[23] As of 17 December, 2020. This is up from $230.5 million in2019. SPAC Insider, “SPAC IPO Transactions – Summary by Year”, available at:https://spacinsider.com/stats/.

[24] NASDAQ Rule IM-5101-2(b).

[25] NASDAQ Rule IM-5101-2(b). For the full Rulebook see:https://listingcenter.nasdaq.com/rulebook/nasdaq/rules/nasdaq-5100-series.

[26] A SPAC “[m]ay seek a shareholder vote to extend itslifespan to a total of 36 months”(emphasis added): “SPAC 101: Transaction Basics and Current Trends”, Winston& Strawn LLP, 2018, available at:https://www.winston.com/images/content/1/3/v2/135061/Winston-Strawn-SPAC-Basics-Presentation-2018.pdf.This same view is taken by a number of other companies. See, for example,Deloitte: “A SPAC has a defined life of 18–24 months to consummate anacquisition—this period can be extendedup to a maximum of 36 months with shareholder approval” (emphasis added):Deloitte, “High Growth Companies Update”, 4 December, 2020, available at:https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/private-markets/deloitte-uk-dp-high-growth-companies-webinar-spacs.pdf.SPAC Alpha (a market research company) also expresses this view: “a SPAC has18–24 months to consummate an acquisition - this period can be extended up to a maximum of 36 months withshareholder approval” (emphasis added): SPAC Alpha, “US SPAC Primer”, 1 June,2020, available at:https://spacalpha.com/wp-content/uploads/2020/06/US-SPAC-Primer_1Jun20.pdf.

[27] Amongst other firms.

[28] Although the practical difference would be minimal (if atall existent), NASDAQ Rule IM-5101-2(b) cannot be understood as reducing the lifespan in theregistration statement to 36 months since this would not be shorter than the listing rule maximum.The lifespan in the registration statement must therefore be disapplied.

[29] NASDAQ Rule IM-5101-2(b).

[30] A SPAC IPO is registered on Form S-1. See here for a pdf ofForm S-1: https://www.sec.gov/about/forms/forms-1.pdf.

[31] This is done via proxy statement pursuant to Section 14(a)of the Securities Exchange Act of 1934. For an example, see the registrationstatement of the SPAC Albertson Acquisition Corp (ALAC):https://www.sec.gov/Archives/edgar/data/1748621/000121390019023903/0001213900-19-023903-index.htm.See the proxy statement filed by the same SPAC:https://www.sec.gov/Archives/edgar/data/1748621/000121390020030734/ea128044-defa14a_albertonacq.htm.

[32] An over 50% extension to the lifespan of the SPAC—andtherefore to the time in which investor capital is locked up—would amount to asignificant change to what investors originally signed up for. This is, ofcourse, even more evident where the SPAC’s charter and registration statementoriginally set an under-24 month deadline.

[33] Layne, Lenahan and Morgan, “Update on Special PurposeAcquisition Companies”.

[34] This follows logically from the aims and objectives of thedivesting investors that make up the vast majority of SPAC shareholderspre-merger: see ‘SPAC to basics (II): investor perspective’.

[35] Typically $25,000: Layne and Lenahan, “Special PurposeAcquisition Companies: An Introduction”.

[36] By increasing the relative share of the public investors:Mayer Brown, “Going Public in the US by Merging into a SPAC: Weighing the Pros& Cons”, 2 November, 2020, available at: https://www.mayerbrown.com/-/media/files/perspectives-events/events/2020/11/going-public-in-the-us-spacs-proscons.pdf.

[37] As of 17 December, 2020. This is up from $230.5 million in2019. SPAC Insider, “SPAC IPO Transactions – Summary by Year”, available at:https://spacinsider.com/stats/.

[38] The typical 80/20 split.

[39] Typically amounting to 24.6% of capital raised at IPO:Klausner and Ohlrogge, “A Sober Look at SPACs”, Stanford Law School, availableat: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3720919.

[40] Ibid.

[41] The typical $11.50 strike price of warrants means thatwarrants will only be exercised if the share price rises above this pricethreshold.

[42] Indeed, at the 75th percentile the sponsor’s promote is140% of the cash delivered upon merger: therefore, in these 25% of cases thesponsor therefore receives a significantly higher proportion of the shares thanpublic shareholders.

[43] Contrast the typical 180 day lock-up agreement agreementfollowing a traditional IPO.

[44] Layne and Lenahan, “Special Purpose Acquisition Companies:An Introduction”.

[45] Douglas Cumming, Lars Haß and Denis Schweizer, “The fasttrack IPO – Success factors for taking firms public with SPACs”, Journal ofBanking & Finance, Volume 47, October 2014, pp. 198-213, available at:https://www.sciencedirect.com/science/article/pii/S0378426614002489?casa_token=GFjKiF33tYgAAAAA:XDzb0ilslViHBghoNm6LjDnNw79sgFIFJqbbnLk5j2LK_N1NurxBVP1AgfUOpShkX9lGAGizoQ.

[46] A sponsor is deemed to be of “high quality” if they areboth (i) affiliated with a fund listed in PitchBook with assets undermanagement of $1 billion or more and (ii) are a former CEO or other seniorofficer of a Fortune 500 company: Klausner and Ohlrogge, “A Sober Look atSPACs”. Under this definition, 24 of the 47 SPACs which merged between January2019 and June 2020 were deemed to have had “high quality sponsors”.

[47] Klausner and Ohlrogge, “A Sober Look at SPACs”.

[48] Ibid.