25 June 2007
The private equity markets have seen the development of an interesting investment vehicle that, after a relatively slow start, now appears to be getting a head of steam.
Special-purpose acquisition companies (Spacs) are interesting and unusual because, unlike the familiar model for private equity funds, they are able to raise investment capital in the public markets through IPOs when they are little more than corporate shells and have no operating track records.
Spacs give investors the opportunity of participating in transactions that are generally only available to conventional private equity funds, but with the transparency and liquidity of a listed company. They are an innovative way to raise capital with the need for behind-the-scenes relationships with, and access to, private equity capital.
The Cayman Islands is often the jurisdiction of choice as it is the leader in offshore investment funds, be it hedge funds or private equity funds, and as such investors and other parties to the transactions are comfortable with the stability, regulation and track record of Cayman.
Spacs originated in the US, where they were typically listed on Nasdaq, but as a result of the effects of Sarbanes-Oxley and other regulatory changes they are now more frequently created as a Cayman-exempted company with shares listed on AIM.
Setting up a Spac
A Spac is typically formed as a Cayman-exempted company by a small group of initial investors, including the management team. In a typical Spac the management team is mandated through the IPO listing document to identify one or more target operating companies within a specified period of time for potential acquisition, failing which the Spac will be dissolved. To a large extent the investor is making the investment on the strength of the management team.
To protect investors from the obvious risks associated with handing over a blank cheque, Spacs generally restrict their own activities and those of their management team following a successful IPO. A number of investor protection provisions have become common and, although initially dealt with through contractual covenants, are now generally embodied in the constitutional documents of the Spac, which in the case of a Cayman-exempted company comprise the memorandum and articles of association.
The more important of these protections include the following:
- A substantial proportion (usually 85-90 per cent) of the net proceeds of the IPO will be placed in an interest-bearing trust account held by a reputable third-party custodian. The terms of the trust will typically limit the use of the funds to the acquisition by the Spac of approved target companies, or the return of funds to investors in the event that no targets are approved and the Spac is liquidated.
- No target companies may be acquired by the Spac without investor approval (typically by super-majority vote) and, if the required majority is not obtained, the proposed target is rejected.
- Dissenting investors who vote against otherwise approved investments have the option of withdrawing from the Spac and receiving back their pro-rata share of the trust fund, or selling their shares and warrants in the market.
- There is normally a deadline of between 12 and 24 months from the date of the IPO for the identification of target companies, conduct of due diligence and completion of the acquisitions.
- The management team are rewarded through capital gains on the shares it retains in the Spac following the IPO, rather then through the remuneration or management fee.
Advantages and disadvantages
Spacs are specialist products with both advantages and disadvantages when compared against conventional funds.
On the plus side, Spacs provide investors with special rights including the right to approve or reject each target company proposed by management and the right to recover a substantial portion of their investment in the event that no targets are approved.
In addition, investors who may not otherwise qualify to invest in private equity funds have the opportunity to participate in the acquisition of private operating companies while retaining liquidity (albeit perhaps limited) as a result of the public listing of the Spac's shares and warrants.
On the negative side, investors are exposed to a lack of investment diversity and, in the event that no target companies are acquired, to the risk of losing the portion of the IPO proceeds set aside to cover expenses. In addition, the requirement for investor approval prior to the acquisition of target companies may result in Spacs being less nimble on their feet than conventional private equity funds with the corresponding risk that opportunities may be lost (or become more expensive) while shareholder meetings are convened.
Additionally on the negative side is the reliance an investor places in the management team. There has been at least one instance where the management team entered into conditional agreements with the target. Prior to completion the transaction collapsed, but the management team had agreed to pay a fee should the transaction not proceed, which was greater than the operating costs retained by the Spac. Trust funds set aside for investors were exposed.
Accordingly, the management team must be aware of the limited operating costs available to the Spac and not allow the Spac to have creditors over and above the cost of funds available. Otherwise a portion of the trust funds may not be available for the investor should the Spac be liquidated.
While significant amounts of capital have been raised through Spacs, they nevertheless form a relatively small part of the global private equity market and will almost certainly continue to do so. Spacs have evolved in the past few years from single-acquisition vehicles common in the US, where the intention and purpose was to acquire a single target company through a business combination with the Spac, to the multi-acquisition vehicles commonly found in AIM listings. With the current investment levels in China and India, the use of Spacs is likely to continue to increase.
Kevin Butler is a partner and Richard Fear is an associate at Conyers Dill & Pearman