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Contributed by Carol Anne Huff, Arnold & Porter
Mergers with special purpose acquisition companies have always been an alternative to the traditional initial public offering market. With that market effectively closed, a SPAC merger may be the only public market liquidity option for many private companies. Obtaining liquidity through private sale transactions is difficult, as acquisitions by below-investment-grade companies are constrained by extremely tight credit markets. For targets seeking to move forward with a deal now, SPACs and their cash sitting in trust accounts are likely looking good.
Because SPACs have a limited period (18-24 months) to complete a transaction, waiting for greater certainty around the timing and extent of an economic recovery is not an option for many SPACs. Of the 81 SPACs currently seeking a business combination, 44 have a completion deadline within 12 months and half of those have a deadline within six months. With the clock ticking, the choice for many SPACs will be to move forward and seek a business combination or liquidate.
SPAC sponsors are unlikely to continue to sit on the sidelines because they are highly incentivized to complete a deal. In fact, after over five weeks with no announced business combinations, Leo Holdings Corp. announced on April 23, 2020 a proposed business combination with Digital Media Solutions. In general, SPAC sponsors receive 20% of the SPAC's pre-business combination common stock as compensation but receive no proceeds from the trust account for these “founder shares” if the SPAC liquidates. The sponsor also loses its “at-risk” capital if a transaction is not completed because it will have funded the SPAC's working capital and deal expenses.
While many SPACs have had success prior to the Covid-19 crisis in seeking an extension of their liquidation deadlines, extensions come at a cost. SPACs’ public stockholders are entitled to vote on the extension and, at the time of the vote, have the option to elect to have their shares redeemed. Sponsors must contribute additional cash to the trust account to incentivize holders not to redeem. Even with sponsors contributing cash to the trust account, many SPAC investors will nevertheless elect to redeem and take advantage of opportunities to deploy their cash elsewhere.
For SPACs seeking to complete a business combination before their liquidation deadlines, there is reason for optimism, as they are well-suited to complete business combinations and take target companies public despite economic uncertainty and market volatility.
Valuing transactions will be challenging while it is unclear when the economy will reopen and what the recovery will look like. Flexibility will be needed for deals to move forward, but this is nothing new for SPACs. SPAC merger agreements often contain features designed to bridge the parties’ different views of valuation. “Earnouts,” allowing targets to retain some upside post-closing based on either the target's future financial performance or stock price performance, escrow arrangements and contingent value rights are common features in SPAC transactions. In comparison to a traditional IPO, the SPAC structure provides greater opportunities for the parties to address uncertainty in valuations.
In addition, SPAC transaction agreements are generally structured to provide for maximum flexibility because the amount of cash that will be available following redemptions is inherently uncertain. The consideration to the target's stockholders generally includes a combination of cash and some amount of “rollover” equity, with this mix adjusting based on the level of redemptions and cash shortfall at closing. A SPAC will also generally seek some room to maneuver in the pre-closing covenants to allow the SPAC to make up for cash shortfalls caused by redemptions through the sale of additional equity or alternative financing.
Lastly, the “de-SPACing” process has always required SPACs and targets to accept some fluidity in deal terms. After a business combination is announced, management of the target and the SPAC's sponsors begin the “de-SPACing” process by marketing the deal to existing and prospective investors. If the market does not like the deal, the stock price will not rise above the redemption value of the stock and investors will redeem, making it unlikely that the closing conditions will be met.
SPAC sponsors tend not to give up easily, though. If they believe that the deal is not being well received by the market, they will seek to renegotiate the terms of the transaction to make it more attractive to public investors or fill the cash shortfall. Only two SPAC business combinations that were announced and pending at the start of the Covid-19 crisis have been abandoned—Allegro Merger Corp.’s proposed acquisition of TGI Fridays and HL Acquisition Corp.’s proposed purchase of an energy sector target.
A recent example of renegotiation is Legacy Acquisition Corp.’s announcement in March 2020 that it was amending the terms of its deal to acquire Blue Impact. The deal was re-struck at a lower implied enterprise value and Legacy agreed to pay its public holders additional cash and/or common stock at closing dependent on the cash proceeds remaining after redemptions. In addition, Legacy has delayed the date for its planned stockholder meeting in order to complete potential PIPE (private investment in public equity) financing for the deal.
SPACs are accustomed to structuring deals with flexibility to take into account changing market conditions and investor appetite and sponsors are aware when signing a business combination agreement that it is often the start rather than the end of negotiations. This ability to adjust will serve SPACs well.
This is not to say that getting deals to the finish line in the current environment will be easy, but that has always been the case for SPACs. Public stockholders’ redemption rights and market forces have always created uncertainties in SPAC deals, requiring creativity and a willingness to adapt to market feedback on the part of both buyers and sellers, even in the most favorable market conditions.
Choosing the right company and valuing it properly will be more important than ever. SPAC investors have always demanded a discount, similar to an “IPO discount,” and investors will continue to look for both value and growth potential. Distressed targets are not, and have never been, the right fit for SPACs.
SPACs that are targeted at sectors poised for growth despite (or because of) the current crisis will likely be the first to move forward with business combinations. For example, SPACs aimed at health care, life sciences, software, and government contracts and services should be able to find targets that will be attractive to investors. SPACs focused on sectors that have been hardest hit, such as hospitality and energy, will need to pivot.
Whether the current environment will result in a change in deal terms is unclear. SPAC sponsors have always sought certainty of closing due to the time pressure and economic incentives to complete a deal, but the current market presents more than the usual share of uncertainty.
Sponsors will likely negotiate for the ability to pay more of the transaction consideration in “rollover” equity in the event of a cash shortfall. Both targets and SPACs will likely seek to line up PIPE investments to make up for any shortfalls in cash caused by redemptions. A PIPE backstop has always been viewed positively by the market but it will be even more important in the current market, both to affirm valuations and to provide certainty of closing.
Even if SPAC acquisition activity proves to be resilient in the current environment, it remains to be seen how many sponsors will bring new SPACs to market. SPAC IPOs returned in late April 2020 with a bang. Social Capital Hedosophia Corp. III priced a $720 million offering on April 21, 2020 (upsized from $600 million), the first SPAC IPO to price since the COVID crisis began. Chardan Healthcare Acquisition 2 was also scheduled to price its $85 million offering on or around April 23, 2020.
Just as there will likely be a market for combinations with good target companies, there will be a market for SPACs being formed by well-known sponsors with proven track records in industries that are likely to weather the Covid-19 storm. Social Capital III, which is targeting the tech sector, is a repeat performance for the well-known management team that completed a merger with Virgin Galactic in Oct. 2019.
SPACs led by less-experienced management teams will face challenges. There are approximately a dozen SPACs in registration with the SEC at present and over 80 existing SPACs seeking business combinations. In addition, new SPACs will face competition from SPACs trading in the secondary market if market volatility causes trading prices to fall below the per-share trust value (and the yield on these investments to increase for those investors willing to hold until the redemption date).
The extent to which sponsors need to offer more investor-friendly terms, such as inclusion of “rights” or greater warrant coverage, remains to be seen. Even Social Capital III amended its terms to provide for 1/3 rather than 1/4 warrant, among other investor-friendly terms. Tighter terms may cause some sponsors to delay going to market until conditions improve—both in the IPO and deal market. For existing SPACs, though, there is reason to be optimistic that new deal announcements will appear into spring and summer 2020.