SPAC-tacular SECP
The draft regulations released by SECP for SPACs should be extensively reviewed and amended before they are formalized.
SECP released draft regulations for SPAC seeking comments from the public.
SPAC is a new concept for Pakistan’s capital market but is prevalent in many countries, including the US, Canada, Malaysia, etc. Under the SPAC structure, a company comprising a group of persons or professionals raises funds from the public to use them for the purpose of mergers or acquisitions within a permitted time-frame
Well received by Pak FinTwit
This is a fairly progressive move by SECP and it was well-received by the very small community that is Pakistan FinTwit (finance twitter).
This was also covered in Dawn
Stock market regulator latches on to idea of SPACs
Commenting on the development, Aftab Ahmad Chaudhry, former managing director of the Lahore and Islamabad stock exchanges before their merger into PSX, said the launch of SPAC regulations in Pakistan is nothing less than revolutionary. “It will unleash a process mergers and acquisitions of small and mid-sized growth companies in the country as previously the merger and acquisition activity was considered synonymous with large or big companies.”
Aftab, who is currently doing equity capital mobilization transaction advisory work and is involved in a number of mid-scale market acquisition, was of the view that the formation of SPACs will boost the opportunities for the specialized fundraising advisors to spot small and mid-sized companies in need of finance and then raise finance through market opportunities provided by SPAC regulations.
“The SPAC regulations are nothing less than an innovation in the public offering framework. In nutshell, SPACs have the potential of shifting the focus of fund seeking companies away from the banks to the capital markets without having to go through the onerous of listing themselves.”
Recent developments on the SPAC front
This section covers some of the developments in the US as the SPAC frenzy started in the US in the last two quarters of 2020.
SPAC Boom
SPACs have raised about $100 billion in 2021 by mid-April, more than 2020's record of $83.4 billion, which itself was more than the amount raised in the nearly 30-year history of these blank-check companies.
Celebrity SPACs
US celebrities from all walks of life have been associated with SPACs. It is hard to know what role they are playing in the SPAC but their names are used to market these SPACs. Shaq O'Neill, Stephen Curry, and Serena Williams are some of the sports celebrities that been associated with SPACs. Singers such as Jay-Z and Ciara have a SPAC. A large number of business and finance personalities have launched SPACs notable amongst them Chamath, Mark Cuban, Richard Branson, and Peter Thiel.
SEC crashing the party
In mid-April 2021, the Securities and Exchange Commission threw a wrench in the works that they will be closely looking at SPAC accounting treatment of the warrants. The guidance from SEC is that warrants will be treated as liabilities instead of equity. This has had the effect of suddenly cooling the market.
After a record of 109 new SPAC deals in March alone, issuance has now come to almost a standstill with just 10 SPACs in April.
Wealth transfer from SPAC investors to Sponsors
SPAC Insiders Can Make Millions Even When the Company They Take Public Struggles
Investors who bought into a special-purpose acquisition company that took a healthcare-services company public last year in an $11 billion deal have suffered steep losses. Promoters of the SPAC still stand to make millions.
Shares of several other firms tied to blank-check companies have also been in retreat recently, raising the likelihood of a similar divergence between returns for insiders and later investors in many other SPACs. A growing gap between returns for insiders and later investors would challenge the common view that blank-check companies democratize finance, critics said, threatening the overall popularity of the product going forward.
“It’s so asinine that you can get this kind of payday for doing something so value destructive,” said Carson Block, CEO of Muddy Waters.
RIP SPACs
S&P came out with a tongue-in-cheek note
RIP SPACs July 2020 April 2021
Even for a financial mania, SPACs didn't last long. These highly speculative schemes have whipsawed from nowhere to everywhere and now back to nowhere – all in a matter of months. Live fast, die young.
Our obituary for the short-but-colorful life of special purpose acquisition companies (SPACs) is a bit facetious, of course. But there's no denying, to use a metaphor favored by cynical Wall Streeters who have seen this sort of thing before, that the SPAC bubble is no longer being pumped up like it had been.
Along with 'meme stocks,' SPACs became a favorite way for investors to play the market while they were cooped up during the lockdown. Fear of losing money last spring gave way to 'fear of missing out' on making it later in the year. So why not stake Shaq on a deal?
As suddenly as it began, the SPAC craze is now winding down. Investors in blank-check offerings, along with those associated equity market investors that typically put even more money into the 'SPAC-quisitions,' are no longer buying sight unseen. Instead, the group that's looking most closely at SPACs right now seems to be the SEC. Which is as clear a sign as any that a boom has gone bust.
Is this the end of SPAC mania in the US or a temporary lull? Are we launching a SPAC boom in Pakistan when it has reached a bust in the US?
What is a SPAC?
Ammar tweeted a thread explaining it.
I will attempt to explain it by contrasting it with an IPO.
How the IPO works
XYZ, a company, is created and develops a business.
XYZ feels that it needs more funds to expand and decides to go for an IPO.
XYZ will develop internal capabilities to get ready for an IPO such as having a corporate governance framework, audited accounts, investor relations department, etc.
XYZ will go for an IPO by filing a prospectus with the regulator.
In the prospectus, XYZ will present details about its business, its historical performance, and the risks it faces. However, the prospectus cannot contain forward-looking statements.
The price at IPO is not guaranteed and it will be based on the investor interest for the IPO either through book building or direct listing. This brings uncertainty to XYZ owners as they are not sure how the market will value their entity.
The company is listed on the exchange with a ticker XYZ.
How SPACs work
Sponsors believe they have the ability to identify companies that will make for good public listed companies.
Sponsors do an IPO for a shell company, a SPAC, at $10 per share. It is listed on the exchange with a ticker ABC. ABC has a certain time period usually two years to identify the company to merge with.
A portion of investors' money received in IPO is placed in the escrow/trust account.
Investors invest in the ABC IPO with the expectation that the sponsors have the ability to identify target companies. ABC has no underlying business other than to search for a company to acquire or merge with.
Once the target company XYZ is identified, sponsors negotiate the price with XYZ’s owners/managers. This provides XYZ a certainty of the price that was not available in step 7 of the IPO process above.
The sponsors then present the merger to a shareholder vote.
If the shareholders vote for it, the merger goes ahead with XYZ now merged with ABC. The ticker of the merged entity now changes to DEF. This process is called de-SPAC as now the SPAC no longer exists, only the merged entity does.
If a significant number of shareholders vote against the merger, the merger may not happen. This is the same uncertainty which the SPAC process was supposed to eliminate.
If two years are up and no merger/acquisition takes place, funds are returned to shareholders in proportion to their shareholdings from the balance available in the trust/escrow account.
Summary of IPO vs SPAC
The difference between standard IPO and SPAC is that in a standard IPO, you are betting on an existing business with existing management. In a SPAC, you are handing over money to sponsors and betting that they can find a business to take public.
Things to look at when investing in a SPAC
The SPAC Management / Sponsors
Goes without saying that in a SPAC you are handing money to sponsors without any underlying business and trusting them to find a business to acquire. The integrity, business acumen, and track record of the sponsors are the key factors to consider when making a decision whether to invest in a SPAC.
The prospectus is the key document
In the case of IPOs, people rarely read the prospectus and invest mostly based on the company hype or their familiarity with the business (my father purchased Trakker shares in the IPO for no other reason than our car was protected by Trakker) or insider information. But there is an underlying business and assets of the company going for an IPO. In the case of a SPAC, investors are investing in a shell company. Thus the prospectus acquires a larger significance. The following are the key terms in the prospectus that the investor should consider:
1. Target Sector
What will be the target sector or industry that SPAC will eventually be investing in? How do the investors feel about that sector?
2. Sponsor compensation and SPAC governance
What is the compensation structure of the sponsors? What will be the corporate governance framework of the combined entity? Are the SPAC shareholders allowed to elect directors on the board? How many shares and warrants are the sponsors getting?
3. Warrants
Warrants allow the warrant holders to purchase shares from the company at a specific price on a future date. The prospectus should be clearly read to understand how many shares the investor has the right to purchase, what is the period in which shares can be purchased and when will the warrants expire.
4. Escrow account
The money invested by investors will be deposited in the escrow. Who is the custodian of the escrow account? What are the instruments that the funds in the escrow account can be invested in? If you are a sharia-compliant investor and the escrow account balance is invested in PIBs or interest-bearing instruments, the additional amount the investor will be getting from the escrow will have to be donated away.
5. The period allowed to find the target company
What is the time that sponsors have to find the target company and merge with it? If the prospectus allows for an extension of the time period, what is the procedure for seeking an extension, and how long an extension can be sought?
6. Shareholder approval and redemption mechanism
How will the SPAC seek approval from the shareholders for the merger and how cumbersome or convenient is the process? For those not agreeing to the merger, how soon will they be refunded?
Review of SECP draft regulations
Below are some of the key clauses of SECP’s draft regulations that I want to highlight and my comments on them.
Short Comments
The minimum capital raise at IPO be Rs.200 million. The acquisition must comprise at least 80% of the aggregate market value of balance in an escrow account and supported by competent valuers' reports.
The justification I can think of for the 80% condition is that SECP is looking for a minimum size of the company to be listed. Let’s assume Rs.200 million is raised in SPAC IPO. 90% of IPO proceeds make it to escrow i.e. Rs.180 million. The acquired entity should be valued at Rs.144 million (80% of Rs.180 million escrow balance assuming zero returns on the escrow balance).
90% of the proceeds from SPAC IPO to be deposited into an escrow account.
The investors should be aware that they are out-of-pocket by 10% of the investment on day 1 of investing in SPAC. The SPAC sponsors are allowed to use the 10% of the funds raised through SPAC IPO for searching for the target, paying management expenses, and any other expenses. If I am the SPAC sponsor, I will ensure that I will completely expense the 10% by the time I do the merger/acquisition or liquidation. There is no incentive for the sponsors to minimize expenses to less than 10% of the IPO amount. In a scenario where SPAC sponsors are bad-faith actors, the 10% allowance is a wealth transfer mechanism from the SPAC investors to SPAC sponsors.
Sponsor ownership and ownership percentage discrepancy.
Draft regulation clause 12.c.vii states that the sponsors of SPAC should hold 30% of stocks for a period of 3 years from the date of SPAC listing
clause 3.4(xv) of the draft prospectus included in the regulations state that sponsors should hold the 51% of SPAC shares for at least three years.
The above discrepancy needs to be removed.
Whereas on one hand, I am sympathetic to the view that SECP wants the sponsors to put the money where their mouth is and have the skin in the game by putting in 30% or 51% of shareholding as their equity. On the other hand, I find this requirement unreasonable. Sponsors are bringing their management expertise to the transaction. Their motivation for SPAC would be less if they not only have to bring the expertise but also significant capital investment. For example, if the SPAC IPO is for Rs.200 million, in the 51% scenario, sponsors are expected to put up more than Rs.100 million. That is not a chump change. If sponsors have that kind of capital available, the only reason they are doing a SPAC will be to charge the investors a management fee because if they have access to Rs.100 million, they may also easily have access to Rs.200 million.
Each merger or acquisition transaction shall be approved by the shareholders by way of special resolution. The shareholders disapproving the merger or acquisition transaction are entitled to a refund of their money out of the escrow account as per entitlement.
The shareholder vote is a key pillar of investor protection in the SPAC process. This process should be made easier so that anyone who wants to oppose the merger can do so easily, quickly without jumping through unnecessary hoops preferably with just a few clicks on the computer if possible.
Refund to shareholders a proportionate share of funds in the escrow account:
To all shareholders, if SPAC is unsuccessful in completing an acquisition in 24 months
To those who voted against the merger to be paid as soon as possible the merger is complete.
The second condition is incomprehensible. Those who voted against the merger should be provided refunds right away and even before the merger process is started. The funds are in escrow and available before the merger. Once the merger happens, the funds in escrow will be used towards completing the merger. There may be no funds left in the escrow to redeem the opposing shareholders after the merger.
Listing twice: a preposterous requirement
The draft regulations have the following clauses which go against everything that a SPAC stands for:
Obligations of SPAC :
12.c.(ii) list the acquired entity within a period of two years from the date of acquisition.;
Winding up of SPAC:
12.p.7 (7) After successfully completion of the acquisition and lock in period of three years as per regulation 12(c), the sponsors of SPAC shall initiate the process of its winding up.
The reason SPAC exists and is listed is to avoid the process of taking the acquired company through the IPO process. The aforementioned draft regulations are requiring the SPAC (which no longer exists) to list the acquired entity (which also doesn’t exist anymore as a separate entity) within two years of acquisition. In addition, they are requiring the SPAC which has merged into the acquired company to wind up within three years (of SPAC listing?). These two clauses need to be deleted. Probably SECP hasn’t thought through how SPAC works.
However, if we are to humor SECP here, it leads to the following:
1. We are talking about two IPOs here. First of the shell company i.e. SPAC followed by another IPO of the acquired entity. Defeats the purpose of SPAC
2. This extends the life of SPAC to a maximum of 4 years (and not two years as stated in the prospectus). Two years for finding the acquisition target and merging with it and then two more years to get the acquired entity listed.
Matters not addressed by draft regulations
Escrow account process if the merger takes place.
The draft regulations only discuss the escrow with respect to its custody or refunds to shareholders in case of opposing votes or winding up of SPAC. The regulations do not address how the custodian will proceed with the escrow account once the SPAC proceeds with the merger.
Let’s take a hypothetical example. Say there are Rs.180 million in escrow. Rs. 150 million were required for the acquisition. All the shareholders voted for acquisition.
The regulations do not mention that if, when, and how the custodian will release Rs. 150 million to complete the acquisition.
There are Rs.30 million remaining in the escrow account after the acquisition. Theoretically, the custodian should release this to the merged entity as it becomes part of the cash balance of the new entity. It has not been addressed.
Corporate requirements of the merged entity
There usually isn’t much for the SPAC in terms of reporting and governance as it is a shell entity. However, the merged entity should have to comply with all the governance requirements that come with listing such as audited accounts with detailed notes and disclosures, corporate governance framework, independent board of directors, internal controls, valuation of the assets on the books, and whatever is required for a listed entity. The draft regulations should address that once a company becomes listed, it should follow all the requirements that are required from a listed company and the penalties that may be applicable to it if it fails to do so.
Regulatory Arbitrage
Draft regulations request the following information in the prospectus:
Please also disclose whether or not SPAC currently have any specific business combination under consideration. If the SPAC is affiliated with a private equity group, then also disclose the members of the SPAC management team employed by the private equity group, which is continuously made aware of potential business opportunities, one or more of which the SPAC may desire to pursue for a business combination.
This should be expanded upon. SPACs should be a mechanism for private equity groups to have committed capital to go search for acquisitions and quickly list them. However, a SPAC should not be a mechanism for a regulatory arbitrage i.e. where companies that are ready for listing instead of going for the formal IPO process take a shortcut approach and merge with a SPAC.
If the problem is in the needless documentation requirements of the IPO process, then the IPO process should be rectified. Not that a backdoor is created for entities to list on the exchange.