Reprinted with permission from the 16 October 2020 edition of the New York Law Journal© 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

2020 has been a record-breaking year for U.S. special purpose acquisition company (SPAC) activity, marked by significant growth in both the size and number of IPOs, novel changes in SPAC terms and the continued development of creative financing arrangements providing SPACs with capital incremental to IPO proceeds. These signs suggest SPACs will be more frequent and formidable bidders in the M&A market, competing for larger deals than they have in the past.

SPACs, also known as blank check companies, are non-operating entities formed to identify and complete a business combination, often in a targeted industry or sector, within a specified period of time after the SPAC’s IPO. IPO proceeds are held in a trust until a business combination is identified, then used to fund the transaction together with proceeds raised through other financing agreements.

U.S. SPAC shareholders typically have the right to vote on whether to approve the business combination transaction and, independent of how they cast their votes, can elect to redeem their shares in advance of the transaction. Following the business combination, the surviving company continues to trade its shares publicly, meaning that SPACs can provide a fast-track to public capital markets for the target company.

Significant Growth

Through September, there have been over 100 SPAC IPOs in 2020, compared to 59 in all of 2019 and 46 in all of 2018, according to SPACInsider.com. SPAC IPOs are growing not only in frequency but in size: the average IPO size in 2020 has been $385 million, almost double the $230 million average IPO size of the past two years, and 2020’s gross proceeds from SPAC IPOs total approximately $42 billion, a significant increase from the $13.5 billion raised by SPAC IPOs in 2019. Already, 2020’s total capital raised from SPAC IPOs equals more than half the amount raised in all previous SPAC IPOs from 1995 through 2019.

Incremental Financing

SPACs frequently raise additional proceeds through financing commitments from institutional investors or the SPAC’s sponsor or affiliate of the sponsor. These arrangements are typically for the purchase of common stock through a PIPE (“private investment in public equity”). The market has developed three variations of these agreements: forward purchase agreements, entered into at the time of the IPO, as well as subscription agreements and backstop agreements, both of which are typically signed concurrently with entry into the business combination agreement (or shortly thereafter).

Funding for backstop agreements is conditioned upon either a shortfall in total cash needed to consummate the transaction or upon redemption of SPAC shares by shareholders. Funding conditions are present in some backstop agreements but are not a feature of subscription agreements, which are typically conditioned only upon consummation of the business combination.

Many recent SPACs have entered into multiple PIPE agreements, frequently raising more than half of the amounts raised in their IPOs. While it has historically been rare for a SPAC to raise more funds from PIPEs than in its IPO, several SPACs this year have done just that. For example, Churchill Capital Corp III raised $2.6 billion in subscription agreements, more than double the $1.1 billion raised in its IPO.

The combination of bigger IPOs, the significant amount of cash raised from PIPEs, the continued ability of SPACs  to access debt financing in connection with a business combination transaction, and the fact that many recent SPAC deals have used SPAC stock as partial acquisition consideration (and occasionally have used SPAC stock as the entire acquisition consideration) results in opportunities for SPACs to target companies that have enterprise values substantially in excess of the amount of a SPAC’s IPO offering.

Churchill Capital Corp III’s PIPE funding enabled it to pursue its $11 billion deal with MultiPlan in July of 2020, paid in a combination of cash and stock, with the transaction value dwarfing the $1.1 billion raised in its IPO. After raising $450 million in its IPO, Conyers Park II Acquisition Corp. raised an additional $700 million of PIPE investments and in September of 2020 signed a deal with Advantage Solutions, Inc. in an all-stock deal valued at approximately $2.27 billion, using the cash to pay principal and interest on debt and any remaining proceeds for working capital and general corporate purposes.

Similarly, in September 2020, Gores Holdings IV raised $425 million in its IPO and an additional $500 million in a private placement in connection with a deal valued at approximately $16 billion, paid in cash and stock.

Innovative Terms

The $4 billion IPO (July 2020) of Tontine Holdings, a SPAC sponsored by Bill Ackman’s Pershing Square, not only set a new record for its size, but introduced innovations in deal terms that, if they catch on, could make SPACs a more appealing opportunity to investors going forward. One of the most noteworthy changes was removing the typical 20% sponsor “promote,” which consists of founder shares provided to the sponsor for nominal consideration. Instead, Pershing Square will purchase sponsor warrants that are not transferrable or exercisable until three years after the closing of the business combination, will represent only 5.95% of the post- business combination company and will have a strike price 20% above the IPO price. Pershing Square has stated that it hopes these features will better align the sponsors with the stockholders and potential merger partners.

Paul Ryan’s SPAC (IPO announced August 2020), Executive Network Partnering Corp., seems to have followed this trend, providing only a 5% promote as well as “performance shares” for the founders, which, following the business combination, convert into common shares based on a formula that awards a greater number of common shares for a higher stock trading price.

Pershing Square also reduced investor incentives to arbitrage. In a typical SPAC, investors are issued warrants along with shares of the SPAC stock and are able to keep all of the warrants even if the investor elects to redeem its shares (frequently receiving all or almost all of its investment back), resulting in opportunities for arbitrage. In contrast, Pershing Square requires that an investor give up 2/3 of their warrants if the investor elects to redeem its shares.

Further, Pershing Square will distribute all warrants received by the company through such redemptions pro rata among the shareholders who did not redeem their shares, providing further incentive for an investor not to redeem. Starboard Value Acquisition Corp. (IPO announced August 2020) similarly introduced a novel variation on the warrant structure by issuing only one-sixth of a warrant with each share of common stock in its IPO, together with a contingent, non-transferrable right to receive an additional one- sixth of a warrant that is redeemable following the initial business combination redemption.

These innovations may allow Pershing Square to target companies that otherwise would not consider a SPAC bid for fear of post-closing dilution by the 20% sponsor promote. The Ackman-led SPAC revealed in its filings that it will search for a “mature unicorn,” or company with a valuation of $1 billion or more. Having committed to an additional $1-3 billion in PIPE commitments, Pershing Square’s war chest of $5-8 billion enables it to take a stake as a minority investor in targets that are significantly larger than what a typical SPAC might pursue. This strategy broadens the horizons for SPACs by opening up a new caliber of company to SPAC investments.

Potential Drawbacks to Dealing with a SPAC

Despite SPACs’ growing size and access to cash, the fact that the funds are held in a trust until a deal is entered into or the SPAC’s investment period ends means that very little economic recourse is available to a target in the event that a SPAC breaches. Occasionally, if a SPAC is sponsored by a financial investor or fund, that sponsor has provided a guarantee of a portion of the damages, or a reverse termination fee, in the event the SPAC fails to close a deal when required. This is not, however, the prevailing practice.

In accepting this recourse risk, targets may be comforted by the economic motivation of the SPAC founders to complete the deal. Also, some targets may be willing to accept this risk because they view the SPAC primarily as a vehicle to an IPO rather than means for their investors to cash out directly. Indeed, this “long-term” view is reflected in the number of all-stock deals with SPACs announced this year, including Mosaic Acquisition Corp. (Vivint Smart Home, Inc.), Conyers Park II Acquisition Corp. (Advantage Solutions, Inc.), Tottenham Acquisition I Limited (Clene Nanomedicine, Inc.) and B. Riley Principal Merger Corp. II (Eos Energy Storage LLC).

Future Developments

With this record year of SPAC IPOs, there are over 130 SPACs currently searching for targets, far more than ever before. Time will tell how many of these ventures will be successful, but the flexibility afforded by their outsized equity commitments, coupled with the ability to take a minority stake in a larger private company, means that a great deal of the SPACs currently hunting for deals may be successfully completing sizable business combinations in the near future.

The Private Equity Report Fall 2020, Vol 20, No 3