Charlie McMillan Summons
2020 seemed to be the golden era of the Special Purpose Acquisition Company (‘SPAC’) in the US. 248 of these companies listed in 2020 raising more money via SPACs than in the preceding 10 years.
But SPACs have actually entered the mainstream to an even greater degree since we last wrote about them. Their popularity grew by orders of magnitude entering into 2021 during the retail trader saga largely centering on the Gamestop short squeeze.
The most notable SPAC listing was famed investor Bill Ackman’s Pershing Square Tontine Holdings (‘PSTH’). This vehicle was the largest blank cheque entity in the world when it IPO’d on the New York Stock Exchange in July 2020 raising US$4 billion.
What became of Pershing Square Tontine Holdings?
Ackman filed to IPO PSTH in May 2020 off the heels of his incredibly well-timed credit default swap trade just as the coronavirus sent American into lockdown. He turned US$27 million into US$2.7 billion. His aim was to capitalise on depressed valuations with his extra US$4 billion in dry powder. But valuations rallied and companies preferred other sources of cheap cash to Ackman’s SPAC listing strategy.
PSTH has a life of two years. Unless it finds a company to merge with by July 2022 (or shareholders agree to extend the company’s life), PSTH will liquidate and return funds to shareholders.
Ackman was on the precipice of a deal to acquire a 10% stake in Universal Music Group (‘UMG’) from Vivendi in a deal structure which was almost impenetrable due to its complexity. In fact, Ackman hosted an almost 3 hour investor call to explain and sell the transaction to shareholders. In short:
- Ackman’s hedge fund adds US$1.6 billion to PSTH cash pile.
- 73% of that cash pile goes toward buying a 10% stake in UMG.
- Shareholders of PSTH can get their $20 back or receive UMG shares directly when it lists or is spun off by the current owner Vivendi.
- Those who receive UMG shares will also gain:
- An interest in a new company (without an expiry date like PSTH) which represents the cash leftover after the UMG deal.
- Tontine warrants in this new company.
- There is a fixed pool of tontine warrants. Those who do not redeem their PSTH shares get to share in the pool of warrants. Therefore, the more shareholders who redeem, the more warrants for those who remain with the company.
- Ordinary warrants in the new company.
Basically, Ackman was looking to reserve the cash remaining from the deal into a new SPAC without a liquidation date.
In any case, the deal is moot because the SEC raised questions about the structure. Ackman went ahead with a smaller deal buying 7.1% of UMG for US$2.8 billion through his hedge fund.
SPACs in Australia
The rise of SPACs has been predominantly an American trend. In the UK, Boris Johnson greenlighted a taskforce to overhaul the country’s SPAC regulation. The London Stock Exchange enacted these new rules facilitating the listing of SPACs on 10 August 2021.
SPACs listing in the US, and now the UK, have the advantage over continental European listings of being able to invest the funds held on trust at a positive interest rate. Otherwise, the SPAC will have to cover the difference resulting from negative interest rates if the SPAC expires.
By contrast, current ASX Listing rules do not allow for the listing of such vehicles so, for the time being, they remain an overseas investment option.
Are SPACs that Special?
SPACs are touted as a listing method that incurs fewer transaction costs when compared to IPOs. But 2020 IPO numbers illustrate that the equity capital market landscape has not been structurally altered.
The reason for this is the hidden costs embedded in most SPACs listed today. An academic study of SPACs listed between January 2019 and June 2020 identified who, on average, bears the costs of going public. In short, the cost arises from dilution. Firstly, promoters ordinarily receive shares in the SPAC. In the study’s time period, every SPAC that merged featured promoters receiving shares equivalent to 20% of the IPO proceeds. This can lead to wonky incentives where promoters would rather find any deal, no matter the quality, before expiration of the SPAC so they avoid losing their essentially free 20% equity stake. See the performance of Landcadia Holdings after its merger with Waitr and resulting law suits for an example of this. In addition, shareholders who buy into a SPAC IPO receive free warrants with that they can keep even if they redeem their SPAC shares at the time of the merger. These warrants can be dilutive if the share price of the merged company reaches strike price. On top of this, underwriters of the SPAC IPO take a fee. The median fee for the SPACs in the study was 7.2%. This is the same fee ballpark that banks take under traditional IPOs of 5-7%.
Next, there is the dilution from redemptions. Redemptions eat away at the cash backing the SPAC’s shares. For example, if the SPAC raises 80 shares via IPO and gives 20 shares to the promoter, 20% of the shares are not backed by cash. This is fine for now because the promoter’s shares cannot be redeemed like the IPO-sourced shares. The graph below illustrates, the more redemptions, the lower the proportion of shares backed by cash.
The academic study found that the median level of redemption for SPACs in the study period was 73% of public shares. Private Investment in Public Equity (‘PIPE’) funding replenishes some cash but this is also dilutive for those that do not redeem.
The costs of dilution crystallise at the time of the merger. Target company shareholders will negotiate a deal based on how much they think their company is worth. They want to receive shares in the SPAC equal to this value. Target company shareholders should value SPAC shares based on their cash backing. The reduction in cash backing means SPAC shareholders holding through the merger ultimately bear the cost of the whole process (unless value is created through the promoter’s involvement which covers this shortfall).
The authors of the study established this by tracking post-merger returns. Of the 47 SPACs that merged in the study period, the median three-month return was -14.5% (the return distribution had fat tails with the mean return in the same period being -2.9%).
It is plainly not the sponsors of the average SPAC that are losing out. Their returns, given their extremely low level of capital invested for their promote are great.
When advertising PSTH to shareholders of Pershing Square, Bill Ackman proclaimed to have designed and listed “the most investor- and merger-friendly SPAC in the world”. The authors validated this claim by noting PSTH as the exception which illustrate the many structural improvements that can be implemented. The sponsor took no promote and actually bought its warrants for US$65 million. These warrants are also only exercisable three years after the merger and at a deep out of the money price. Pershing Square was also required to invest another US$1 billion at the time of merger in exchange for units and more out of the money warrants. The result is that Pershing Square gets paid only after shareholders are rewarded with a positive return. The Executive Network Partnering Corp and Ribbit LEAP, Ltd. SPACs listed with similar alignment of incentives with public shareholders. Finally, IPO shareholders received only 1/9th of a warrant per share – the lowest of any SPAC to that point – and tontine warrants which incentivise against redemption.
Admittedly, this study focuses on 2020 which was certainly an outlier year for this kind of blank cheque investment vehicle. SPACs have existed for years but have never been so widely popular. Indeed, Ackman invested in Burger King in 2012 which later merged into Restaurant Brands International through a Pershing Square co-sponsored SPAC. Moreover, the study misses out on the last 6 months of 2020. Overall, though, it warns of the structural deficiencies in most SPACs which inherently weigh on returns.
As outlined in our previous SPAC article, there are many non-financial benefits that the SPAC pathway has over IPOs. However, in financial markets, transaction costs evidently are major considerations for investors. It seems that the prevailing norms for SPAC terms, which make PSTH an outlier in terms of structure, do not justify unseating the IPO as the pre-eminent method of going public. Moreover, these non-financial benefits can be achieved without the current high median cost of going public via a SPAC.
Charlie McMillan Summons is a Research Analyst with the University Network of Investing and Trading
Pershing Square Holdings, Ltd Letter to Shareholders, 28 August 2020.