26 May 2021
Many commentators point to the SEC staff statement on accounting and reporting considerations for warrants issued by SPACs which was originally announced on 12 April, 2021 as the main cause for the marked slowdown in new SPAC IPOs. In short, this provided that because SPAC warrant instruments have traditionally included provisions that provide for potential changes to settlement amounts depending on the holder, such provisions would preclude such warrants from being classified as equity and instead should be accounted for as derivative liabilities measured at fair value each reporting period. However, whilst it is true that the accounting issue has in the short-term put the brakes on new SPAC IPOs as law firms and accountants seek to clarify the SEC position and reach agreement on the amendments necessary to obtain equity treatment, viewing these changes as an impediment to the SPAC market in the longer term is simply incorrect. Firstly, the calculation of the warrant price is a simple Black-Scholes calculation, which valuation firms can run and confirm quickly. Secondly, this issue applies to all SPACs with warrants including these features (which the overwhelming majority of outstanding SPAC warrants do), not just new SPACs, requiring those SPACs seeking targets and those who are in the process of de-SPACing to also re-characterise and value their warrants. Thirdly, the impact of the liability accounting decreases with de-SPAC transaction size, rendering the impact minimal where the de-SPAC transaction value is 5x – 6x the size of the SPAC, as is common in this market. Therefore, whilst it is true that this is one of the causes for some SPACs to have been paused, it has not caused SPACs to be withdrawn and has instead simply caused a build-up in the pipeline for SPACs.
Rather, the current state of the SPAC market is being driven by investment conditions. The two key drivers being:
Amount of capital / recycling ratio – put simply, the size of SPAC issuance in Q1 2021 has left investors with SPAC strategies with very little allocated capital remaining. In such a situation firms are unwilling to upsize the capital allocation to their SPAC strategy, due to diversification risks, preferring instead to wait for their deployed capital to be recycled through successful de-SPACs before they look to invest in further SPACs. Whilst a number of sizeable de-SPACs have been announced, these have not yet completed and so are locking up additional capital in PIPEs – with approximately USD47 billion of capital currently locked up in PIPEs for announced but uncompleted deals. These announced de-SPACs need to complete to produce a sufficient pool of recycled capital for the volume of new SPAC issuance to pick up again. In the meantime, new SPAC issuers are having to look beyond the traditional SPAC investor firms and rely more heavily on ‘friends and family’ and close relationship firms to cover their books.
SPAC share prices – the volume of SPAC issuance and increasing competition for de-SPAC targets combined with general market sentiment, which is coming off previous frothy highs, has led to a large number of SPACs trading below their initial USD10 share price – as of 18 May 2021, approximately 50% of the 150 most recently issued SPACs were trading below USD10. In these market conditions, investors can generate returns by buying into existing SPACs at below the 24 month redemption valuation (which in many cases is now considerably shorter) and look for a guaranteed risk free return from the Trust Proceeds if no de-SPAC occurs or if the target is not one in which the investor sees value. Further, with many SPACs trading down on day 1, investors can adopt a wait and see approach and look to invest in a SPAC through day 1 trading below USD10. This makes it harder for new SPACs to fully cover their books pre-pricing.
The main question is what this means for SPAC terms, the market, the hundreds of SPACs which have filed but not yet launched and what future SPACs may look like. In this regard we believe there are four key considerations:
Flight to quality – in the recent SPAC frenzy, SPACs from “lower quality” Sponsors with limited investment records were bought and traded in the same manner and with the same appetite as SPACs being issued by “Tier 1” Sponsors who possess the infrastructure to not only find but also successfully execute on the de-SPAC transaction. This appears certain to change as greater bi-furcation in demand will be seen between the well-known and less well-known Sponsors as capital provision dries up and some of the less well-known Sponsors struggle to find de-SPAC targets.
a) Warrant Terms – after a tightening of terms through Q4 2020 and Q1 2021, with warrant terms coming in from ½ to ⅓, ¼ or even ⅕ we are now seeing a loosening of such terms with Asia Sponsors generally back to ⅓ or ½;
b) SPAC Size – new Sponsors are re-evaluating the size of SPAC launches and looking to go to market with a smaller target raise in order to allow a covered book to be built based on guaranteed investor and friend and family support;
c) Investment Horizon – the traditional 24 month horizon is being re-evaluated with some SPACs having come to market with an 18 month or even 12 month investment window, in some cases with additional returns being provided to investors for an extension of the terms;
d) Over-funding Trust Account / Additional Economics – one recent US SPAC came to market with an over-funded trust account (USD10.10 per share) and then offered to increase the over-funding for every month by which the 12 month investment horizon was increased. Whilst additional economics are not expected to become the norm, more SPACs may start to look at over-funding their Trust Accounts to provide better guaranteed returns to investors; and
e) Forward Purchase Agreements – SPACs are increasingly looking at entering forward purchase arrangements with anchor investors prior to launching their roadshows to demonstrate support in the management team and a guaranteed amount of committed funds for their de-SPAC.
Each of these changes would help develop additional demand for the SPAC in question.
Asia Demand – SPAC demand has traditionally been from US based investors. However, with the growth of Asia Sponsors, we are seeing increasing demand from Asia based investors. As new participants in this market, they are not constrained by capital re-cycling considerations which some US based investors are under and so provide a unique opportunity for Asia based Sponsors to attract support for their SPACs; and
De-SPACs – as set out previously, the capital available for new SPACs will depend on existing SPACs reaching a successful de-SPAC and capital re-cycling occurring. If we see a number of the SPACs which are reaching their 24 month horizon successfully de-SPACing additional capital will flow back into the market.
In light of the above, whilst there has been a temporary pause in new SPAC issuances, we believe that issuance volume will increase back to a sustainable, long-term level at the early-mid 2020 rate as SPACs become the preserve of high quality, well-known Sponsors and repeat issuers who have a track record and real “story” to support the value generation that they offer investors. For such Sponsors, SPACs will continue to offer a real opportunity to raise money for investments which might be outside of their traditional mandate or to complement their existing investment thesis whilst for investors they offer an opportunity to get exposure to such high quality names, with limited downside risk (other than opportunity cost / cost of capital) for the money which they invest in SPACs.
Finally, as the SPAC market right-sizes and demand for SPACs from Asia based Sponsors increases, we expect to see an increasing percentage of SPACs using Cayman entities, rather than Delaware, as such offshore structures are better known in Asia and allow for statutory merger provisions to be utilized for de-SPAC transactions with the primarily PRC based targets.
As a firm which: (i) has been involved in many of the recent Asia Sponsored SPACs as well as a large number which are currently ongoing at various stages of submission; and (ii) with an award winning PE/M&A team in Hong Kong and Cayman, which has completed in excess of USD65 billion of transactions in the last two years, Appleby are uniquely placed to assist on both SPAC and de-SPAC transactions.
For further information, please contact:
David Bulley, Partner, Appleby