Podcast transcript: Why PE is on the SPAC inside track

24 min approx | 25 February 2021

Winna Brown

Today, I am joined by two of my colleagues, Karim Anani and Alex Zuluaga.

Karim is the Transactions Advisory Leader for the Americas and along with Alex, co-leads our SPAC practice. Gentlemen, I am excited to have you both on the podcast today. Thank you so much for joining me.

Karim Anani

Nice to be back on, Winna.

Brown

I know Karim, this is your second time around!

Anani

That’s right!

Brown

Very popular guy and Alex, welcome.

Alex Zuluaga

Appreciate it, thank you.

Brown

Now guys, before we dive into the discussion, I just wanted to take a moment to level set. Now SPACs or blank check companies have been around for years, so this is not a new concept. Yet, it is not until the last 12 months or so that SPACs have become almost mainstream and in 2020, almost US$80b was raised through SPAC IPOs and this compared to less than US$20b in 2019. Are you able to highlight why SPACs suddenly become so popular, and Karim, why do you think that is?

Anani

The widespread acceptance of a SPAC as an alternative method of raising capital is typically primary capital going on balance sheet, but it can also be primary and secondary capital that goes towards an operating company and is an acceptable route to go today. It is acceptable because the product is probably better understood; the malleability and adaptability of the SPAC vehicle to meet the needs of an operating company and its investor group is second to none, by the way of how a deal can be shaped, how you wind economic interests, where you put lockup periods in place, the type of institutional investors that you can bring into a transaction. These are all very relevant factors.

Today, the Wall Street bankers, financial institutions, private equity firms understand a lot better that’s really driving the popularity of the SPAC vehicle. I’d also say coverage; as more and more blue-chip companies like to merge with SPACs and go public that route. It is in the press, people are looking at it and saying, ‘well, if company A that could have gone through an IPO raised privately elected to go through a SPAC, let us explore that ourselves; the abundance of capital and the speed at which you can raise capital through the SPAC vehicle and through a merger is quite appealing, Winna.

Brown

From what you’re saying, previously SPACs were less understood they were used for smaller listings, but really, they have become more high profile and we are seeing as a result, the market being more accepting and open to it.

Anani

That’s right, what I would say there is a key factor here. When a company is looking to undertake an IPO for example, they cannot market the company on future projected earnings or revenue and alike, because that is just the way the IPO rules work. However, when it comes to a SPAC merger, because factually on a piece of paper, this is a merger although the vast majority of SPAC transactions do not result in the SPAC taking control of an operating company, but rather making a minority investment in an operating company, it is still considered a merger. And in merger transactions, you’re allowed to talk about future projections, synergies, EBITDA, growth, whatever the KPIs that matter for that company. And because you can talk about future projections, when you go out and you market the operating company, and looking at the pre-money market valuation, you can take those future projections and bring them back in time today and say this is what I would like my value to be, because I know this company is going to be there 12 months, 24 months, 36 months from today. And you’re taking this long jump and this leap of here’s what the company is worth in well, 12, 24, 36 months, but I would like to get my valuation today, and you can effectuate that and you can raise capital based on a higher valuation as a result.

Brown

So, given what you’ve just outlined about the differences between the merger and what information you can present to the market, Alex, do you think that this is part and parcel of why SPAC exit is particularly interesting for PE?

Zuluaga

Absolutely, PE is very adept at negotiating transactions, so you’ve got the aspect of the SPAC mergers that is a true negotiation with another party. And then, in terms of all the liquidity needs and everything that Karim mentioned before, you’re addressing a lot of important factors of PE, considering when they are going through a transaction. So, with the ability to cash out of position or a fund organization and create that liquid capital in a public instrument. It is a very attractive option for PE.

Brown

And what would be some of the risks that a PE-backed company needs to contemplate if they are weighing of the traditional IPO exit versus SPAC as an exit?

Zuluaga

The risk really is around the possibility of minimum cash not being there. And so, really thinking about what mechanisms you’re going to have in place in order to avoid a redemption situation where the deal doesn’t go through. If you think about an IPO, there is always a risk that when you get appraised, the market timing isn’t right and then you’re not going to move forward with the transaction. So, while it is a different type of risk, it is just based off of facts and circumstances at that point in time for the PE, to see what makes the most sense for them. And that’s why defining your transaction goals are very important when you’re thinking about your portfolio of companies.

Brown

Well, SPAC is a very quick transaction being a merger and suddenly companies find themselves being publicly listed. What are some of the challenges that you’ve had to help management teams work through so that they understand the journey of exiting through a SPAC and waking up the next day to be a public company as opposed to the long 6-month or 12-month journey to prepare for a traditional IPO?

Zuluaga

Maybe, I’ll take a step back here and go through what the normal mechanism was before. I mean, previously, there was a lot of invalid interest from SPACs going into operating companies and because it was attractive, you’d have those operating companies      be opportunistic and move forward those transactions. But, being put into a position where they are opportunistic, they might not have had a true path going forward on being public as quickly as they would and so there is a lot of rush in those types of situations.

Now, what we are seeing is a lot of companies and particularly PE companies are starting to get ahead of that and start to prepare their financial statements, start thinking about processes and improving those processes, so that they have very little execution risk associated to themselves and they are in a better negotiating position when they are starting to talk to SPACs. Obviously, execution risk is very important to SPAC because of their finite timeline.

Brown

Karim, you guys are both working with a lot of SPACs and there are a lot of success stories out there. But ultimately, there are a few SPACs that do fall apart, in your experience, how often do these SPAC deals fall apart and how can a PE sponsor of a target company prevent this from happening?

Anani

There are different time periods in a SPAC deal life that a deal can crash and burn. Very early on, as you’re negotiating and going through exclusivity, we see more deals come apart because of a difference in valuation or you can’t raise a PIPE or something to that effect. Those are not announced, and you don’t hear about them. The more public ones are where there is a signed merger agreement, and the deal is announced and from there, for one reason or another, the deal does not consummate. The latter example here is becoming more rare. I would say less than 5%, probably less than 2% of the time, and why does that happen? It is because economics don’t make sense. There is a shift in the company’s profile, industry profile, it could be, it’s just taking way too long to get a deal done from the compliance perspective, the committed PIPE moneying is not willing to commit further, or a SPAC is ending and is starting to see redemptions come out of the SPAC and people aren’t willing to grow their equity for another 3 months to see that this deal comes to closure. There are a variety of reasons that will lead to a deal falling apart, but like I said, once a deal is announced and the pipe is committed, it is not common.

Zuluaga

Just adding into that, one thing to think on the front end is who the SPAC partner is going to be and most SPACs will identify a target industry, and so most times you want to have a SPAC that is focused on your industry because that was based off their investment thesis, and so when you start moving away from the SPAC’s investment thesis too much, you might end up having more turn on historical SPAC investors in terms of redemptions, but as Karim mentioned, that can be mitigated through the use of pipes and backs offs.

Brown

That’s a good tip if you’re looking for a SPAC, find one who’s investment thesis is in your sector, so they understand your business and the merger can go a lot smoother, presumably. Are there other tips that you can share for companies that are looking to attract a SPAC?

Anani

Getting your house in order and basically being something into IPO ready, will make the company a lot more attractive for a SPAC exit. Getting your financial statements and audits done of the historical periods and shrink their SX compliant and making sure your auditors are undertaking what is commonly known as PCAOB audits, and getting ready to render PCAOB level audit opinions on the historical financial statements, if interim financial statements are needed, getting those in order, thinking about your MDNA and drafting that. Getting these compliance matters out of the way that are backward looking, increases the attractiveness of a SPAC merger moving towards fruition because there is sometimes a bit of long build in getting a company ready to undertake and file the initial form S4, that is required with the SEC. And so, if you’re shortening that time period, that really can be helpful. Furthermore, building out the necessary skillset and capabilities within the company, so that it can operate and behave as a public company in a short period of time is a must. It will be difficult for a company that is not prepared whatsoever to behave, act and report its results as a public company, seeing how condensed the SPAC timeline is. And, from start to finish you can be a public company going through a SPAC merger inside of 5 or 6 months today.

Brown

So, Alex, if you were advising a PE-backed portfolio company, why would you suggest to them or recommend to them that they think about a SPAC exit, over either a sale or a traditional IPO?

Zuluaga

With a SPAC, you can utilize projections as Karim had mentioned before and kind of telling that part of the story for the organization. You’re not necessarily going to be able to do that within an IPO setting, but you would be able to do that within just a normal sale transaction to another PE strategic. But then it is also thinking about, what is important for that organization, what are you really trying to do in order to derive the most value for that organization? If it’s truly funding the organization, and you’re going to end up rolling over most of your equity, then SPAC is very compelling, because you’re going to be able to put all that capital back to raise to the SPAC back into the pipe and really funnel that into the organization. If you have a higher need for an exit, then there are going to be certain SPACs that are not going to be interested in changing the ownership structure such that you exit completely, and so maybe a SPAC transaction isn’t as relevant for you in terms of the judiciary duties and alike, it is worthwhile exploring each of the options to see what is the right fit.

Brown

And given the way the market has been so hot off late, do you think a SPAC exit has yielded better pricing and better results, for the investors?

Zuluaga

It is difficult to say whether it is better pricing because it will be theoretical. Most companies aren’t looking at an IPO or looking at a sale exit and comparing it to a SPAC. Sometimes, you might have an auction process in which you will be able to see that, but unless you are involved in those auction process, you’re not going to be able to have that data point. But certainly as you look at multiples on companies that have gone through SPAC transactions, you’re seeing an increase in multiples out now that could be part or based of off the composition of companies that are being put into transactions and having these companies that are driving some of that multiple. There are certainly interpretations that there is favorable valuations going through SPAC transactions currently.

Brown

We’ve just been talking about the SPAC itself and why it is an attractive exit? If we shift gears a bit, why would investing in a SPAC be an attractive option for an investor?

Anani

Investing in a SPAC and seeding a SPAC is probably attractive to an investor because there is typically a warrant that is attached to share at the date of IPO. Most SPACs priced their shares at $10 a share. As an investor, if you can get in on the IPO, you put in $10, you get $10 more or less guaranteed because the $10 you’ve just seeded into the company goes into a trust account, and is protected and you can ask for it back if you don’t like the deal that the SPAC merger brings you, and that it is 100% secure and you typically earn some level of the minimal interest. In addition to a guarantee of getting your money back if you don’t like the deal put forth by the SPAC sponsor, there is a partial warrant attached to each share, and that warrant is a freebie to come into the SPAC IPO. Typically, 30 days after a SPAC debuts its IPO, you can detach the warrant from the actual share, and you can hold them separately. And, as a result, there is a little bit of an arbitrage play that comes in. If you just want to redeem your cash at the time ADLs put forth, you can take it back at no risk and you can hold the warrant, and the warrant’s intrinsic value (time value of money) is worth something, and you have upside, so, there is no downside almost. The other thing is, if I am buying at $10 as an investor, and the deal starts at $14 or $15, I can decide, do I want to roll my equity into the newly merged company, or do I want to redeem at $10 a share which really doesn’t make sense if the stocks trading at $14 and you can just sell the shares and exit with a gain. The motivations are different. I would say there are other motivations of investors who put money with certain zero SPAC sponsors, PE firms seeding SPACS, etc. knowing that reputationally, the SPAC sponsors can bring deals to market that they would never have access to as a common investor, and as a result, they are getting in at the ground floor of an exciting new company. It’s going to make its debut as a publicly traded company through a SPAC merger. These are some of the drivers that attract investors into SPAC IPOs.

Brown

You’ve touched on something that I would like to kind of hook a thread on. You mentioned that we are starting to see how leading private equity firms are now registering their own SPACs and we are starting to see this to be a growing trend. Do you think that, I am going to use my quotations here, that we can expect to see a SPAC fund sitting alongside a tech fund and a credit fund in a future world of private equity?

Anani

Many private equity houses already have their own SPACs that are ceded and some of them are launching multiple SPACs month in-month out. I wouldn’t say you have a fund that is going to hold SPACs, but I would like it as every SPAC is regarded as a standalone fund that is going to go and effectuate a merger.

In the traditional PE structure, you raise a fund of a billion, 2b, 5b, 10b dollars and there are multiple portfolio companies that will go into the investment fund. When it comes to SPAC, think about it as each SPAC will do one deal. And so, if you wanted to do three or four deals, you will launch three or four SPACs, and you will effectuate mergers on a one-to-one basis and that is how you will transact as a PE house.

Brown

We talked about how the success of a SPAC relies on the ability to identify a good target, and negotiate a good deal, and those are all skills that private equity is known for? Do you think though, there is either a perceived or a real conflict of interest by having a PE sponsor, a SPAC, effectively the acquisition targets for a SPAC are largely the same as the acquisition targets for their PE funds?

Anani

It is two different investment philosophies. The type of investment philosophy of buying 10, 15, 20, 30% of a company is very different than what you see in your typical PE investment fund. Furthermore, PE buyers are typically value buyers. They will go out, look at companies, get it at an attractive price, turn it around and strategically exit down the line. When you’re investing in a SPAC, or launching a SPAC, you’re taking that company public in a short of period, once its identified, and you’re carrying equity that is liquid, that is subject to a certain lockup period. Lockup periods can vary in time frames from 6 months to 12 months or when certain thresholds are met. But then you’re holding a liquid stock that you can dispose of in the open market at that appropriate time. So, two different investment strategies, two different investment approaches, could there be a perceived conflict? There is always a perceived conflict, but there are ways to work through them. In the sense, it is actually a different way of investing money.

Brown

Thinking of SPACs, a liquid investment, a short turn around and a minority stake versus a fund which is all about value creation, longer-term holding as compared to a SPAC and not necessarily immediately liquid. There is been a lot of I guess, controversies, one way of putting it in the market recently, and there has been signs of potential additional regulatory scrutiny around investors and the stock market in general. Do you think that it is inevitable, given the sharp rise and popularity of SPACs, that the mechanism can also be expected to be scrutinized by the SCC?

Zuluaga

That is, I believe trying to get ahead of some of the issues with SPACs by issuing some disclosure guidance. Clearly, in terms of making sure they are informing potential investors and so they were thinking ahead and adding in some additional regulatory measure so that the public is protected to a certain extent. I’d say with any type of newer vehicle, you’re going to end up having constantly evolving views. So, naturally you’re going to have potential for new regulation in SPACs and all type of capital market transactions as things become more popular and as people see different sides of the vehicle.

Brown

I am going to ask each of you to share with me, how do you think SPACs are going to evolve?

Anani

The ingenuity and engineering different aspects of SPAC mergers will continue to evolve the product and how it is being utilized has shifted quite dramatically over the course of not only the last 3 or 6 months, 9 months or 12 months; so, expect it to see more. I think aligning the economic interest of the SPAC sponsor and what is called the SPAC carry or the founder shares with the long-term good of the company, is going to be more and more of a trend with things like sales structures and the light coming in pre packets in the perspectives of SPAC that is undertaking an IPO. I could also say that the malleability and the flexibility of engineering deals that I mentioned earlier in this podcast will continue to evolve and bring the best of what is possible to both parties that are merging, both the SPAC as well as the operating company.

Brown

Excellent. Alex, any thoughts?

Zuluaga

There is a couple of things that could potentially happen. I think you might see more of a rise and multi-entity deals. Most SPACs have a preference to acquire one entity and there’s the possibility that more than one entity is going to be included within a SPAC that adds to the complexity. But I think that that is likely to happen a bit more often. And then, with the number of SPACs out there, certain operating companies are going to think about the possibility of carving out some of their assets, including them into a SPAC and so, I don’t think that is necessarily happening immediately, I think that there are some instances of that occurring, but I don’t think that will become a little more prevalent in the future.

Brown

Thank you and I am going to make my own prediction. I know neither of you have had much sleep in the last 6 months, thanks to the crazy popularity of SPACs. My prediction is, I don’t think you guys are going to get any sleep for the next year; I am sorry to say. You guys have been doing a fantastic job and until SPACs continue in their rising popularity, you guys will be in the front and center helping companies negotiate and engineer and finesse those mergers. So, thank you very much for taking the time to be with us here today.

Zuluaga

Likewise. Thanks for having us.

Anani

Thank you, Winna.