The Promise of SPACs is Drying Up

The call on hedge funds is putting a deathly squeeze on SPACs, which in turn is making them a ridiculously expensive financing option for target companies.

Last week I attended the largest conference dedicated to Private Investments in Public Equities, or PIPEs, which was held in Shanghai this year. Prior to last fall’s meltdown, PIPEs were a popular method for small- and medium-sized Chinese companies to raise capital from foreign investors; usually hedge funds or private equity firms. Often times the PIPEs were executed in parallel with a reverse merger between the Chinese company and an existing shell company trading OTC (Over The Counter) in the US.

But the global financial crisis has sapped investor appetite for Chinese PIPEs, and this year’s Conference would have been more aptly named “The Creative Financing Conference.” Much of the discourse focused on other, novel ways for Chinese companies to stay afloat. This led to an interesting focus on SPACs, which are one of the few—if not only—remaining pools of capital available for Chinese SMEs looking for a public listing abroad.

A SPAC, or Special Purpose Acquisition Corporation, is like a reverse IPO; the SPAC’s management first executes the Initial Public Offering, and uses the proceeds to subsequently acquire and operate an existing company. Because the SPAC’s management is legally prohibited from knowing their acquisition target at the time of the IPO, SPACs are often referred to as “blind” or “blank check” companies. Another interesting peculiarity is that any acquisition target identified by management (post-IPO, of course) must be put to a vote from the SPAC’s initial investors, i.e. those who invested during the IPO. If the investor doesn’t like the acquisition target, she can vote “no” and recoup her initial investment along with some interest and warrants. What makes the game really interesting is that the SPACs typically must identify and acquire their target within 18 months of the IPO, otherwise they are obligated to return the proceeds to all the investors, and the SPAC is dissolved.

SPACs were all the rage in the run-up to the economic collapse. As recently as January, the New York Times cited 57 SPACs that had raised $11.3 billion from their IPOs and were still looking for acquisition targets, many of them focused on China. For the multitude of withering Chinese SMEs, the flood of SPACs looking to spend cash in 2009 beckoned like a glass of cold lemonade in this financial desert.

But after a few hallway conversations with those in the “SPAC know” at the Conference, SPACs began to look more like a mirage. To begin, it has become increasingly difficult for SPAC management teams to successfully execute their acquisitions. According to a senior executive in America’s Growth Capital, about 30 hedge funds constitute the bulk investors who have supported SPAC IPOs. And since most of them have had or are in danger of redemption calls, they are content to vote “NO” on any proposed acquisitions, take their cash, and run. Normally, 30% dissention among SPAC investors is grounds for dissolution, but in the last couple months the squeeze on hedge funds has become so tight that SPAC management now expects 100% turnover of their original investors; i.e. they expect all their investors to vote “no” no matter what acquisition target they bring to the table.

This painful reality is bad news for SPAC management, most of whom have committed a couple million dollars and two or more years of their time to their SPAC. The last thing they want is dissolution. Walking the tightrope, they are highly motivated to find a willing target and come up with innovative ways to backfill dissenting SPAC investors who are simply waiting to veto the project and cash out. This includes offering aggressive pricing to other PE investors and/or debt financing to fill the gap. But the combination of the SPAC’s management’s carry, warrants, and additional equity for debt or backfill investors piles up quickly. In some cases, the cost of capital borne by the acquired company is over 40% of the total capital received in a deal.

And therein lays the rub. For a target company to accept an acquisition by a SPAC under these terms, the entrepreneur must really be desperate for the cash. But this obvious fact doesn’t bode well for the ultimate holders of the SPACs public equity, i.e. the original investors. Indeed, many of the stronger companies that I’ve dealt with in China have elected to postpone raising capital until the financial markets come out of hibernation. With their clocks ticking, and nothing but rocks and hard places for months to come, we can expect a wave of SPAC dissolutions in 2009, as many reach their maturity date.