SPAC Sponsor Funds
By Zachary Bird, CPA, Manager, Assurance Services, Alternative Investment Group
With the popularity of special purpose acquisition companies (SPACs) reaching an all-time high in recent years, many are wondering where all the capital comes from. Unsurprisingly, a large percentage of the capital is raised from private equity or venture capital funds.
A SPAC has no current operations and is created with the objective of identifying and acquiring an existing company. To understand a private equity investment in a SPAC, it is important to first understand the process and life span of a SPAC.
Initially, a SPAC sponsor management team forms to raise capital to create a SPAC. This team typically consists of individuals who have certain expertise in a particular industry or market sector. The team then raises seed capital for a SPAC sponsor from various sources, including private equity or venture capital-backed funds. The SPAC sponsor’s capital is used to create the SPAC. The initial shares and warrants of the SPAC are called founder shares and founder warrants. Founder shares are non-redeemable.
The sponsor entity typically purchases 25% of the total intended share capitalization of the SPAC, of which 5% is subject to forfeiture if the underwriters do not exercise their overallotment (which is an important risk consideration). An overallotment is an option commonly available to underwriters that allows the sale of additional shares that a company plans to issue in an initial public offering or secondary/follow-on offering. The option can be exercised within 30 days of the offering, and it does not have to be exercised on the same day. The underwriter hired for the IPO process typically gets a 15% overallotment exercisable for the same units in the IPO.
Once capital is raised from these seed investors to form the SPAC sponsor, the sponsor management team forms the SPAC. The SPAC has three distinct segments in its lifecycle: initial capitalization stage up through IPO; ’34 Act reporting and target search/due diligence; and de-SPAC/business combination.
Additional capital is raised through the IPO process by selling units that are typically priced at $10. The units sold in the IPO generally include one redeemable share and a fraction of a warrant. The warrant is contingently exercisable for a period of five years upon the completion of a business combination and can be called by the issuer for nominal consideration if not exercised at certain price thresholds — typically $18. The shares and warrants become separable from the units typically no more than 52 days after the IPO. At that point the unit, shares, and warrants can all trade separately, which is an important point of reference when quantifying fair value. The capital raised by this process is placed into a trust which is then generally invested in money market funds or short-term U.S. government securities such as bonds.
The SPAC then has approximately 18 to 24 months to acquire an organization the SPAC sponsor management team believes has great potential in the industry. If an acquisition does not occur during this time period, the SPAC is dissolved. In most cases investors are entitled to a share of the remaining value of the trust after expenses, pro-rated based on the number of shares they hold.
If a target company is identified and approved, then the SPAC and target company merge and form a publicly traded company. This is commonly known as the de-SPAC process.
Because every SPAC requires initial capital to fund its IPO and acquisition processes, there are numerous opportunities for private equity and venture capital funds to invest.
There can be — and generally are — multiple private equity and venture capital firms that provide capital to the SPAC sponsor via SPAC funds. See below for a sample organizational chart for this structure:
Investors at this stage also assume the risk of investing early on. This could mean that no SPAC deal is closed and their capital sits in a trust account earning minimal interest for two years. Alternatively, if the SPAC deal is closed and the operating company’s stock performs poorly, then investors would see negative returns in their portfolio.
SPAC Fund Investment Strategy
A typical investment strategy for a SPAC fund is to invest substantially all of its assets into one or more SPAC sponsor entities. The objective is to realize appreciation on its investment through the IPO and acquisition process so the common stock and warrants can ultimately be sold on the open market for a profit. However, this sale on the open market comes with a critical caveat: The shares and warrants are restricted and cannot be sold until certain criteria — typically based on time, price hurdle, or both — are met.
These investments consist primarily of an equity interest in the SPAC sponsor itself, which represents a percentage of beneficial interest in the common stock and warrants held by the SPAC sponsor in the particular SPAC.
The standard structure of SPAC transactions (such as placing IPO proceeds in a trust and the ability of the IPO investors, under certain circumstances, to elect not to participate in the acquisition transaction and receive their entire investment back) affords certain protection from risks. However, the SPAC fund’s investment is fully at risk given that there is no assurance the fund will achieve its investment objective.
SPAC Sponsor Fund Valuation Considerations
It is common practice for a SPAC fund, from the time that the investment is made until it receives shares and/or warrants, to value the investment at transaction price less any capitalized deal expenses. As mentioned earlier, the common stock and warrants held by a SPAC fund are generally subject to numerous restrictions which are usual and customary for SPAC transactions. This is a critical factor to consider when evaluating valuation. There are numerous ways to account for these restrictions.
During the time leading up to the lapse of these restrictions, and once the restrictions are fully removed, the fund typically no longer uses the transaction price. Instead, it marks the investment to the current fair market value (i.e., the price at which the security is trading on the listed exchange). Discounts are also considered by management since their shares are restricted and not allowed to be sold on any exchange. This methodology is further discussed below. Each restriction and discount differs depending on the type of restriction and management’s best judgment.
A time restriction means the SPAC fund is unable to sell its shares or warrants for a certain period of time (i.e., one year). This means that until that restriction has lapsed, SPAC fund managers will need to determine how to estimate the fair value. One common method is placing a percentage discount on the current trading value of the security, as determined by management, at the beginning of the restriction period and adjust it based on the time lapsed of such restriction.
Price Hurdle Restrictions
A price hurdle restriction means the SPAC fund cannot sell its shares or warrants until the common stock has met certain price conditions (e.g., the share price of the company is trading at or above $18 for 30 consecutive trading days). Since the market is unpredictable, it is difficult to determine when this restriction will lapse. In this case, management may determine a certain discount to apply until the price hurdle is met.
Time and Price Hurdle Restrictions Combined
In certain circumstances, both time and price hurdle restrictions apply to the company’s shares and warrants. If an investment is subject to both restrictions, management may apply a discount and then ratably adjust the discount over the life of the restriction.
A few additional things to consider for financial statement reporting on these types of entities:
- These securities generally are reported as Level 3 investments per FASB ASC 820 Fair Value Measurements, even though they are publicly traded (due to the discounts taken for the restrictions). Once the restrictions are removed, the shares and warrants are generally reported as Level 1 investments as long as there is an active market for the security.
- Share and warrant information, including the various applicable restrictions on the shares and warrants post-acquisition, is publicly available since the SPAC is registered with the Securities and Exchange Commission (SEC).
- These SPAC funds typically do not charge management fees. Fund management is generally compensated through carried interest or incentive/performance allocations, which are typically subject to negotiation between investors and management prior to launching the SPAC fund.
- Additional capital may be called from investors to pay for typical SPAC fund expenses such as professional fees. The additional capital is typically reimbursed to investors once the SPAC fund exits an investment and distributes the proceeds in accordance with the SPAC fund’s partnership or operating agreement.
SPAC Industry: Looking Ahead
Although the SPAC market seems to have cooled off a bit, SPACs still appear to be a popular investment choice for private equity and venture capital funds looking to expand and diversify their investment portfolio. A SPAC is an alternative IPO that decreases the risks associated with the underwriting process, which is why they have grown in popularity compared to traditional IPO filings. Because of this, many operating companies will likely continue to utilize this process to bring their companies to the public markets. Since these deals continue to be successful, and in certain cases highly successful, it makes sense that private equity funds will continue to utilize investments in SPACs as another weapon in their arsenal to generate alpha.