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In contrast, shareholders rejected quite a few other proposed SPAC
mergers, forcing many of these shell companies to return money to
investors. As a cascade of liquidations came in recent months, SPACs
began looking dicey again.
What accounts for this change in sentiment? Tight liquidity and lower interest rates have produced less attractive returns for hedge funds, which make up the bulk of investors in SPAC stocks, bankers and lawyers say. Valuations have also declined dramatically from when initial announcements were made. News of dissolutions combined with a tough M&A climate further depressed trading in SPAC shares and added to a logjam in initial public offerings. "Generally, shareholders have raised the bar as to what makes a good acquisition target for a SPAC, and as a result, it's become more difficult for SPACs to get a deal approved," says William Haddad, a partner at DLA Piper's New York office who has worked on many SPACs. As an alternative to traditional initial public offerings, SPACs have been a success that seemed impervious to the credit turmoil. Dozens of major investment figures -- Texas buyout veteran Thomas Hicks, and New York financiers Nelson Peltz and Ron Perelman among them -- lent their names to SPACs. Even as the credit crunch was settling in and the overall IPO market was slack, SPACs were raising record volumes in IPOs in the last quarter of 2007 and the first three months of this year. The SPAC, in fact, has many fans, including hedge fund investors, all of whom argue its plausibility as a product. Though structurally flawed, SPACs have staying power, say sponsors who, judging from the expanding IPO pipeline, believe that with many private equity buyers sidelined in the credit crunch, it's still an auspicious time for SPAC offerings. "The timing is fortuitous for us," U.S. Filter Corp. founder Richard Heckmann told an overflow crowd at a recent SPAC conference sponsored by Morgan Joseph & Co. in New York. Heckmann, an ardent SPAC champion who led a $433 million IPO in November 2007, gushed: "When we were doing acquisitions at U.S. Filter, we would try to get the money to acquire companies. This time around, I've got the money, and there are a lot of companies that look exciting to me." Despite that fervor, bankers and lawyers agree that some compelling news is needed to renew confidence in SPAC IPOs. The market could use several large acquisitions along the lines of Freedom and GLG, which might help SPACs overcome negative sentiment and structural hurdles. A big deal would also provide liquidity to hedge fund investors and free up capacity for future IPOs. All of which is proof that SPACs as an asset class continue to fumble their way to maturity. But for all the self-promotion, there's no guarantee that it will get there. Still, SPACs have come a long way since they first surfaced in the early '90s. EarlyBirdCapital Inc., an obscure investment boutique in New York, claims to be the architect of the SPAC and holds a trademark for the product. Its chairman, David Nussbaum, was with GKN Securities Corp. (now Investec Ernst & Co.) when he helped launch one of the first SPACs in 1993 with the IPO of Information Systems Acquisitions Inc. Over the next decade, a few SPACs would sporadically emerge whenever conventional IPOs flagged. In August 2003, EarlyBirdCapital engineered a $24 million IPO for Millstream Acquisition Corp., which merged with NationsHealth Holdings LLC to form NationsHealth Inc., a medical products and services company that didn't exactly flourish (its stock peaked at $8 and is now trading at 16 cents in the OTC.BB). But it was a tantalizing beginning for EarlyBirdCapital, which would lead manage about 30 more SPAC IPOs. The firm did not respond to requests for comment, citing quiet-period restrictions. SPACs have defied deeply held skepticism about so-called blank-check companies, which are created solely to buy operating companies. In an attempt to conquer that skepticism, their structure has undergone a controlled evolution over the years, with proponents going to great lengths to remove the stigma. Or at the very least, they've tried to answer regulatory concerns over trading, disclosure and conflicts of interest. It's no secret the Securities and Exchange Commission has never been enamored of SPACs, though there's nothing under the Securities Act of 1933 that bans them. In prior years, SPACs had been the purview of relatively small,
obscure issuers whose IPOs and subsequent acquisitions were shepherded
by investment banking boutiques. More recently, the major firms have
flocked to SPACs with increasingly larger issuances. By the time Goldman, Sachs & Co. announced in March that it would underwrite a $350 million SPAC, the amount seemed small by comparison.
To date, roughly 160 SPACs have raised more than $21 billion through IPOs since 2004. In 2007, SPACs accounted for 18% of all IPOs in the U.S., up from 7% in 2006, according to Dealogic.
In a bull market, the SPAC seemed like a no-brainer. Its taxonomy improved with some star-studded issuances. By 2006, former Apple Computer Inc. co-founder Steven Wozniak had his own SPAC; so did Michael Gross, a founding partner of Apollo Management LP who raised $375 million in May 2006, the largest at the time. Franklin says Gross' Marathon Acquisition Corp. and the SPAC structure inspired him. "It's the most efficient way to deploy capital, and you've got a real strategic advantage by having a lot of capital in the bank," Franklin said at the Morgan Joseph conference. To understand the attraction of SPACs, you need to dig into their unusual structure. The formula is simple enough. A management team raises money for a shell company through an IPO on the promise that it will complete an acquisition within 18-24 months. The IPO proceeds, minus working capital and taxes, are held in an interest-bearing trust, which is used to buy the target asset if one can be found. Terms have improved for investors over time. The trust used to be 80% of proceeds; today, that percentage is closer to 100%. (Underwriters' fees come out of the cash in trust but are generally not paid until the acquisition is completed.) Once a target is identified, shareholders can approve or reject the acquisition. Over time, the threshold of what constitutes a rejection has increased, from 20% to 35%, sometimes even to 40%, of public shareholders. If they reject the deal, shareholders get the cash back, eliminating downside risk. If they approve it, shareholders own a piece of the upside. A SPAC share structure is complex. A SPAC investor typically receives one unit consisting of one share and one warrant. The marked-to-market units are traded, as are the common shares and warrants, largely on OTC.BB. Trading activity generally picks up in the period leading to an acquisition announcement and to the period just before it's completed. If a SPAC liquidates, the common shares participate but the warrants expire. A unitholder has the option of selling the warrant on the open market to reduce the cost basis and theoretically lock in the difference between the adjusted cost basis and the amount held in trust (plus the shareholder's share of any accrued interest in the trust). For example, if an investor in a $100 million SPAC purchases a $10 unit, that $10 is backed 100% by cash in the trust. If the warrant trades at $1, the investor can sell it and get an adjusted cost basis of, say, $9. A SPAC generally has two years to complete an acquisition. If it's unable to identify a target or complete an acquisition, the shareholder gets back just the $10, less expenses, plus interest. But there's also an option layered on top of that. If the SPAC announces an acquisition, the shareholder has the option to vote in favor of the deal and become a conventional equity holder of the new company or to vote against it and convert the common share into its pro-rata portion of the trust. Or the shareholder can sell the common share on the open market, possibly at a premium to its conversion value. "A lot of trading strategies have looked at this as a way of making a low-risk investment but generating returns in excess of the risk-free rate," says Steven Kaplan, managing director of Ladenburg Thalmann & Co., a New York boutique that's been active with SPACs. It's that combination of the limited risk afforded by the cash held in trust and the prospect of owning a security with a market value more than the cash if the SPAC is well received that accounts for its persistent appeal among high-net-worth individuals and hedge funds. "It's hard to get those risk-adjusted returns that a SPAC offers anywhere else in the stock market," says Andrew Garcia, head of SPAC strategies at Pine River Capital Management LP, a Minneapolis hedge fund. No one knows for certain how many hedge funds invest in SPACs, although industry estimates put it at between 30 and 60. A cursory search of SEC filings consistently turns up certain investor names, such as HBK Investments LP of Dallas; Boston-based Baupost Group LLC; Weiss Capital Management Inc. of Palm Beach Gardens, Fla.; QVT Financial LP of New York; Korenvaes Capital Management LP, also of Dallas; and Sapling LLC, also of New York. To be sure, return numbers are difficult to calculate because not all investors hold a SPAC share throughout its life cycle, from the IPO to approval date and beyond. The chart on page 41 tracks price performance based on the purchase of every SPAC (at the market price on Dec. 31, 2004, for the 13 SPACs that went public before 2005 and at the IPO price for 143 that went public after 2005) and assuming a holding period of all unit components through April 18. CRT Capital Group LLC, a Stamford, Conn., investment boutique that specializes in SPACs and also tracks total returns for individual SPACs, provides some indicators as well. As of July 13, 2007, 28 completed acquisitions posted a median return of 13.2% and a mean of 41%. As of April 21, the 49 that completed SPAC acquisitions posted a median return of minus 29.7% to date, or an average of minus 7%, though the numbers may be skewed by a few individual cases. (These returns assume warrants were exercised for cash.) The advent of the credit crunch has brought a revaluation of SPAC shares, which make returns for investors less enticing. First, interest rates are lower, so interest generated in trust accounts is less. Second, the ability of hedge funds to leverage returns has diminished. So a $10 unit with a common share that historically traded at a discount of 5% or 6% now trades at a larger discount to reflect the higher cost of capital. Warrants that used to trade at 75 cents to $1 now go for around 50 cents -- or much lower. "The warrants have been trading lower than we'd seen in the past," says Christopher Gastelu, an executive director at UBS Investment Bank. "The warrant has to do with expectations that a deal will be completed. During the bull market, there was a lot more optimism that deals were fairly easy to do, but sitting in a tougher environment, there's a perception that deals might not push through." Pessimism among investors has been fueled by the recent spate of liquidations -- nine as of the end of April, compared with five all last year. (Shareholders have rejected 15 SPAC acquisitions since 2004, as of press time.) Why the failures? In certain cases, it was bad timing for some industry-focused SPACs. Both Chicago-based Grubb & Ellis Realty Advisors Inc., a $50 million SPAC, and New Canaan, Conn.-based Cold Spring Capital Inc., a $120 million SPAC, were buying real estate development companies in the midst of the subprime mortgage crisis. Other SPACs fell victim to a lengthy proxy process they must undergo to win shareholder approval. "The duration risk is one of the challenges for a SPAC," says John Shaw III, a director at Deutsche Bank AG, which has underwritten about a dozen SPAC IPOs since early last year. Boston's Harbor Acquisition Corp., which raised $80.8 million in an IPO in 2006, was set to buy Elmet Technologies Inc., a Lewiston, Maine, supplier of custom-engineered components such as medical imaging devices, for $125 million. Harbor CEO Robert Hanks says Elmet has a "high quality management team" and "incredible profit margins." But it took 11 months from Harbor's announcement to approval. "It should have been through the SEC in the May-June 2007 time frame, but it went much longer than expected, and that delay cost shareholders an incremental $700,000 in legal and accounting expenses," he says. In another instance, North American Insurance Leaders Inc., a $115 million SPAC based in New York, proposed to buy Deep South Holding LP, an Irving, Texas, underwriting management company, in August 2007, nearly 18 months after its IPO. By then, one investor says, the SPAC management was "paddling upstream to convince shareholders they're getting good value." Besides risks associated with a lengthy process, a major theme SPAC experts frequently cite is the size of proposed deals. Many acquisitions are simply too small relative to the cash trust and the potential for significant dilution from the warrants overhang. "Some of these deals looked very much like secondaries," Heckmann told the conference. "A SPAC acquisition should be exciting." SPACs have enormous opportunities to acquire companies with high growth, he argued, but size is important for investors. "A bigger transaction is needed to soak up the warrants dilution," he added. Smaller deals tend to get rejected these days. Ascend Acquisition Corp., for example, looked like it had something going for its target in ePAK Resources Pte. Ltd., an Austin, Texas-based manufacturer of engineered products for the semiconductor industry. Yet Ascend failed to generate enough votes last month, despite its best efforts to get its story across. One of the criticisms was that the company, while fast-growing, is tiny. Ascend raised about $41 million in May 2006 in an IPO EarlyBirdCapital underwrote. Its target posted $36.2 million in 2006 revenue, a 35% increase from the prior year, and $5.6 million in Ebitda, up 57%. "It was forecasting enormous growth, which, while possible, entailed a leap of faith on the investors' part," says a SPAC analyst at a hedge fund. "If you look at the track record of SPACs in general, oftentimes they failed to hit those lofty guidance numbers that the management provides." Because ePAK's operations are based in China and the company lacked an audited financial reporting system, the approval process took longer. The deal also involved performance hurdles that ePAK would not hit until March. By then, valuations had deteriorated and investors were reluctant to risk approving the acquisition and owning shares of a small, illiquid company. "If you're a hedge fund investor and you've got the choice of asking for your $10 back -- which gives you a small return or breakeven -- or you can invest that $10 to own 4% of a microcap company that's got no liquidity, in this sort of market where there's a real premium on liquidity, you'll always ask for your money back," says Charles Severs, managing director at CRT Capital. "Ultimately the markets might improve and help solve this problem, or more likely the SPAC structures will improve." Simply by virtue of its size, Freedom's reverse merger with GLG, Europe's largest independent alternative asset manager with $25 billion in assets, was favorably received. Its shares traded at about 2 times the IPO price and blew through the strike price, effectively addressing the issue of warrants dilution. "You need to create a big enough spread to absorb the uncertainties and the friction of the warrant overhang," Franklin says. GLG, though, hasn't been immune to the choppy markets. Its unit is down about 32% this year, partly due to recent news about the untimely departure of a key manager, Greg Coffey. Not that there haven't been smaller successes. Pre-GLG, there were a handful of home runs, either in shipping or China-related acquisitions. New York private equity firm Terrapin Partners LLC, which sponsored $58 million Aldabra Acquisition Corp., scored a $160 million purchase of Great Lakes Dredge & Dock Co. from Madison Dearborn Partners LLC. The deal returned 191.5% to Aldabra investors as of mid-2007. In 2005, Navios Maritime Holdings Inc., a 50-year-old Greek owner and operator of dry bulk carriers, merged with the listed International Shipping Enterprises Inc. and was showing a 286.3% return to investors as of last month. Last year, the $34.5 million Chardan South China Acquisition Corp. merged with A-Power Energy Generation Systems Ltd., which through an operating unit boasts the largest provider of distributed power generation systems in China. Its unit price showed a 211.3% return to investors, according to Morgan Joseph's May 5 tally. However, these are few and far between, given the total number of SPACs. Of 50 companies that have completed acquisitions to date, many have not performed to expectations, though part of that is the larger market. Once a SPAC buys a company and "de-SPACs," it's no different from any other public company, with the investment subject to the rigors of the public equity markets. Some higher-visibility stocks have been pummeled. Returns have fallen for investors in San Francisco beverage maker Jamba Juice Co., which merged with Steven Berrard's Services Acquisition Corp. International for $265 million, and Smart Balance Inc., which Boulder Specialty Brands Inc. acquired for roughly $500 million, both in 2006. As of July 2007, an investor in the Jamba Juice SPAC vehicle would have generated a total return of about 60%, and about 74% in Smart Balance, according to CRT's data. Last month, those numbers looked a lot different: The return on Jamba was minus 64.4% and Smart Balance, 9.3%. In some cases, management has had to offer more favorable terms to certain shareholders, such as transferring some of management's incentive to them, for a yes vote. In a rare instance, Aldabra 2 Acquisition Corp., Terrapin Partners' second SPAC, offered contingent value rights earlier this year to get shareholder approval on a $1.6 billion acquisition of Boise Cascade LLC's newsprint, paper and packaging operations. This involved a promise to the first 60% of institutional investors who voted yes to pay up to $1 per share if the stock trades below $10.50 in a year's time. Shares of the new company, Boise Inc., now trade around $4. The SPAC market, says Terrapin partner Sanjay Arora, "is in poor shape at the moment, but that reflects the broader equities market." Some investors may not be easily swayed. "How many deals have been approved where someone has a choice of taking $9.75 or a stock and watch it go to $4?" says a hedge fund investor. "It only needs to happen a couple of times and you're going to be very suspicious." Yet sponsors and their investment banks aren't fazed, and impresarios have moved on to their next pet SPACs. Franklin and Berggruen teamed up for a $1.035 billion SPAC float on the American Stock Exchange, in addition to a €600 million ($931 million) SPAC on NYSE Euronext Amsterdam, with vague plans to explore opportunities in North America and offshore. Terrapin Partners hopes to price its third and fourth IPOs, along with about 70 others. Underwriters, now including J.P. Morgan Securities Inc., are furiously trying to tweak the structure -- including slashing the management incentive up front or structuring earnouts -- to break the IPO logjam. But some investors say that what needs to happen first is for some of the 70 or so funded SPAC sponsors to bring some blockbuster news on the M&A front. For smaller SPACs, however, finding the right target that will hold up as a viable public company with sufficient institutional backing will continue to be a challenge, particularly in today's climate. "There's a balance going on right now, as management teams and bulge-bracket banks realize they have to look at how the company in the transaction looks on a pro forma, post-acquisition basis," says Pine River's Garcia. "You have to have a view towards creating a public trading company." The GLG deal may have raised the bar for future SPAC acquisitions,
but everything must fall into place to squeeze a deal through. The
economics of the vehicle have to be right for investors, and
shareholders have to believe the deal will trade at a significant
premium to the cash in trust for it to pass muster. "It's all about the
deal," says Deutsche Bank's Shaw. Or, as one investor points out,
"These days, people don't give the managers the benefit of the doubt.
They give them the doubt." -- Vyvyan Tenorio See TheDeal.com story on the change in sentiment toward SPACs Categories Deal Video
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In the curiously complex world of special purpose acquisition companies, a 
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