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Egregious Founder Shares. Free Money for Hedge Funds. A Cluster***k of Competing Interests. Welcome to the Great 2020 SPAC Boom.
Bill Ackman hates SPACs, but Bill Ackman also loves SPACs.
It’s a brilliant, blue-sky afternoon in mid-August, and Bill Ackman is enjoying being, well, Bill Ackman.
Maybe it’s the sun. Or maybe it’s the aftermath of his latest tour de force — the IPO of a $4 billion special-purpose acquisition company, or SPAC, the largest of its kind during a year when such blank-check deals are exploding.
Sporting a baseball cap, aviator shades, and a faded polo shirt, the 54-year-old hedge fund mogul eases into the poolside lounge chair at his Hamptons home — where, ever since the Covid crisis hit, he has been living and working — and settles into a Zoom interview, adjusting the computer for the best angle of his incognito look.
But if you’re expecting Ackman to be relaxed, he’s not. Instead, he quickly rattles off how well his first SPAC has performed. Over eight years, his Pershing Square Capital Management hedge fund’s investment in Burger King — which merged in 2012 with a SPAC Pershing Square co-sponsored and has since become part of a bigger fast-food conglomerate called Restaurant Brands International — has returned 19 percent per year to the hedge fund’s investors. Earlier this year, when Covid punished the stock, Ackman bought more of Restaurant Brands’ shares; it’s now the third-largest holding in Pershing Square's portfolio, worth about $1.6 billion.
Restaurant Brands’ consistent, long-term gain makes it an outlier for a company that began as a SPAC, a publicly traded shell company that raises money in hopes of finding a merger partner that will endure the higher costs demanded by SPAC sponsors and underwriters to avoid the protracted process of going public on its own.
Like numerous other forms of Wall Street financial ingenuity, these vehicles have had a checkered history — and shockingly terrible performance.
Since 2015, the 89 SPACs that have completed mergers have an average loss of 18.8 percent (and a median loss of 36.1 percent), compared with the average aftermarket gain of 37.2 percent for other IPOs through July 24, according to Renaissance Capital, which tracks IPOs. Only 29 percent of the SPACs had positive returns.
But Ackman, always the contrarian, was so taken with the success of the Burger King deal that he had been itching to do another. After the pandemic hit, Ackman thought the disruptive market it created would make SPACs more valuable to companies wanting to go public.
“If we’re going to do it, this is the moment,” Ackman thought. Then he began contemplating the structure — “and how to make it better.”
That’s not just hype. To start, Ackman’s Pershing Square Tontine Holdings got rid of the premier feature of SPACs — so-called founder shares that typically give their sponsors 20 percent of the new company, pretty much for free.
“I thought it was egregious,” he says. “It is one reason why the track record of SPACs is often poor.”
Ackman also got rid of other common SPAC features that create, in one participant’s words, a “clusterfuck” of competing interests that also drag down performance. He changed the terms of the warrants investors receive along with stock in the IPO and also promised to invest at least $1 billion of Pershing Square’s capital to help complete a merger. Both of these moves should make a costly secondary offering in the form of a private investment in public equity, or PIPE, unnecessary.
Ackman’s SPAC seems to have struck a nerve: It was oversubscribed by three times, meaning he could have raised $12 billion had he wished. Along with the wild success of what Wall Street bankers like to call concept stocks — stocks like Virgin Galactic Holdings, Nikola Corp., and DraftKings, all of whose shares initially skyrocketed after their deals with SPACs were inked — Tontine has been lauded as further evidence that SPACs have shed their dodgy past and become mainstream.
Yet while some other SPAC practitioners have tinkered with such issues as founder shares and warrants, longtime SPAC players don’t think Ackman’s Tontine will force many to make radical changes. And there’s been little move in that direction since Tontine’s IPO.
“Bill Ackman is Bill Ackman; he stands alone,” says Douglas Ellenoff, a partner at law firm Ellenoff Grossman & Schole who has been advising SPACs for 15 years. “I do not think other firms or sponsors are going to follow his model — because it hurts their interests.”
At a time when money is rushing into SPACs, that statement might give one pause. These boxes of cash have raised $40 billion so far this year, according to SPAC Analytics. That’s three times as much as in 2019. Sports executives like Billy Beane of Moneyball fame and politicians like former House Speaker Paul Ryan are launching them, while everyone from pension funds to sovereign-wealth funds, mutual funds, and Robinhood day traders is getting in on the action.
Long-time practitioners acknowledge SPACs are now in a speculative market, if not a downright bubble. “I do think the market has gotten very, very frothy, and I do see a couple of cautionary flags,” says Jeff Sagansky, a media executive turned dealmaker whose fifth SPAC merged with DraftKings to great acclaim earlier this year. “There are a lot of SPAC sponsors that just are really not qualified.”
“Is there too much SPAC money chasing too few opportunities?” he asks. “I don't think we know that yet.”
But the way SPACs are structured seems to make that inevitable.
SPACs are often viewed as an alternative to a traditional IPO or a merger. There is, however, another way of thinking about them: as a new form of asset management, similar to private equity or hedge funds.
“SPACs started out not generally accepted as a legitimate form of asset management, but now they are regarded as totally legitimate,” says Stephen Fraidin, a partner at law firm Cadwalader.
Hedge funds Third Point, Glenview Capital Management, and Starboard Value, as well as private-equity funds Apollo Global Management, TPG Capital, and Fortress Investment Group, are among the brand-name alternative asset managers who’ve launched SPACs in the past five years.
One of the things SPACs have in common with other forms of asset management — specifically alternative asset managers — is the outsize compensation for their founders.
“SPACs are a compensation scheme, like people used to say about hedge funds, but it’s even worse,” Ackman tells Institutional Investor. “In a hedge fund, you get 15 to 20 percent of the profit,” he says, in reference to the incentive fees hedge funds earn on the gains in their portfolio. “Here you get 20 percent of the company.”
For a small fee of $25,000, he explained in a recent letter to investors in his hedge fund, “a sponsor that raises a $400 million SPAC [the average size this year] will receive 20 percent of its common stock, initially worth $100 million, if they complete a deal, whether the newly merged company’s stock goes up or down when the transaction closes.”
Even if the stock falls 50 percent after the deal closes, “the sponsor’s common stock will be worth $50 million, a 2,000 times multiple of the $25,000 invested by the sponsor, a remarkable return for a failed deal,” he wrote.
Meanwhile, Ackman noted, the IPO investors will have lost half of their investment.
And there is another advantage: The 20 percent stake is also referred to as the “promote,” a nod to the work sponsors perform in landing a deal. However, that money is considered an investment, not a fee, which means sponsors can pay a lower capital-gains tax on the return if the stock is held longer than a year.
“To make matters worse,” Ackman added, “many sponsors receive additional fees for completing transactions, which can include tens of millions of dollars in advisory fees, often paid to captive ‘investment banks’ that are often 100 percent owned by the sponsors themselves.” Underwriting fees paid in a SPAC IPO are around 5.5 percent of the capital raised, he noted — higher than those of the average IPO.
Critics say the lure of free money can push sponsors to do bad deals, especially if they are coming up against a deadline to get one done.
Typically, SPACs can only hold onto the cash raised from investors for two years. If they don’t strike a deal within that time frame, they must give the money back, with interest. Most deals are struck in about a year, but some go right up to the wire — with poor results for other shareholders.
A case in point is Landcadia Holdings, whose co-chairmen were Jefferies Group CEO Richard Handler and Tilman Fertitta, a billionaire sports, restaurant, and casino owner and reality TV star. With only two weeks to go before Landcadia hit its two-year deadline on June 1, 2018, it announced a deal to buy Waitr, a Louisiana-based regional competitor to Grubhub, for cash and stock valued at $308 million, according to a purported class-action lawsuit filed in a Louisiana federal court in September 2019.
If Landcadia had not found a deal, the sponsors would have had to forfeit their lucrative founder shares. Jefferies — which also served as underwriter for the deal — would also have been forced to relinquish at least $10 million in fees, the lawsuit claimed.
Investors suing Handler, Fertitta, and Jefferies say that the prospectus issued in connection with the merger with Waitr gave false and misleading statements, including that the company was on the verge of profitability. At the time the merged stock began trading, the lawsuit alleges, none of Waitr’s financial statements, Securities and Exchange Commission reports, or Sarbanes-Oxley certifications were “true, accurate, or reliable.”
Waitr stock is now down more than 60 percent since the SPAC’s IPO, trading a little over $3.50 per share, from the SPAC IPO price of $10. The merger was completed on Nov. 15, 2018, after the sponsors received an extension from shareholders to undertake the due diligence necessary to complete the deal.
Jefferies and Handler declined to comment on the lawsuit. Fertitta could not be reached.
Yet despite Waitr’s sinking stock, the two men came back to the market with another SPAC, Landcadia Holdings II, last May. Their past failure didn’t seem to matter. That blank-check company agreed in June to merge with Golden Nugget Online Gaming, and the SPAC has surged more than 70 percent since the IPO.
Like many financial innovations, SPACs were invented to get around regulations.
In 1993, to combat the fraud and manipulation rampant among small blank-check companies in the prior decade, the SEC instituted what’s known as Rule 419, which forbade trading in the shares of such companies until after a merger is completed. Knowing that such a restriction would deter investors from buying into the IPOs, blank-check practitioners created a new structure to skirt the rule: the special-purpose acquisition company.
The SPAC structure allowed for trading, but also included many provisions similar to the SEC’s new mandate — like allowing investors to opt out of the merged company and get their money back once a deal is done. But there are no regulatory provisions that specifically affect SPACs; each prospectus states that Rule 419 doesn’t apply.
The big change that started to bring in institutional investors occurred after the financial crisis, in 2010. Until then, an investor who chose to redeem his shares could not vote on the proposed merger.
To help get deals approved by shareholders, SPAC lawyers convinced SEC examiners to allow SPACs that decoupled the vote from the redemptions.
It was a brilliant move. SPAC IPOs had always included a combination of shares and warrants. Decoupling the vote meant investors could vote for the deal, redeem their shares, and get their cash back — with interest — but still hold onto the warrants, which would be extremely valuable if the stock of the merged company soared (and no great loss if it did not). It was called the SPAC arbitrage trade, and hedge funds — the dominant investors in SPAC IPOs — loved it.
“We made the vote easier,” explains Ellenoff, who was involved in the negotiations with the SEC. But he admits the change created a new issue: Even if there were no problems in getting shareholders to approve a deal, should they redeem — and approximately 50 percent of them do — there might not be enough money left to consummate the merger transaction.
Enter PIPEs. Once a target is identified, the SPAC sponsor can take the deal, on a confidential basis, to institutional investors and mutual funds that otherwise might be wary of investing in a blank-check company, as long as they agree not to trade the stock until the deal is announced.
These investors agree to what’s essentially a secondary offering, which is often preferred shares or convertibles that have priority over the original shareholders, often on preferential terms.
Bringing in PIPE investors was a “game changer” that brought in “smart capital with price certainty from high-quality investors,” says Tyler Dickson, co-head of the banking, capital markets, and advisory division at Citi, which is one of the leading underwriters of SPAC issuance.
The problem with all these machinations is that each layer adds its own costs — and dilution to shareholders.
Decoupling the vote from the redemption “can make it economically sensible to buy every SPAC at the IPO,” says one veteran SPAC participant. “You’re giving a free warrant. But the kind of people interested in free warrants are hedge fund arbitrageurs. So you can raise capital, but once you identify a target, you have to raise money all over again.”
As he explains it, “You’ve got to find someone willing to sell to you, and you’re scrambling to raise money.”
The sponsor, he says, primarily wants to get the deal done. “If he gets it done, he’s going to get stock. So the person getting the founder stock is the same person negotiating the price for the company he’s going to buy and negotiating with multiple PIPE investors.”
He goes on: “Imagine trying to do a deal when you have all these different, conflicted people at the table. You’ve got the guy doing the merger, who wants the best price; investors are out for themselves; and the guy with the biggest conflict is the guy who is negotiating with all the shareholders. He gets a windfall if he gets the deal done. Don’t you think he’d be willing to pay a higher price for the company with other people’s money?”
“It’s a clusterfuck,” he concludes.
Ackman found a way around that problem by designing the Pershing Square SPAC to have the smallest upfront warrant ever, thus minimizing the risk of shareholder redemptions and the need to raise expensive PIPE capital. Long-term investors, including an Asian sovereign-wealth fund and Canadian pension plans, piled in. The final list included “very few hedge funds,” Ackman says.
The Pershing Square Tontine warrant is so complicated that he offers a diagram to explain it. In a SPAC IPO, investors get a unit consisting of common stock and a portion of a warrant, typically one-third. However, investors in Pershing Square Tontine get one-ninth of a warrant per share upfront but can only get the other two-ninths of a warrant — making up the third — if they hold onto their shares after the redemption date. If they do sell their stock, their two-ninths of a warrant is distributed among the warrant holders who remain. (Pershing Square has its own warrant, which it purchased for $65 million and could be worth many multiples of that: The warrant gives the hedge fund the right to buy up to 5.9 percent of the company for $24 a share — but only three years after Tontine closes on a deal.)
“The Pershing Square terms are not an evolution, but a revolution,” says Cadwalader’s Fraidin, who worked on the IPO.
Another hedge fund sponsor has already taken a shine to the warrants structure. A few weeks after the Pershing Square Tontine IPO, activist hedge fund Starboard Value entered the SPAC arena, filing for a SPAC IPO with warrant terms designed to work like those of Pershing Square.
Sponsors, however, aren’t the only ones getting hip to the problem of free money.
No one but Ackman has nixed founder shares. But restructuring them happens about 50 percent of the time, says Citi’s Dickson. “Best-in-class sponsors create value and typically earn their full promote. However, as a sponsor, you have to be able to negotiate a successful deal. The partnership needs to work for all.”
Sagansky, who has now launched six SPACs, including DraftKings, says he is always flexible. “We’re long-term SPAC sponsors; we'll do whatever is right for each deal,” he says. “In the case of Williams Scotsman, which has been an incredibly successful deal, we took none of our founders’ shares upfront; they were all on an earn-out.”
The $1 billion merger of Sagansky’s Double Eagle Acquisition Corp. with Williams Scotsman International, a storage company, was completed in November 2017, a little more than two years after the SPAC’s IPO in September 2015. Shares of the company, now WillScot Mobile Mini Holdings Corp., have jumped 74 percent since the merger. “Virtually every one of our SPACs after a year or two have all traded up significantly,” Sagansky says. That’s not to say they’ve all created great long-term value: Since their debut, the shares of three of Sagansky’s six SPACs are down about 90 percent each.
Other SPAC sponsors downplay the promote, and say they are now putting cash into the deals.
“I typically invest at least $100 million in my own SPACs,” Social Capital CEO Chamath Palihapitiya wrote in an email. “At the end of the day, the promote isn’t that important. What’s more important is the price of the deal, the sponsor of the SPAC, if they are investing personally, and the quality of the company.”
Palihapitiya’s first SPAC, which merged with Virgin Galactic last year, is one of the more successful SPACs in recent times. It peaked early this year at $42.49, a more than 300 percent gain since the IPO. It is now trading above $17— still up more than 70 percent since launch.
Regulatory filings show that Palihapitiya owns 33.75 million shares, 10 million of them purchased for $10 a share, or $100 million. Since Virgin Galactic has a market cap of $4 billion, Palihapitiya’s 16.6 percent stake is now worth around $660 million. The deal was such a hit that Palihapitiya has launched two more SPACs this year; one of them just reached an agreement to merge with Opendoor, an online real estate startup. Last week, he filed for three more.
SPAC veterans give Palihapitiya credit for bringing venture capitalists to the SPAC party, or what he calls “IPO 2.0.”
“Virgin Galactic gets done at the last minute by a sponsor who was very close to failing on his mission and does a Hail Mary — to buy Virgin Galactic. It works out, and it goes up significantly. And all of a sudden, everybody's like, ‘Wow, I never thought of Silicon Valley deals for SPACs,’” says Ellenoff. “Because it had always been real private-equity deals with real revenue and real EBITDA. And all of a sudden, what could have been a colossal failure for the SPAC market becomes the bellwether.”
SPACs have often been the route to the public markets for companies with no other choice. While that’s not necessarily the case for VC-owned companies, WeWork’s aborted IPO last year and the poor showing of some unicorns that did make it to market have also played a part in making SPACs an alternative to a traditional IPO for these companies, says Enrique Abeyta, a former hedge fund manager who has invested in SPACs and is launching a newsletter at Empire Financial Research to follow them.
Even Benchmark general partner Bill Gurley, a well-known VC player, came out endorsing SPACs as “a truly legitimate and preferable doorway into the public markets” in a recent blogpost.
Some recent SPAC mergers are doing better than in the past, according to Renaissance Capital, which reported that the common shares of the 21 SPAC mergers completed since the start of this year had outperformed the market, with a gain of 13.1 percent from the traditional $10 offer price, as of July 24. But that’s only because of the sector's two highest performers, DraftKings and Nikola, which were up 274 percent and 199 percent, respectively, by that time. The median return was still negative — a decline of 16.7 percent.
Many SPAC players argue that returns will continue to improve because the market has matured. Yet history suggests caution is in order.
The glut of SPAC issuance this summer, including Ackman’s $4 billion SPAC and the next largest, a $2 billion SPAC executed by former Citi banker Michael Klein — his fourth — is leading to a record quarter. But in the waning weeks of the summer, says Dickson, there was less demand for the IPOs. “They crossed the finish line successfully, but their aftermarket trading has been more anemic,” he says, adding he is nonetheless “optimistic” about the fall pipeline.
“There is a lot of money going into SPACs, all of which have a limited amount of time to find good targets,” warns Priya Cherian Huskins, senior vice president at insurance brokerage Woodruff Sawyer. “The question is, what is the inventory of good targets? If that inventory is limited, then we should expect to see two things. Number one, SPACs may overpay for the targets, in which case the investment will ultimately perform poorly. Or some SPACs may, in desperation, accidentally purchase really bad companies.”
Short-sellers are already smelling blood. On September 10, Nate Anderson’s Hindenburg Research unveiled a scathing attack on one of this year’s SPAC darlings, electric-truck maker Nikola, calling it “an intricate fraud built on dozens of lies.” While Nikola has denied the accusations, the SEC and the Department of Justice are reportedly examining the claims, the stock has lost a third of its value since the report surfaced, and founder Trevor Milton has stepped down as executive chairman.
Notably, the SPAC that merged with Nikola, VectoIQ, was running out of time to find a partner before it would have had to return investors’ capital. It announced the merger agreement with Nikola on March 3, little more than two months shy of its two-year deal deadline of May 16. To get the SPAC off the ground, VectoIQ had also offered investors one warrant for each share — a much richer deal than the one-third that has become the norm.
Ackman can only hope that his SPAC’s unique structure and the size of his target — it is expected to have a more than $10 billion market cap — sets him apart when looking for a merger candidate.
Much media speculation has focused on the possibility of Pershing Square’s SPAC merging with what Ackman calls a “mature unicorn.” But he says it’s more likely Pershing Square will choose a private-equity or family-owned company, as fewer than ten companies fit the profile of the target he is seeking.
One that has been mentioned for months is Airbnb, which recently made a confidential filing for an IPO. That isn’t dissuading Ackman — who says he has had preliminary talks with management — especially since tech stocks have been reeling.
“Companies that are trying to go public are exactly what we are targeting,” he says. He thinks a market downturn would only make it easier. “We can give them certainty and we can be done in a month,” he says.
And while Ackman has shined a spotlight on the flaws of SPACs, he still argues that “the basic construct is a good idea.”
“The problem,” he says, “is greed took hold of SPACs.”