“shells” advertised for sale to private companies seeking this avenue to go public.
The number of reverse mergers rose steadily from 2003 to 2008. Falloff in 2009 was relatively modest compared to the decline in the number of traditional M&As (see Figure 1.7). In terms of deal value, however, 2006 was the banner year and the value of these deals generally declined over the years 2008–2013.
Figure 1.7 (a) Value of Reverse Takeovers (b) Volume of Reverse Takeovers. Source: Thomson Financial Securities Data, March 6, 2015.
For many companies, going public through a reverse merger may seem attractive, but it actually lacks some of the important benefits of a traditional IPO – benefits that make the financial and time costs of an IPO worthwhile. The traditional IPO allows the company going public to raise capital and usually provides an opportunity for the owners of the closely held company to liquidate their previously illiquid privately held shares. This does not automatically happen in a reverse merger. If the company wants to sell shares after the reverse merger, it still has to make a public offering, although it may be less complicated than an IPO. Being public after a reverse merger does not mean the shares of the combined company are really liquid. It all depends on how attractive the company is to the market and the condition of the market itself.
One advantage of doing a reverse merger is that it gives the company more liquid shares to use to purchase other target companies. Prospective targets might be reluctant to accept illiquid shares from a privately held bidder. Shares from a public company for which there is an active market are often more appealing. Thus if the goal is to finance stock-for-stock acquisitions, a reverse merger may have some appeal.
Reverse mergers have often been associated with stock scams, as market manipulators have often merged private companies with little business activity into public shells and tried to “hype” up the stock to make short-term fraudulent gains. The SEC has tried to keep an eye out for these manipulators and limit such opportunities.
Special purchase acquisition vehicles (SPACs) are companies that raise capital in an IPO where the funds are earmarked for acquisitions. They are sometimes also referred to as blank check companies or cash-shells. SPACs were very popular between 2006 and 2008, especially in 2008. The number of SPACs peaked in 2009 and declined in the years that followed (see Figure 1.8).
Figure 1.8 (a) Value of SPACs (b) Volume of SPACs. Source: Thomson Financial Securities Data, March 6, 2015.
Usually between 80 % and 90 % of the funds are placed in a trust that earns a rate of return while the company seeks to invest the monies in acquisitions. The remainder of the monies is used to pay expenses. Shareholders usually have the right to reject proposed deals. In addition, if the founders do not recommend a deal within a defined time period, such as 18 months, or complete a deal within 24 months, the monies are returned to investors less expenses plus a return earned in the capital. This contrasts with private equity investments, where shareholders do not have to approve specific deals.
Such investments can be risky for investors as it is possible that the company may not complete an acquisition. If that is the case, investors could get back less money than they originally invested. Even when the company does complete deals, they do not know in advance what targets will be acquired. During the period of time between the IPO and the completion of an acquisition, the funds raised are held in a trust fund and typically are invested in government securities.
The IPO offerings of SPACs are unique and differ in many ways from traditional IPOs. In addition to the differences in the nature of the company that we have discussed, they usually sell in units that include a share and one or two warrants, which usually detach from the shares and trade separately a couple of weeks after the IPO. Because the market for these shares can be illiquid, they often trade at a discount – similar to many closed-end funds. The post-IPO securities can be interesting investments as they represent shares in an entity that holds a known amount of cash but that trades at a value that may be less than this amount.
Founders of SPACs benefit by receiving a share, usually 20 %, of the value of the acquisition. Normally, other than this ownership position, the founders of the SPAC do not receive any other remuneration. Their shares usually are locked up for a period, such as three years, after the IPO date.
In Chapter 4 we discuss the various factors that lead to a value-destroying M&A strategy. With SPACs, however, there is no strategy as investors are seeking to convert their liquid cash into an equity investment in an unknown company. Not surprisingly, in a study of 169 SPACs over the period 2003–2010, Jenkinson and Sousa found that over half of the deals immediately destroyed value.14 They compared the per share value of the SPAC at the time of the deal with the per share trust value. They reasoned that if the market value is equal to or less than the trust value, the SPAC should be liquidated and the acquisition should not go forward.
In spite of the disappointing results of Jenkinson and Sousa, there is an explanation for SPAC's continued popularity. The investments are liquid and the shares have been sold to the market in the initial IPO. This compares favorably to private equity investments, which are not very liquid.
In spite of the fact that the market prices as of the acquisition approval date indicated ex ante that the deals would be value-destroying, more than half of the deals were nonetheless approved by investors. Jenkinson and Sousa found that investors who went along with the recommendations of the SPAC founders in spite of a negative signal from the market suffered –39 % cumulative returns within six months and –79 % after one year. The fact that the founders recommended the deal is not surprising given that they derived their compensation by receiving 20 % of the capital value of any acquisition. Therefore, they want the investors to approve an acquisition as that is how they get their money. The deal may cause investors to lose money, but it can still make the founders a significant return. In light of the poor performance of SPACs it is surprising that roughly three quarters of deals are approved by the SPAC investors.
Holding Companies
Rather than a merger or an acquisition, the acquiring company may choose to purchase only a portion of the target's stock and act as a holding company, which is a company that owns sufficient stock to have a controlling interest in the target. Holding companies trace their origins back to 1889, when the State of New Jersey became the first U.S. state to pass a law that allowed corporations to be formed for the express purpose of owning stock in other corporations. If an acquirer buys 100 % of the target, the company is known as a wholly owned subsidiary. However, it is not necessary to own all of a company's stock to exert control over it. In fact, even a 51 % interest may not be necessary to allow a buyer to control a target. For companies with a widely distributed equity base, effective working control can be established with as little as 10 % to 20 % of the outstanding common stock.
Holding companies have certain advantages that may make this form of control transaction preferable to an outright acquisition:
● Lower cost. With a holding company structure, an acquirer may be able to attain control of a target for a much smaller investment than would be necessary in a 100 % stock acquisition. Obviously, a smaller number of shares to be purchased permits a lower total purchase price to be set. In addition, because fewer shares are demanded in the market, there is less upward price pressure on the firm's stock and the cost per share may be lower. The acquirer may attempt to minimize the upward price pressure by gradually buying shares over an extended period of time.
●
