Monday, December 17, 2007
Last week Endeavor Acquistion Corp., the special purpose acquisition company, completed its buy-out of American Apparel, Inc. American Apparel is now a public company almost a year after it first originally agreed to be acquired and almost 18 months after Endeavor first went public. The acquisition was a nail-biter -- if Endeavor had not completed it by this December it would have been forced to liquidate under its constitutional documents.
A SPAC is a company organized to purchase one or more operating businesses. The equity funds to acquire these businesses come from an initial public offering by the SPAC. At the time of the offering, the actual target acquisitions are unknown; it is only afterwards that the SPAC’s organizers will begin to identify and attempt to acquire these businesses. The SPAC’s organizational documents will typically provide it eighteen to twenty-four months to agree or complete an acquisition before the SPAC is required to liquidate and return the remaining offering proceeds to investors. During this interim period, the proceeds of the initial public offering are held in a trust or escrow account. A typical SPAC also requires that its initial acquisition or acquisitions constitute at least eighty percent of its net assets excluding deferred underwriters’ discounts and commissions, though lately this threshold has been creeping down towards a sixty percent hurdle rate. Investors have a right to pre-approve this acquisition and if they vote against it and follow certain perfection procedures they are entitled to redeem their shares for a pro rata share of the remaining offering proceeds held in trust.
SPACs are now all the rage. According to SPAC analytics, through December 10, 2007, sixty five SPACs completed initial public offerings raising $11.407 billion in aggregate gross proceeds. This compares with no offerings in the entire period from the late nineties through 2002. The size of individual SPAC offerings has also increased. In 2005, over two-thirds of SPAC initial public offerings were for $100 million or less. But in 2006, forty SPACs announced initial public offerings for an aggregate amount of $3.4 billion, and over half attempted to sell more than $100 million in securities. This included one offering greater than $500 million With this rise in offerings, has come an increase in mainstream private equity participation. Managers from traditional private equity fund advisers are now forming their own SPAC vehicles as alternatives to commencing their own private equity funds (Lou Holtz and Dan Quayle even have one).
But SPACs have their problems. A purchase of SPAC securities is typically an investment in a single, to-be-determined acquisition. At the time of his or her purchase, a public investor is uncertain what business or industry the SPAC will enter, the size of the SPAC’s acquisition and the leverage it will bear and whether the SPAC’s management will have any facility in the industry of the investment. Their influence on these matters is instead limited to a vote on the acquisition. However, this vote is one that has an inherently coercive aspect to it; a nay vote entitles an investor only to their share of the remaining offering proceeds, an amount that is less than their original investment. Loss aversion and framing therefore psychologically biases investors to approve the acquisition in a hopeful attempt to recoup their initial investment. A SPAC investor is also left relying upon the SPAC sponsors to select an appropriate target. Yet, these sponsors often lack the buy-out expertise that fund advisers have, typically do not have the equivalent level of resources, experience or investment affiliations, and often are not as well versed in the industry of their acquisitions as fund adviser principals are. The result is that they are arguably less likely to make similarly successful investing choices as private equity fund advisers.
These problems were full on display in the Endeavor Acquistion. First, the problems of inexperienced SPAC management and the wide latitude they have for acquisitions was illustrated by Endeavor's largely fruitless search for an acquisition target. According to their preliminary proxy, Endeavor looked at the following entities before agreeing to acquire American Apparel (Endeavor presumably omitted the names to protect the innocent and as required by confidentiality agreements):
- A branded restaurant chain with franchising operations that was headquartered in Los Angeles, California and owned by a private equity firm.
- A well-known national chain of weight loss centers headquartered in California also owned by a private equity firm.
- A restaurant chain headquartered in California that had strong regional brand recognition on the West Coast.
- A regional ethanol producer headquartered in the Midwestern United States
Endeavors first three buy-out attempts were trumped by other buyers; it withdrew from bidding on the fourth potential acquisition over price. Then, according to the proxy, things got better:
In July 2006, Mr. Ledecky [CEO of Endeavor] met with Endeavor consultant Mr. Martin Dolfi to discuss deal flow. He discussed with Mr. Dolfi the philosophy espoused by Mr. Peter Lynch to “invest in what you know.” Mr. Ledecky then asked for examples of products that Mr. Dolfi used and enjoyed. Mr. Dolfi indicated that he enjoyed the clothing sold at American Apparel. As a way to reinforce the discussion, Mr. Ledecky instructed Mr. Dolfi to research the American Apparel company. Mr. Dolfi returned in August 2006 with a research book presentation on American Apparel.
But the acquisition of American Apparel was not so smooth. A SPAC acquisition of a private company also side-steps many of the gun-jumping provisions of the Securities Act since the proxy statement to approve the transaction, which includes the relevant financial and other information, is not immediately filed, yet investors can trade the SPAC shares in the interim in anticipation of the acquisition. The problem of this was quite apparent with Endeavor as the stock became an arbitrage play with significant amounts held by hedge funds taking advantage of the information disparity. Finally, Endeavor ultimately renegotiated its agreement with American Apparel to pay a higher price. One of the reasons cited by Endeavor for this was the limited time remaining for the SPAC to complete its acquisition before it was required to liquidate. Not the best reason in the world to pay more money for a company.
The rise of SPACs has been a discussion point and concern among M&A practitioners for almost three years now. SPACs were big in the 1970s but fell into disfavor due to a number of high-profile implosions and complaints over the quality of their acquisitions. But like Frankenstein arisen from the dead, they are back. The rise of SPACs is a derivative effect of the private equity bubble. The Investment Company Act of 1940 effectively makes impossible the public listing of a private equity fund. And Investors shut off from private equity are turning to SPACs as a substitute. Given the past troubles with SPACs this is a dubious effect at best. There is also no real reason to permit SPACs yet shut-off private equity funds from the public markets. It is yet another reason why the SEC should take steps to fully revise the Investment Company Act to bring it into the modern era.