The special purpose acquisition company (SPAC), sometimes called a “blank check company,” is the newest darling of the stock market for going public because it’s so much easier, quicker, and cheaper than a regulation-heavy traditional IPO.
As you know, SPACs are created for the sole purpose of acquiring or merging with an existing company. And there is no deal more perfectly suited for Representations and Warranty (R&W) insurance than one involving a SPAC.
Private Equity took years to embrace R&W coverage, which transfers the indemnity risk away from the Seller to a third party – the insurer. It’s just a matter of time before SPACs do the same.
SPACs have been in the news lately.
Oakland A’s executive vice president (and former general manager) Billy Beane of Moneyball fame partnered at the end of January with RedBird Capital Partners to form RedBall Acquisition, a SPAC set up to the acquire a pro sports team. Hedge fund leader Bill Ackman raised $4 billion for his SPAC, the largest listing to date. All told, SPAC listings have raised just about $40 billion so far in 2020, eclipsing the $13.2 billion raised in 2019, according to SPAC Research.
PE firms and big-name investment banks like Goldman Sachs are getting in on the action.
Partly driving this trend is the pandemic. The valuations of private companies are falling, and they’re looking for liquidity fast – which is something traditional IPOs definitely don’t offer, especially in this time of market volatility. SPAC IPOs aren’t as dependent on market performance to be successful. Finally, they also allow sponsors to acquire quality companies at lower valuations.
All this means opportunity for savvy investors, who enjoy the many benefits a blank check company provides:
- It’s safe. Money raised for a SPAC during the IPO sits in a trust until there is an acquisition. You don’t lose money if the deal doesn’t go through.
- In two to three years, investors can potentially see a sizeable return. You could put the money with a PE Firm, but that capital is committed for seven to 10 years.
- They can walk away. Founders of SPACs must make an acquisition within two years. They must convince investors to back the deal. If an investor isn’t happy – they can take their money and walk.
- Less than 10% of SPACs fail to complete an acquisition.
- The value of the acquisition sometimes brings the stock price well above the usual starting price of $10/share. And sponsors and shareholders have a vested interest in increasing value.
Sellers love SPACs because they regularly outbid other offers to get these acquisitions and they are under time pressure. SPACs consistently pay more than everybody else. PE firms can’t match these premiums because they want to get the best return on investment.
Why R&W Insurance Is Perfect for SPACs
SPAC founders are under tremendous time pressure to get deals done within the two-year deadline, which, except under very specific circumstances, is set in stone.
They need deals to go smoothly and on schedule. Plus, the longer it takes SPACs to complete a business combination – the more leverage the target has to insist on narrow Reps and Warranties and other Seller-favorable terms.
That’s where R&W insurance comes in. It hedges risk for both Buyer and Seller and is built to facilitate fast acquisitions. Here’s why:
- It transfers risk of breaches of the Seller reps and warranties to the insurance company.
- It provides a hedge to Buyers. The board of directors of the SPAC and shareholders are protected if a post-closing breach occurs. They won’t be subject to covering that loss.
- When this coverage is made part of the deal early on, there is no need for the sometimes contentious negotiations over reps and warranties because, if there is a breach, the insurer pays the damages.
This speeds up the process – not to mention saves on legal fees, about 20% savings on the negotiations part of the deal. The management team of the acquisition target will likely work with the SPAC going forward, so if negotiations are amicable, it means a good working relationship going forward.
- The target company keeps more money in their pocket rather than in escrow. You can’t understand how big a deal the removal of escrow is. A typical SPAC purchase is $200M to $1B, which means typical escrows are from $20M on the low side to $100M. If you can relieve tens of millions of those dollars because R&W is in place, it’s a no-brainer.
- Sometimes due diligence by the SPAC team is not as thorough because they are trying to save time and money. R&W underwriters could point out things they could diligence a bit more. They could uncover soft spots in diligence that should be addressed.
- Provided this approach is used at the opening of negotiations, the target company will gladly pay for R&W coverage. The SPAC doesn’t incur any premium cost, which can run $500K to a couple of million. A target will gladly pay that to have $2M in escrow instead of $30M.
- R&W insurance is also another hedge for Directors and Officers Liability insurance. Say a SPAC has a two-year D&O policy with a six-year tail. If R&W coverage is in place, those D&O Underwriters are open to shrinking that tail premium because there is less exposure.
- R&W coverage is another way to persuade possibly uncomfortable shareholders. This is not usually an issue. But it’s one more argument in your favor to get it done.
SPAC sponsors are incentivized to make deals work, because if they have to give money back to investors, they don’t get paid and could lose standing in the eyes of potential future investors in other SPACs.
With SPACs there is no history of performance. Investors look at the sponsors’ reputation and expertise when they decide to buy shares, as do target companies when they decide to accept offers. A tarnished reputation makes it hard to move forward.
If deals are eight times more likely to close with R&W coverage in the PE market, I would believe it’s at least that much in the SPAC market.
Given all this, why aren’t SPACs running to R&W insurance right now?
Until recently, most sponsors have been big-time banks and successful investors and executives. They have experience in M&A, of course, but as Strategics they held so much leverage over their targets, R&W wasn’t necessary. So they never really considered it – or even knew what it was.
Today, large PE firms, who have embraced R&W insurance, are coming to the forefront as SPAC sponsors. R&W is definitely in their “toolbox”.
It’s clear that Representations and Warranty insurance is ideal for SPACs. To find out how this specialized type of insurance can change the game for you, whether you’re a SPAC sponsor or a target company, contact me, Patrick Stroth, at email@example.com for all the details.