The notion that our economic and financial systems are “rigged” in favor of the wealthy and the connected is fueling much of the current political debate and has increased distrust in Wall Street. Rather than getting caught up in the emotion of the “us versus them” argument, it is helpful to take a step back and take a more in-depth look at one recent offering to better understand the system.
The biggest initial public offering (IPO) of 2016 thus far was on February 23 by a company that has no assets or operations. This so-called “special purpose acquisition company (SPAC)”, also known as a blank check company, raised $500 million to buy oil and gas assets at low prices. The company is led by a former CEO who also led a spin-off from Enron (before Enron collapsed) which used new drilling techniques to become the largest producer of crude oil in the US. He has publicly indicated that he sees the oil market coming back into balance within two years and sees opportunities as the industry restructures. Investors are betting on the jockey, not the horse, and there is no horse yet.
SPAC’s have surged recently, with 20 formed in 2015 after seven years of little activity. Those SPAC’s pan to invest in a variety of industries and have traded at +/-3% of their IPO price as they have yet to utilize the cash they raised. And there will be plenty of competition for this new SPAC, as other types of investment funds have raised as much as $100 billion to eventually invest in oil and gas assets.
Here are the mechanics of this particular SPAC, which was sold through its 160-page prospectus:
• The IPO sold 50 million Class A shares at $10, raising $500 million. The $500 million will be held in trust and invested only in US government securities until its first deal (the “initial business combination”).
• The company has two years to make its initial business combination and if no deal is completed the funds, less expenses, will be returned to investors.
• IPO buyers will have the opportunity to tender (sell back) their shares for the full $10 just prior to the initial business combination.
• The sponsor of the company purchased 12.9 million Class B shares for $25,000. These shares will convert to Class A shares after the initial business combination. This conversion will reduce the value of all Class A shares by 20% because there will be more shares supported by the same amount of assets. The sponsor/managers will have paid $25,000 for over $90 million of Class A shares. (The managers have some restrictions on selling these shares.)
• The sponsor agreed to loan the company up to $300,000 to cover expenses related to the IPO and this non-interest bearing loan will be repaid from the IPO proceeds.
• A total of 5.5% of the IPO proceeds will eventually be paid to the underwriters, or the investment banks that bring the IPO to the market and sell it to investors and other brokers.
• The company will pay the sponsor $10,000 per month for office space and support until the initial business combination.
• The sponsor and managers won’t be paid for their services, except for out-of-pocket expenses, until the initial business combination. After that, the managers may be paid management or consulting fees.
• Among the risk factors listed in the prospectus are that the officers will allocate their time to other businesses, may be affiliated with entities engaged in similar business activities and may have competitive financial interests that conflict with the company’s interests. These may simply be boilerplate disclosures but potential conflicts are clearly not prohibited.
It’s natural to ask why this deal is structured this way; after all, there are plenty of other ways the managers of the company could be compensated. They could be paid a salary, or fees for each deal they close, or they could be paid some percentage of any profits. All of these approaches have pros and cons, and none is perfect.
There are also plenty of valid reasons for such a deal structure, such as the need to attract talented management and the alignment of the managers’ interests with the investors’. The cynical reasons, though, are pretty simple – this is “business as usual’ and the way it has typically been done, and if the market will bear it, what’s the big deal? (Never mind that the investment is sold by compensated brokers to investors who rarely if ever fully understand how the thing really works.)
The big deal is the assignment of risk, and this is where the average investor may be justified in feeling things are rigged. Ideally, risk and return are aligned – the higher the risk assumed, the higher the potential return, and vice versa. In this offering, the managers have a clear incentive to make a deal within the two-year period, even if it’s not a good deal; if they fail to make a deal they make no money. If the investments aren’t successful, however, the loss would be disproportionately borne by the investors. For example, if the value declines by half, the investors will be out half their investment, but the managers will still own 20% of the shares, valued at somewhere north of $40 million even after the decline, for which they paid a whopping $25,000. The start-up costs are also covered, so while this may not be a totally riskless transaction for the sponsor and managers, it’s pretty close.
The opportunity to participate in the slump in oil prices and an anticipated recovery by buying distressed assets at low prices, under the guidance of well-regarded industry veterans, may still be enticing. It may pay to be patient, wait until the fund makes its “initial business combination” and the value of the shares have been diluted by the managers’ additional shares, and then buy shares on the open market at the lower, diluted price. You may miss out on some gains if the first deal takes off immediately, but why subsidize the managers with 20% of your investment if you don’t have to?