Venture capitalists are increasingly playing in the public markets, many of them through an obscure vehicle known as a special purpose acquisition company, or SPAC. Just 13 such companies filed for IPOs in 2004, but that number soared to 42 as of mid-September of this year, according to industry trade publication The Reverse Merger Report. More to the point, a staggering 31 of this year’s SPACs include participation of active venture capitalists or other private equity professionals.
Why would private non-control investors want any part of a public control acquisition entity? It gives private equity firms a low-risk-and low-cost-way to leverage the public markets while backing entire management teams.
A typical SPAC involves a group of operating executives trying to raise an IPO for the purpose of acquiring an unidentified company in a loosely defined industry sector. Some SPACs allow for the purchase of multiple companies, but standard IPO sizes of $30 million to $100 million usually keep the number at one. They come with limited shareholder protections-such as around 90% of IPO proceeds being held in escrow and majority shareholder approval required to make an acquisition-but really are amorphous structures built upon a common trust in the management team. Kind of like non-diversified private equity funds, except that most of the buyers are hedge funds enamored with detachable warrants.
SPACs-also known as blank check acquisition companies-are far from new, and they aren’t without their detractors. As the “blank check” moniker suggests, such structures are relatively susceptible to abuse, and actually spent most of the 1990s as the exclusive domain of penny-stock traders and boiler-room operators. More recently, however, they have regained respectability thanks in large part to the underwriting imprimatur of trusted boutiques like Broadband Capital, EarlyBird Capital, Maxim Group, Morgan Wedbush Securities and Rodman & Renshaw.
Why It Makes Sense
After talking to SV Life Sciences of Boston, it quickly becomes clear why VCs are jumping on the SPAC bandwagon. The firm was formed in 1994 to invest in startup health care companies, and has raised $819 million for three “traditional” venture capital funds. It also is involved in a SPAC called Confluence Acquisition Partners I.
Back in 1995, SV Life Sciences purchased approximately $11 million worth of preferred convertible stock in Laser Vision Centers Inc., a St. Louis-based operator of laser surgery centers for the correction of nearsightedness. The investment doubled in value within the first month, with SV Life Sciences ultimately exiting at a high multiple shortly after a 2001 merger of Laser Vision Centers and TLC Laser Eye Centers Inc.
Earlier this year, a quartet of former Laser Vision executives formed Confluence Acquisition Partners I, and asked SV Life Sciences to take a piece of the action. The two sides held a one-hour due diligence meeting, resulting in an agreement whereby SV Life Sciences would receive a 15% pre-IPO position in exchange for its advice on potential acquisition targets and a sharing of relevant deal flow.
James Garvey, CEO of SV Life Sciences, says that his firm needed to commit only $3,000 (that’s thousand, not million) up front from its management company, with additional investment required only if, and when, it votes in favor of a specified acquisition. It’s kind of like the evolution of entrepreneurs-in-residence, except that it’s a management-team-in-residence and the venture firm bears very little financial responsibility.
“This is very low-risk for us and not really what we do, so it’s not something we spent very much time on,” Garvey explains. “It really comes down to the fact that we’ve worked with the [Confluence] guys before and believe that they are a very smart team.”
It seems that a lot of VC participation in SPACs has been prompted by existing relationships. Paladin Homeland Security Fund, for example, is a minority shareholder in Fortress America Acquisition Corp. because some of partners know Fortress CEO Thomas McMillen, a former Congressman who most recently ran Global Secure Corp.
“We’ve known Tom for years, and he came to us with an interesting proposal focused on acquiring a homeland security company,” explains Michael Steed, founder and managing director of Paladin. “The really nice thing is that we get to vote on the first [acquisition]… which makes it a very sophisticated vehicle.”
Neither Garvey nor Steed expect to spend much of their time on SPACs, with SV Life Sciences already raising a new venture fund (with a target of $400 million) and Paladin expecting to lunch its second Homeland Security Fund at the beginning of next year.
For other firms, however, SPACs are more salvation than sidelight. Take the example of Menlo Park, Calif.-based private equity firm McCown De Leeuw & Co., which is out of dry powder from its $750 million fourth fund and has been told that its returns are not strong enough to secure a follow-up. Rather than shutting down, the firm has opted to raise its own SPAC called MDC Acquisition Partners.
The basic idea is to raise $80 million from the public markets, and then do a deal so good that it would put McCown De Leeuw back in the good graces of its limited partners. If successful, McCown could shine a beacon of viability for other firms unable to raise follow-on funds via “traditional” means.
So will the public markets bite? Probably, say market analysts, noting that MDC Acquisition Partners is unusual among SPACs, in that it offers public investors a chance to buy into a “name” private equity team (no matter how diluted).
The bigger question, however, is whether or not other private equity funds will follow suit, thus turning SPACs into an alternative fund-raising avenue. The answer is probably “yes” in the short-term and “no” in the long-term. Today’s private fund-raising market is saturated-particularly for middle-market buyout firms-which means that there are a lot of potential SPAC issuers.
At the same time, the hedge fund market is going gangbusters, which means that there are a lot of potential SPAC buyers. Down the road, however, private fund-raising volume is expected to decrease, while hedge funds likely will fall victim to the gravitational force of economic cycles.
“The timing is great for [SPACs] right now, but it’s a cycle like anything else,” says a SPAC-involved VC who asked to remain anonymous due to SEC quiet period restrictions. “If anyone should understand that cycles eventually end, it’s venture capitalists.”