Whether the SPAC boom is a bubble or not is a question which is polarising deal makers, investors and more recently short sellers the world over and whilst we’ll allow economists, financial journalists (and now there is controversy, perhaps Piers Morgan) to offer their view, the reality is that SPACs are already influencing the leveraged finance markets.
SPACs are an attractive exit proposition for private equity portfolio companies; their ability to meet high valuation multiples and execute transactions in very short timeframes offer fund managers the ability to pay down debt and create sizeable exit opportunities. Compared with an IPO, it also offers cash up front to funds looking to exit a portion of their position in an asset, and to do so perhaps sooner than a traditional IPO. Compared with traditional buyouts, it also allows a fund to maintain a stake in assets that the fund is confident will continue to grow in the future. In short, the SPAC serves as an efficient method for taking some value off the table in a volatile market.
Much of their success to date has been down to low interest rates, easy access to financing, concerns about the effectiveness of a traditional IPO pricing mechanism in the midst of Covid, strong performance by public equities and the offer of a faster route to becoming public without the regulatory burden of a traditional IPO. This may become more problematic in a more challenging environment coupled with an increased focus on SPAC’s lack of transparency, complexity and fee structures. Time will tell………
Insuring the SPAC Lifecycle
Here at Paragon we have in the last year been working on insuring SPACs at every stage of their lifecycle, from their incorporation to the de-SPAC acquisitions of target businesses and the placing of the necessary programmes for the business combination. Our experience has shown us that realistic expectations have to be met with regards to pricing at every one of these stages as SPACs jump through the respective regulatory, legal, and commercial hoops.
- Incorporation & IPO
The jurisdictions of choice for the SPAC’s incorporation and listing will dictate the cost and coverage of its insurance requirements. The vast majority of SPACs have so far been listed in the United States and whilst the recent publishing of the UK Listing Review by Lord Hill shows the welcome influence from the Chancellor to relax unfriendly UK listing rules for SPACs, the reality is that Amsterdam is currently emerging as Europe’s centre for blank-cheque companies over London.
The management team and board of directors constituting the SPAC is usually selected by its sponsor before the IPO with additional directors appointed shortly thereafter. As soon as the SPAC is publicly traded, the management team and the SPAC’s directors are susceptible to litigation from investors. With the heightened regulatory scrutiny, media attention and increasing litigation it is critical these directors have appropriate insurance coverage and fully understand what that coverage is. Having the correct Directors and Officers (D&O) insurance and Public Offering of Securities Insurance (POSI) programmes in place for these directors is business-critical as there are significant differences between a SPAC IPO and a traditional IPO - predominantly around disclosure requirements with the relevant listing authority, methodology of valuation for fund raising and the length of the listing process.
Realistic expectations have to be managed on the substantially increasing costs of D&O insurance both in the United States and Europe (the cost of a typical D&O insurance program for a SPAC more than doubled in 2020 with POSI costs also facing price hikes due to the limited number of underwriters offering the product).
From the insurer side, these increasing premiums are in part due to a couple of factors:
- recent litigation and spiralling claims. Further the simple volume of SPACs now trading, the aggressive position being taken by short sellers and accompanying media attention brings with it an additional risk of litigation, making insurers even more cautious;
- the increasing number of SPACs has considerably slowed the D&O insurance placement process as insurer workloads are dealing with the increasing number of submissions. Furthermore, there is a limited number of insurers (6 or 7) that have the ability to write D&O policies for SPACs; and
- even prior to the current pandemic, the IPO D&O insurance market was already experiencing a hardening market long before the rapid proliferation of SPACs.
Consequently, underwriters will base their modelling around these main parameters:
- Fundraise: The higher the SPAC IPO, the higher the risk for an underwriter and subsequently the higher the D&O premiums;
- Experience: Have the sponsors behind the SPAC successfully executed SPAC IPOs previously? Do they have experience in the industry and jurisdiction of the target company they plan to acquire? and
- Jurisdiction: where is the SPAC entity planning on being incorporated and in what jurisdiction is the potential target company? Experience has shown that if the SPAC is based outside of the United States and the target company in a perceived riskier territory, the premium cost can increase significantly.
The insurance market is trying to respond to the demand for SPAC coverage with specific D&O product suites offering coverage from the IPO to the business combination but these are very much in their infancy and it will be interesting to see how these evolve over time.
2. De-SPAC Acquisition
Once a SPAC has agreed to buy a target business it will enter into a sale agreement to acquire the shares in that target company. At this juncture the SPAC should consider taking out M&A insurance to insure the unknown and unforeseen liabilities that may arise out of the acquisition (through Warranty & Indemnity (W&I) or Representations & Warranties Insurance (RWI)), likewise with regards to insuring any known risks that arise in the due diligence and disclosure processes by using Contingent Legal Risk insurance.
M&A insurance offers a myriad of commercial drivers for both buyers and sellers and they apply equally to SPAC transactions. Whilst most SPAC acquisitions are not structured as full cash-out sales (the target company’s sellers are frequently locked up, unable to sell shares for a period post-closing), there is a current trend of sellers limiting their liability for any breaches of the representations / warranties (“Breach”) in the sale agreement to a nominal level (as low as $1). This ‘clean exit’ position taken by the seller means that SPACs should consider taking M&A insurance in order to have meaningful recourse (against an A-rated insurer) in the event of Breach.
Even if a seller does agree to have a higher level of liability under the sale agreement the SPAC may have legitimate concerns over the financial covenant of the seller to respond to a cast iron Breach. These concerns can relate to the seller’s credit worthiness, the jurisdiction they reside in or the fact that there is a diverse selling shareholder base. M&A insurance also offers the ability to avoid the discord or dis-incentivisation of bringing a claim for a Breach against their own management team if they are the party giving the representations / warranties under the sale agreement. This enables all parties to focus on the performance of the newly listed business rather than defending litigation.
SPAC transactions increasingly are being run as auction processes with several SPACs competing against each other for the same target businesses. Those SPAC bidders (whose sponsors can corral institutional investors into a PIPE deal) and who have M&A insurance built into their bids will always differentiate themselves to sellers and management warrantors alike, as the ability to cap their liability for a Breach is extremely attractive. Given M&A Insurance is now almost a market standard in auction processes, to not include in an offer will put that buyer at a serious disadvantage.
We have recently advised on several SPAC acquisitions and there are a number of nuances which pose a challenge to obtaining M&A insurance when compared to a traditional, private M&A processes.
There is a perception that the timelines in which SPACs complete acquisitions means that the granularity and scope of the due diligence and the thoroughness of the disclosure process (without proper guidance) are not akin to that of a private M&A process. These are the same concerns insurers have when insuring accelerated M&A or distressed processes and so early engagement of an experienced broker is critical.
The timelines have also raised concerns with insurers who are standing behind both the D&O as well as the M&A programmes of insurance. Should there be issues with the acquisition due to the SPAC (and therefore their directors) not being as diligent as they should have been, insurers can become overly aggregated and become exposed to claims for both a Breach and a D&O matter.
M&A insurance isn’t there to fill in any shortcomings in process so early engagement of the banking, legal and insurance advisors is critical to make sure that the SPAC can obtain fulsome M&A coverage.
3. Business Combination
In the United States, as soon as the parties close on the acquisition, the D&O coverage of the SPAC (and that of the target entity) will expire with the change in control. The new entity’s directors and officers must be covered by a new D&O insurance policy known as the “go-forward” policy. Specifically, there are up to three separate D&O policies that may need to be in place and triggered as the transaction closes:
(a) a tail/run-off policy for the SPAC company’s D&O policy;
(b) a tail/run-off policy for the target company’s D&O policy; and
(c) a D&O go-forward policy for the newly combined publicly traded entity.
The problem with (a) and (b) is making sure that there is coverage when a claim arises after the acquisition closes where the questionable actions occurred before closing. The SPAC’s and the target’s D&O policies will require a “tail/run-off policy” added to them, i.e., additional premiums have to be paid to the D&O insurer so that both the policies will continue to react after closing. Insurers will charge an upfront premium to be paid at closing for each of these policies and these tail/run-off policies usually have a 6 year policy period.
The D&O policy for the newly combined public company will provide cover for the new company for claims based on actions taking place after that transaction closes. This looks and feels like the D&O insurance policy of any new, publicly traded operating company.
In the UK the completion of a target by a SPAC is defined under the Listing Rules as a reverse takeover and consequently the SPAC listing will be annulled. The shares belonging to the newly combined group are re-admitted to the correct market exchange upon publication of the applicable prospectus or admission document. Consequently a new POSI insurance policy will need to be obtained and the existing D&O policy of the SPAC and the D&O policy for the former target company will require a tail/run-off policy.
Sensible planning should be done well before the SPACs proposed acquisition to double check all the insurance policies are fit for purpose and make sure that the business is more than adequately protected post acquisition.
As the SPAC goes through its IPO and the subsequent M&A process they face many regulatory, legal, and commercial challenges. Early and correct advice from experienced advisors is crucial when obtaining the appropriate amount and type of insurance.
For our comprehensive paper or a guidance call on insuring a SPAC's lifecycle please contact:
Andrew Johnson - firstname.lastname@example.org
Spenser Lee - email@example.com
“The great 2020 money grab” — that’s what Carson Block, the swashbuckling short-seller behind Muddy Waters, declared of special purpose acquisition companies as last year drew to a close. To quote him more recently on the subject, the market is currently in a Spac bubble full of “garbage”, he said in this interview with Zer0esTV. Wall Street doesn’t seem so convinced.