SPARCs: A New Era of SPACs?

In July 2021, Bill Ackman told investors he would be liquidating and returning capital in his Pershing Square's $4 billion SPAC, the biggest ever SPAC, after failing to find a suitable target company to take public through a merger. However, on September 29, 2023, the US Securities and Exchange Commission (SEC) declared effective a registration statement for Pershing Square SPARC Holdings, Ltd., which is contemplating a unique variation on the traditional special purpose acquisition company (SPAC) structure. Could this new structure be the ultimate solution?

The realm of special purpose acquisition companies (SPACs) has witnessed a surge in popularity in 2020 and 2021, offering an alternative route to public markets for private companies. However, amidst this SPAC frenzy, concerns regarding deal structures and potential conflicts of interest have emerged. Enter the SPARC (special purpose acquisition rights company), a novel variation spearheaded by Bill Ackman through his investment fund, Pershing Square Capital Management, L.P., which was designed to address these concerns and potentially reshape the SPAC landscape.

In light of the Pershing Square SPARC, the first of its kind and whose success or failure could set the path for the future of a “SPARC market”, we delve into the world of SPARCs, examining their characteristics, differentiating them from traditional SPACs, and exploring their potential impact on the investment landscape.

SPARC: A Redefined SPAC Structure?

SPARCs share similarities with SPACs in their fundamental structure and purpose. Both entities are formed as shell companies with the primary objective of identifying, acquiring, and taking a private company public through a merger or acquisition. However, SPARCs introduce a crucial distinction in their capital raising mechanism.

The fundamental distinction between SPACs and SPARCs lies in the timing of capital raising. SPACs raise capital upfront at the time of their initial public offering (IPO), placing pressure on management to identify and execute a merger within a two-year timeframe. SPARCs, on the other hand, defer capital raising until a target acquisition has been identified and approved by shareholder, as they issue "acquisition rights," which are essentially warrants that grant holders the right to invest in the SPARC when a target company has been identified and a merger agreement is reached. This approach mitigates the risk of funds being deployed prematurely or on potentially ill-fitting targets.

Key differences between SPARCs and SPACs

The absence of upfront capital raising sets SPARCs apart from SPACs in several key aspects:

• Investor Commitment - Deal Visibility, Certainty & Funding:
  In traditional SPACs, investors put their money into the SPAC's IPO without knowing the identity of the business they're investing in. They typically have only a general idea of the industry the SPAC sponsor will focus on. The IPO proceeds are held in trust while the SPAC looks for a suitable target company. Once a business combination agreement is signed and cleared by the SEC, SPAC shareholders vote on the proposed deal. They have the option to redeem their shares for their share of the funds in trust. Until then, their invested capital is tied up. And unless a SPAC shareholder actively chooses to redeem their shares, they'll automatically invest in the combined company after the merger. In contrast, the SPARC doesn't seek upfront capital from public investors. Instead, it waits until it has secured a deal, at which point rights holders can choose to invest in the combined company. If a rights holder doesn't take action, they won't be invested in the combined company.
  
  On the other hand, the Pershing Square SPARC gives potential targets additional funding guarantees after the merger (through Forward Purchase Agreements), regardless of fluctuations in the target company valuations. Pershing Square achieves this by committing to purchase $250mn of public shares (subject to lock-up restrictions) if the exercise price for the acquisition rights is $10 per share, which could increase proportionally as the latter increases up to $40 per share (or $1bn committed). This is a notable departure from traditional SPACs where, unless the sponsor agrees to invest at closing, the business combination faces the risk that investors withdraw their funds, leaving the company with insufficient capital to complete the merger. This may necessitate additional financing to provide the necessary cash, often through private investments in public equity (PIPE) transactions. If the PIPE transactions is less active, the business combination might not receive sufficient cash to meet its post-closing capital needs.
  
  Furthermore, unlike traditional SPACs, SPARC ensures that investors only become shareholders upon opting in, granting the sponsor sole ownership until the merger. This offers target companies greater deal certainty by eliminating the potential for shareholder opposition. A full shareholder redemption is often only a theoretical concern given the incentives for SPAC investors to approve mergers regardless of whether they choose to redeem their shares, as they retain upside in the post-combination through warrants.

• Enhanced Alignment of Interests & Sponsor Promote:
  SPARCs avoid the potential for idle capital accumulation, a common drawback of SPACs. By deferring capital raising until an acquisition is secured, SPARCs ensure that investor funds are utilized efficiently. In addition, they also foster a stronger alignment of interests between investors and the SPARC management team. Investors only invest when a concrete acquisition opportunity arises, creating a shared focus on identifying and executing a successful deal.
  
  In traditional SPACs, sponsors often receive a percentage of the SPAC's stock at a very low price, known as the promote, which assured the sponsor financial gains even if the post-combination company loses value, thus leading to mis-alignment of interest. With the Pershing Square SPARC structure, the sponsor's primary financial incentive is tied to the performance of the post-combination company. First, the shares purchased through the above-mentioned forward purchase agreement are subject to lock-up restriction, ensuring that the sponsor will have an interest in the overall health of the company beyond the combination. Second, the SPARC sponsor receives warrants, which can only be exercised if the share price of the combined company is 20% higher than the initial investment price. This means that the sponsor only benefits if the company is successful, which aligns their interests with those of the investors. It is to be noted that this structure is similar to one Ackman used in his traditional SPAC, which was not a typical structure then.

• Reduced Opportunity Cost & Dilution For Investors:
  SPARCs avoid the potential for idle capital accumulation, i.e. the opportunity cost, a common drawback of SPACs. By deferring capital raising until an acquisition is secured, SPARCs ensure that investor funds are utilized efficiently. In the case of Pershing Square, its SPARC gets up to 10 years to complete a deal, compared with most SPACs that face a deadline of between two and three years, during which time no investor capital is being held by the shell company.
  
  On the other hand, the Pershing Square SPARC will not offer IPO warrants, which are used to supplement the funds raised during an initial public offering. This will be beneficial to SPARC investors as they will not be diluted by such warrants and will get to keep more of the company ownership.

Where do we go from here?

SPARCs represent an innovative variation on the traditional SPAC structure, offering a more investor-friendly and informed approach to public listings. By eliminating upfront capital raising and providing investors with the opportunity to evaluate specific acquisition targets, SPARCs have the potential to enhance investor protection, promote informed investment decisions, and increase the likelihood of successful mergers or acquisitions. As SPARCs continue to evolve and gain traction in the investment landscape, they may reshape the dynamics of public listings and offer attractive opportunities for both investors and private companies seeking to enter the public markets.

However, SPARC structures have yet to find full adoption and backing from target companies and investors alike. For target companies, while SPARCs provide a minimum amount of post-closing cash, they do little to alleviate other issues such as uncertainty around the timing of closing, its likelihood and the cash amount post-closing, potential dilution from the sponsor warrants, limited post-closing public float prior to the lock-ups expiring, as well as the onerous disclosure requirements of a public company. On the other hand, investors may be put off due to the precipitous drop in interest in traditional SPACs, a market that is still undergoing scrutiny by the SEC resulting in new rules which may extend to the SPARCs as well.