This article is written by Nikunj Arora, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

In the middle of the COVID-19 pandemic, the US raised approximately $ 83 Billion from nearly 247 Special-purpose acquisition company (“SPAC”) listings in the year 2020. SPACs are the most talked about in recent times and act as a shortcut to Global Listings. SPACs which are popularly known as ‘Blank Check company/companies’ are shell corporations designed to take companies public without taking the Initial Public Offer (“IPO“) route. In India, the companies are gearing up for the structure of ‘De-SPACing’ which means a reverse merger into a listed SPAC for which companies need to externalise/create an off-shore entity. One of the biggest issues regarding this structure apart from various regulatory concerns is that transfer of shares to an off-shore entity is taxable under Indian laws. However, there are various benefits the Indian companies will gain from the said structure, such as access to capitals, better valuations, global visibility, shorter process, less compliance which act as a crowd puller. Almost all the Indian tech unicorns are set to be evaluating this particular type of listing and ReNew Power Pvt. Ltd., India’s leading pure-play renewable energy producer, and RMG Acquisition Corporation II, has already announced its first listing from India’s SPAC listing in the current times, to list itself on Nasdaq.  

Private Equity, as the name suggests, is composed of money being invested into private companies. The private equity firms take money from other companies and high-net-worth individuals (“HNWI“); these firms put all the money together and invest in buying and selling businesses. After raising a certain amount, for example, $ 10 million, the firms close this amount so that no new investors can put their money in that fund, and then that fund can be used to invest in the tech sector or healthcare industries. Private equity firms make money in many ways. Firstly, raise money from Limited Partners (LPs) like pension and retirement funds, endowments, insurance companies, and wealthy individuals. Secondly, by selling portfolio companies at a profit. Thirdly, by sourcing, diligence, and closing deals to acquire companies. 

Private equity (“PE”) firms have been looking for SPACs as an alternative investment opportunity and the future of SPACs likely involves the participation of PE firms. 

Special-Purpose Acquisition Companies

What are SPACs?

SPACs or ‘blank-cheque companies’ are corporate shell companies with no actual commercial operations but are created solely for raising capital through an IPO to acquire a private company. This is finished by selling normal stock with shares generally sold at $10 each and a warrant which gives the investor the inclination to purchase more stock later at a fixed cost. Once the funds are raised from the public, they will be kept in an escrow account until one of two things happen:

• First, the management team of a SPAC, also known as sponsors identifies a company of interest which will then be taken public through an acquisition, using the capital raised in the IPO, or
• Second, if the SPAC fails to merge or acquire a company within a deadline, typically two years, the SPAC will be delisted, and investors get their money back. 

SPACs are designed to raise money through an IPO and then later use that money to acquire a private limited company. The number of SPAC IPOs has waxed and waned over the years in tandem with the economic cycles, and they have been making a resurgence of late. Some notable SPACs include:

• Palihapitiya’s Social Capital Hedosophia Holdings, which acquired a 49% stake in British spaceflight company Virgin Galactic in 2019.

The structure of SPACs allows investors to contribute money towards a fund without any knowledge of how their capital will be used, and thus, the term ‘blank-cheque companies’ is used for SPACs. 

A private limited company wants to go public through a SPAC because private companies see it as a way to get the cash influx of public markets while avoiding some of the regular requirements and hazards of a traditional IPO. 

The following are some additional benefits of the same:

• There is greater price certainty and control over the private company compared to the company taking the traditional IPO route because there is less guesswork in determining which price to offer the shares. 
• The management expertise that may be part of the sponsor group can also play an important role in helping companies continue to grow.
• If SPACs are successful, the price should appreciate and investors will make money and may be able to exercise warrants and buy more shares at a lower price.

(Note:

• An Escrow Account is an account where funds are held in trust while two or more parties complete a transaction.
• A Hedge fund is a form of alternative investment that pools capital from individual or institutional investors to invest in a variety of assets and uses complex strategies to build its portfolio and manage risks.)

How does SPACs work?

• There is a group of people in the management which are called sponsors, who decide to form a SPAC. 
• This group of management (sponsors) then raises money through IPO by selling the units of the company.
• The units which are sold are usually priced at a rate of $10 and are made up of one share and a warrant (a contract that allows investors to buy some number of additional shares of common stock.)
• The investors can buy or sell shares for the current market value after the IPO because SPAC units trade like stocks.
• The money raised by the IPO goes into an escrow account. 
• The sponsors have 18-24 months to acquire the target private company. If they fail to acquire the target in a given period of 2 years, the SPAC will be delisted, and in most cases, investors will be entitled to get their money back. 
• If the target is identified and approved, the SPAC and the target business combine into a public limited company. This is known as the De-SPAC process. 
• In the said De-SPAC process, a decision has to be made by the shareholders whether to stay invested or exit their money out of the acquisition. 

Regulatory framework in India

In India, the SPACs face a regulatory drawback as there is a lack of targeted laws concerning SPACs.

• Companies Act, 2013: As per Section 248 of the act, the Registrar of Companies is authorised to strike off the name of the companies which do not start operation within one year of incorporation. SPACs usually take 18-24 months to identify a target, perform due diligence and acquire the same. Thus, making a hurdle for a SPAC.
• SEBI Regulations: Section 26 of the Securities and Exchange Board of India (“SEBI”) (Issue of Capital and Disclosure Requirements) Regulations, 2009 (amended Aug 2017), sets minimum eligibility conditions for a public offer:

1. The issuer is required to have a net tangible asset of at least INR 3 crore in each of the preceding three years (earlier requirement of a maximum of 50% to be held in monetary assets has been done away with in case the entire public offer through the sale.)
2. The issuer is required to have a minimum average consolidated pre-tax operating profit of INR 15 crore during any three of the last five years.
3. The issuer is required to have a net worth of at least INR 1 crore in each of the last three years. 

SPACs do not meet the above requirements as they do not have any operational profits or non-monetary tangible assets. 

• Exchange Requirement: The following are the major SPAC exchanges that have their SPAC-related regulations: 

1. NASDAQ in 2018, proposed that the number of round-lot holders should be reduced and the net tangible assets of $5 million be maintained by SPACs to remain listed. 
2. The London Stock Exchange (LSE) requires a listed entity to delist and reapply in case of a reverse merger.
3. Canada’s Toronto Stock Exchange (TSX) is actively promoting SPACs and has separate guidelines for the same. 

The National Stock Exchange (“NSE”) and the Bombay Stock Exchange (“BSE“) require compliance with SEBI regulations. In addition to this, the NSE requires the companies to have positive operational cash accruals (Earnings before Depreciation and Tax) for the last two years, making SPACs ineligible for listing.

The legislature of India currently does not have any comprehensive and strict regulatory requirements for SPACs, however, the SEBI has formed a committee of experts to examine if the regulations for SPACs in India can be brought or not, which may increase the chances of domestic listing of the start-ups. 

Taxation

India has not defined any law/statute regarding SPACs. In the current scenario, the foreign SPACs are targeting/acquiring Indian companies for offshore listing. Therefore, the following are the tax considerations in the offshore listing of Indian Companies:

• The first case is when the Indian company (“Target”) has been acquired by the foreign SPACs (“SPAC”) and makes the target its wholly-owned subsidiary. The said transaction could be completed when SPAC would purchase shares of the target. Thus, the following will be tax considerations: 

1. Under the Income Tax Act, 1961 (“ACT”), the Indian shareholders shall be liable to capital gains tax.
2. In the case of a share swap agreement, the Indian shareholders would likely realise capital gains as the fair market value (“FMV”) of SPAC shares is expected to be higher than their cost basis of the shares in the target. Both of them need to be valued to arrive at FMV under the Act.

• In the second case, if the target is acquired by the SPAC, it could be merged with the SPAC resulting in the cross-border merger, to which the former would become resident of the jurisdiction of SPAC. If the merged company were to be an Indian company then:

1. Transfer of assets by the target to the merged company would be tax-neutral in India.
2. The shareholders of the target would not have any tax incidence.

• The third case would be the tax implications post listing of SPAC. 

1. When there is a merger of the target into SPAC, the Indian office of the Indian company shall be treated as a foreign company/branch office of the merged foreign company. 
2. The branch office in India would be termed as Permanent Establishment (“PE”) of the SPAC in India for tax purposes. Thus, a PE of the foreign company shall be taxable in India at 40% of its net income.
3. The repatriation of income outside India of the PE shall not be taxable. 
4. The Indian shareholders of the SPAC may be subject to tax in the country of SPAC on the dividend paid by SPAC to the shareholders, by way of dividend withholding tax.
5. To avoid double taxation, the foreign tax credit in India has to be considered carefully. 

Private equity investors

What is a private equity/private equity investor?

To understand the term ‘private equity, we have to break down the term. The word ‘private’ is used because the private equity funds/investors are interested in acquiring the private companies that have not been listed on a stock exchange. The word ‘equity’ is used because the private equity (“PE”) funds are exclusively focused on equity investments. 

Thus, PE funds typically invest in unlisted private companies and take a certain amount of share in their ownership. Unlisted private companies reach out for PE funds because initially, they were finding it difficult to tap capital through the issuance of equity or debt instruments. 

The private equity investors/firms provide financial assistance or backing and invest in the private equity of start-up or operating companies through various investment strategies. These investors/firms will acquire control or a minority position in a company and then maximise the value of their investment. PE firms receive a return on their investment through an IPO, M&A, or recapitalisation. 

Most private equity firms/investors specialise in deals with a specific type of targets based on the lifecycle stage of the targets. Some PE firms are interested in established companies with stable cash flows and leveraged buyout transactions, while others are interested in young firms with high growth potential. 

The Fund Structure

There are two main ways by which the PE firms are typically structured:

• Limited Partnership: This type of partnership is much more popular in the US. In this case, there are two types of partners, i.e, general and limited. 

1. General Partners (“GP“) are involved with the management of the fund, target company portfolio selection and post-investment advisory. GP charge the partnership management fee and have the right to receive carried interest. This is known as the ‘2-20% Compensation structure’ where 2% is paid as the management fee even if the fund isn’t successful, and then 20% of all proceeds are received by GP. A hurdle rate is added to the partnership agreement which defines a certain minimum rate of return that needs to be achieved before accruing the carried interest to GP.
2. Limited Partners (“LP“) are involved in providing the investment capital. LP receives all of the fund’s proceeds after deducting 20% of the amount which is to be given to GP. 

• Closed-end fund: A closed-end fund is primarily used in Europe. It typically involves a newly created entity and the investors provide capital to that entity and the management firm signs a management contract with the entity. The compensation schemes remain very similar under this type of structure and the classical 2-20% compensation structure follows. 

Private equity in India

According to the Indian Private Equity Report 2020 from Brain & Company (see here), the PE and Venture Capital investment deals rose to $45.1 billion which was their highest level in the last decade. Under SEBI (AIF) Regulations, 2012, the PE funds are registered as alternative investment funds (“AIF”). 

The following are the statutes that impact the PE investments in India: 

• The Companies Act, 2013 regulates all the conditions related to issuance and transfer of shares (and other securities) and assisting governance to boards and shareholders.  
• The Foreign Exchange and Management Act, 1999 (“FEMA”) enables the Reserve Bank of India (“RBI“) to regulate every foreign investment into Indian target companies, following the powers of RBI under the Reserve Bank of India Act, 1934. 
• The Income Tax Act, 1961 regulates all the direct-tax related PE transactions which shall include taxes on income generated, capital gains tax, tax benefits, any exemptions thereof, any applicable double taxation avoidance treaty. 
• The Consolidated Foreign Direct Investment (FDI) Policy is amended by and again by the Department for Promotion of Industry and Internal Trade (“DPIIT”) of the Government of India. 

The following are the regulatory authorities which have an impact on PE transaction:

• The Ministry of Corporate Affairs which issues various circulars/notices/regulations which govern a PE transaction through the Companies Act, 2013.
• The RBI governs the foreign exchange transactions under FEMA.
• The DPIIT.
• The SEBI regulates the substantial acquisition of shares and takeover of public companies, and public offerings of securities on India’s stock market. 
• The Competition Commission of India (“CCI“) which issues directions to prohibit the industrial practices which have an appreciable adverse effect on competition, which may be read along with the Consolidated FDI Policy.
• The Insurance Regulatory and Development Authority.

SPACs-pe investors: a relationship

The SPACs are gaining certain popularity amongst the PE investors as a source for investment and in recent years most PE firms have opted SPACs as an investment opportunity. In the coming years, most PE investors will join the race to raise capital/money through SPACs. 

In 2019, the private equity-backed SPACs raised $1.17 billion in US markets through IPO and then in 2020, this number rose to $12.21 billion when 37 PE-backed SPACs raised money through this process. According to a recent study conducted through the US IPO market, 22 SPAC IPOs backed by PE firms had raised $9.12 billion in domestic markets this year. 

The most important reason why SPACs act as an attractive investment opportunity because they offer an exit through IPO, thus, providing both buyers and sellers greater control over overvaluation. SPACs also allow the respective sellers to generate more cash at the time of closing and are the trustable route to enter the public markets even when the markets are volatile. 

The following are some more examples that can help to recognise the role of SPACs on PE firms/investors:

• Riverstone Holdings which is a multinational PE firm situated in New York, US, has completed two transactions of SPAC IPO in recent years. In 2016, the firm completed a transaction amounting to $500 million and then in 2017, the firm completed a $1.035 billion SPAC IPO transaction. 
• Centerview Capital, a US PE firm, had completed its first SPAC IPO transaction and generated around $402.5 million in 2016. Again, in 2019, the firm generated $450 million via SPAC IPO transaction.
• More US PE firms such as Thomas H. Lee Partners and Apollo Global which is a global alternative investment manager firm sponsored the SPAC IPO and raised approximately $400 million in 2017 and 2018, respectively.
• The Yucaipa Companies, LLC an American private equity firm raised $300 million through the famous SPAC IPO transaction.
• Opendoor, an online real estate company raised around $1 billion through a SPAC sponsored by Mr Chamath Palihapitiya, the Silicon Valley investor, and institutional investors like BlackRock. 
• Videocon D2h, an Indian direct broadcast satellite service provider owned by Dish TV and Videocon, in 2015, was listed on NASDAQ with a SPAC ‘Silver Eagle Acquisition Corporation’ through a reverse-merger. 
• Yatra, an Indian online travel agency and travel search engine, did a reverse-merger transaction amounting to $218 million with ‘Terrapin 3 Acquisition Corp, which is a US-based SAPC. After this transaction, in 2016, the company started trading on the NASDAQ. 

Why SPACs are appealing?

PE firms are attracted to SPACs because there is attractive economics inherent in the SPAC model. SPACs usually require a relatively low upfront investment and there is a shorter investment horizon. 

• The management team, which are called sponsors, will contribute an amount that shall be equal to 2.5% or 3% of the gross IPO proceeds. The said contribution of the amount will be done in exchange for 20% of the outstanding shares (equity value) of the post-IPO entity. In addition to this, there will be an exchange for warrants to make a purchase of the additional shares at a 15% premium to the $10 price of the IPO. 
• The shares of the sponsors/founders are subject to a specified lock-in agreement for 1 year following the business combination. Even if the stock price of the company falls after the business combination or post-business combination such that the warrants will have no value, the 20% ownership of the sponsor will (almost in most cases) exceed its initial contribution. 
• If the value of its portfolio companies increases above the annual hurdle rate which is usually 7%-8% owned by the investors, the private equity fund sponsor in such a case will realise the gain. 
• Another advantage of the SPACs is that they are capable of earning returns quickly as against a standard private equity fund. This advantage will only be applicable if the shares of SPACs are publicly traded. 

SPACs & Private Equity

A typical SPAC IPO transaction is a straightforward proposition but involves the complexity of the post-IPO business combination. These complexities are usually a part of an M&A, part capital markets/IPO and involve complex financial arrangements, for example, equity backstops to ensure closing of a transaction. Now, PE firms are there to identify and acquire the businesses which are involved in complex transactions, thus, the complexity in any transaction acts as a strength to the PE firms. 

In this case, if general investors, SPACs provide them access to investment in acquisitions, buy-outs, and another type of investment transaction. Even if the PE funds are usually restricted to such investment transactions, they are looking to use SPACs in their strategies. The following are the advantages of SPACs as against traditional structures used by PE firms for investment transactions:

• During the pre-acquisition phase, the SPACs offer limited risk and certainty of return. If the SPACs fail to complete an acquisition or the investor does not want to participate in the said acquisition, he will be having security and certainty of return liquidation from the funds held in the trust account (which is known as an escrow account).  
• SPACs offer greater liquidity to the investors. SPAC investors are usually benefitted from the liquidity of publicly-traded securities and can control the timing of an exit. Therefore, the investors are usually attracted to SPACs because they get better liquidity and control. 
• Another great advantage of SPACs to the PE investors is that it offers additional leverage and to the investors which shall include additional securities such as warrants. The potential advantage of this additional leverage to the investors is that they will get the ability to leverage their initial investment, thereby enabling them to invest more capital at a predetermined price (which will be premium to an IPO price), even if the said investor proposes to receive back its capital in a pre-business combination redemption or tender offer.  

The advantages of SPACs mentioned above have led various PE investors to choose them as an investment vehicle. 

SPACs v. IPOs

BASIS	SPAC MERGER	TRADITIONAL IPO
Timing	3-4 Months (From LOI to closing).	6-9 months ( starting from initial prospectus drafting to close of IPO).
Process	Limited disturbance to management, owner and employees. Due-diligence necessary but it is done by limited team members. U.S. Securities and Exchange Commission (“SEC”) review process can be postponed until after the closing.	Comprehensive preparation required which includes the whole management. Dealing early with the market participants. A complete SEC review process is required.
Costs	Usually a lower direct expenses and indirect costs.  A typical underwriter fee: 5.5%.	Usually a higher and full range of direct expenses and indirect costs. A typical underwriter fee: 6.0%
Other	Dedicated and focused senior management. Provide stamp of approval and supplement to the management.	Lack of capital market experience, international and well-known management.  There is a risk of IPO being rescheduled due to the underwriter queue.

There are many listed ways through which a private company can go public, and the most common route is through a traditional IPO, where it is subject to regulatory and investor scrutiny of its audited financial statements. The company hires an investment bank to underwrite the IPO and this process takes 4-6 months to complete. This involves roadshows and pitch meetings between company executives and potential investors to drum up interest and demand in its share, and not all IPOs succeed. SPACs are shell companies and their track records depend on the reputation of the management teams. A SPAC IPO skips the roadshow process, thus, making it list in a much shorter time. This has led some investors to buy shares in companies listed through SPACs due to the lack of scrutiny compared to traditional IPOs, thus, SPACs makes a great impact and acts as an attractive investment opportunity for all PE investors. 

Concerns over SPACs

Various concerns are being raised by LP (limited partners, as mentioned above) who put their money/capital into the PE firms’ funds including:

• Implication for management fees,
• Team focus,
• The asset selection process,
• Buy-out funds.

In an interview (see here), Mr Gabriel Zadra, senior managing director, at Cliffwater LLC, an institutional investment advisory firm situated in New York, US, said that the investors in the country are preferring their fund managers to invest in these ‘blank-check companies’ through their funds rather than setting up SPACs as their new business line. According to him, this would avoid the conflict where a manager may divert opportunities, resources, and fees from serving limited partners in its PE funds. 

There may be a conflict of interest because the profits which are to be generated from SPACs may not necessarily convert into some high-yielding investments for the clients (high net-worth individuals). Therefore, when a PE firm sponsors a SPAC as a separate line of business, there can be complexities in the business. 

Some other notable concerns over SPACs are:

• PE executives take salaries from both their funds as well as SPACs.
• When a PE firm raises SPACs even if they don’t have funds, which means outside of their funds. 
• The activity of SPACs relating to deal flow and the potential competition that can arise with buyout funds. 

Conclusion

Even before the Covid-19 pandemic, SPACs were at that point on the ascent, floated by the equity blast and hot IPO market in 2019. The studies show that the pandemic has slowed down the pipeline of traditional IPOs, and on the other hand, SPACs have bucked the trend. With the quality of management teams improving, fewer disclosure requirements and a relatively straightforward listing process, blank check companies (SPACs) are booming. The SPACs are most popular in the US and major SPAC IPOs transactions occur in the country, thus, terming it as ‘American Phenomenon’, SPACs have caught the attention of investors in other jurisdictions. Antony Leung, the former finance secretary of Hong Kong, raised $1.5 billion on the New York Stock Exchange (“NYSE”) through his SPAC in 2018. 

The question is what is making SPACs so popular among the PE firms/investors. PE investors are familiar with raising capital on the private market to finance future takeovers/acquisition, however, in a SPAC they raise from public backers, thereby, allowing them to widen their investment base which ultimately eliminates the time commitment and other hurdles of raising finance from LPs. A venture capital analyst at PitchBook, Mr Cameron Stanfill, who specialises in SPAC research, said that the PE firms get a large economic stake in the business for less upfront investment. A PE firm sponsoring a SPAC usually owns between 2%-3% of the shares in the public listing of the said entity. 

References

1. https://www.business-standard.com/article/markets/how-spacs-can-help-make-indian-firms-a-key-part-of-global-listed-markets-121030300468_1.html
2. https://www.investopedia.com/articles/financial-careers/09/private-equity.asp
3. https://www.interviewprivateequity.com/what-do-private-equity-investors-do/
4. https://www.investopedia.com/terms/s/spac.asp
5. https://www.moneycontrol.com/news/business/markets/renew-power-takes-spac-route-first-by-indian-company-to-list-on-nasdaq-6568491.html
6. https://economictimes.indiatimes.com/markets/stocks/news/should-india-embrace-spac-the-new-alternative-to-ipo-around-the-world/articleshow/80745313.cms?from=mdr
7. https://news.bloomberglaw.com/securities-law/insight-private-equity-and-spacs-a-mutually-beneficial-relationship
8. https://pitchbook.com/news/articles/private-equity-spacs-2020s
9. https://www.thehindubusinessline.com/business-laws/regulatory-challenges-for-spacs-in-india/article34124252.ece
10. https://corporate.cyrilamarchandblogs.com/2020/09/using-spac-vehicles-as-a-means-of-listing-outside-india/
11. https://tax.cyrilamarchandblogs.com/2020/09/assessing-indian-tax-considerations-for-successful-offshore-listing-of-indian-companies/#more-2154
12. https://indianexpress.com/article/explained/what-are-spacs-and-why-are-they-under-the-scanner-7242646/
13. https://www.paisabazaar.com/mutual-funds/private-equity-investment/
14. https://www.mondaq.com/india/corporatecommercial-law/1023428/private-equity-comparative-guide
15. https://www.ogier.com/publications/2020-private-equity-embraces-the-special-purpose-acquisition-company-during-a-record-year
16. CNBC

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