Bay Street’s ‘blank-cheque companies’ should elicit caution

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Four months into Canada's experiment with "blank-cheque companies," the results seem wildly encouraging. With three deals already sold, more than half a billion dollars has been raised and a fourth issuer is now in the process of going public.

Yet, as good as this looks, no one knows how this story will play out. Raising money is one thing; delivering strong long-term stock market performance is another. That's why Canadians ought to exercise caution before blindly investing in whichever deal comes next, no matter how lucrative the early track record.

Formally, "blank-cheque companies" are known as special purpose acquisition vehicles, or SPACs. These companies have existed in the United States for a few decades, but only crossed the border into Canada this March.

SPACs raise money through an initial public offering and then use the proceeds to strike an acquisition within a specific time frame – typically two years. The companies they buy are privately owned, and being acquired allows the targets to go public without the hassle of launching time-consuming and expensive IPOs.

Although SPACs go public with the intention of buying something, they can't have any acquisition targets in mind while fundraising – earning them the "blank cheque" label. Because investors largely go in blind, they must trust the SPAC's management team. To date, the Canadian deals have been for acquisition vehicles run by well-known Bay Street folks including David Goodman (Dundee Corp.), Neil Selfe (Infor Financial Group), Reza Satchu (Alignvest Management Corp.) and now Tony Melman (Acasta Capital).

Other co-founders they have brought on board include Corporate Canada's Gord Nixon, Nadir Mohamed and Bonnie Brooks.

Because these deals are new to Canadians, few people know of their performance south of the border. The short version: It isn't pretty. In 2013, SPAC Analytics, which tracks the market for these vehicles, found that 72 of the 198 SPACs since 2004 had liquidated and delivered almost nothing to investors; 111 of the SPACs that made acquisitions delivered an average return of minus 14.4 per cent.

There's another, more glaring issue. The people who arrange the SPACs and then search for the acquisitions invest decent sums of money – in Dundee's deal, for instance, the Goodman family invested $4-million – but they are also given additional special founders' shares for next to nothing. Dundee's SPAC ended up raising $104-million and the Goodmans own 23 per cent, but paid an average share price of just $1.34. Public investors had to pay $10 apiece.

The way some people are looking at this, it's as though the founders get a 20-per-cent fee – referred to as a "promote" – for simply striking a deal. Mergers and acquisitions bankers, by contrast, typically earn 1 to 2 per cent for executing a transaction.

The special founders' shares also give extra control over any acquisition. When a SPAC finds a target, it must get approval from its shareholders to complete the deal. But when the founders already have 23-per-cent control of the company, the hurdle to reach a simple majority isn't that hard to clear.

Then there is the history of hedge funds toying with SPAC votes. In the United States, hedge funds have been known to buy stakes in SPACs and then hold other shareholders ransom by blocking an acquisition until they are given extra concessions. Canadians typically don't encounter such aggressive behaviour, but there's nothing to stop U.S. hedge funds from crossing the border and doing something similar here.

As strong as these arguments are, the reality isn't so cut and dried. In conversations with three of the four founders of Canadian SPACs, they addressed each of these issues head on – acknowledging they've heard all these worries before.

In defence of what many say are exorbitant fees, the SPAC founders argue they are much less egregious than traditional private equity funds, which collect a 2 per cent management fee annually. Multiply that by five to eight years and the investor is already out 10 to 16 per cent – plus the fund manager takes 20 per cent of the profit. SPAC founders, by contrast, have to put up their own capital, and will lose it if they don't strike an acquisition in two years – whereas the public investors are guaranteed their money back.

The founders are also mandated to keep some skin in the game – at least for a short period of time.

Once they make a qualifying transaction, the Toronto Stock Exchange forces them to hold their shares for 12 months. This holding period is also likely to last longer because targets can request an extension before agreeing to a deal.

As for the hedge fund dilemma, Canadian SPACs are keenly aware of it and some have taken specific measures to try to ensure their public investors are funds they trust. Ninety per cent of Infor's investors, for instance, are Canadian funds.

And if you're wondering about the underwriters who earn fat 6-per-cent fees for underwriting these IPOs, their commissions are also subject to strict rules. Roughly half their fees are held back until the SPAC strikes its acquisition.

So the issue isn't as black and white as some people make it out to be. But that doesn't there mean isn't reason to be cautious. SPACs are typically sold in frothy markets – such as the current one in Canada – and that means there is also a risk of overpaying for whatever asset they buy.

That these vehicles have arrived can be a good thing. But they need to earn investors' trust.