Bill Ackman and Tontine Holdings rewrite the terms for SPACs

Bill Ackman, founder and CEO of Pershing Square Capital Management.

Adam Jeffery | CNBC

This week, Bill Ackman, through Pershing Square Holdings, is sponsoring the largest Special Purpose Acquisition Company ever raised.

A SPAC, also known as blank check companies, has no commercial operations and is formed strictly to raise capital through an initial public offering for the purpose of acquiring an existing company.

Pershing Square’s SPAC will be called Pershing Square Tontine Holdings and will raise $4 billion by offering 200 million units at $20 per share. Additionally, Pershing Square will be acquiring between $1 billion and $3 billion of units, for a total amount of capital of up to $7 billion. However, based on Pershing Square’s current assets under management, we do not expect their contribution to exceed $1.5 billion, for a total capitalization of $5.5 billion.

This is the second time in its history that Pershing Square has sponsored a SPAC.

Pershing Square also served as co-sponsor of Justice Holdings, with Nicolas Berggruen and Martin Franklin. Justice Holdings raised approximately $1.5 billion in its initial public offering in February of 2011 (including a $458 million investment by Pershing Square).

In April of 2012, Justice Holdings purchased from 3G Capital a 29% stake in Burger King Worldwide Holdings Inc. for $1.4 billion in cash, and subsequently merged with Tim Hortons, to form Restaurant Brands International. Pershing Square still remains the second-largest investor in Restaurant Brands International. As of June 30, 2020 the stock of Restaurant Brands International has generated a compound annual total return of 19% since its merger with Justice Holdings, even after losing 30% of its value during the COVID-19 pandemic.

How it works

The basic structure of a SPAC is that investors buy common stock in the IPO of a blank check company, in this case, for $20 per share. In addition to the common stock, they receive warrants as an incentive for them to invest.

These warrants are generally detachable, allowing the investor to trade them as separate securities and inviting the short-term investing arbitrage world into SPACs, which often make up a significant part of the shareholder base. The SPAC sponsor will then find a company to acquire and investors will essentially have the choice of staying invested in the SPAC through the acquisition or redeeming their shares for the full amount they acquired them for.

The structure of Tontine Holdings is unique on many different levels. First, each unit consists of: (i) one share of common stock, (ii) one-ninth of a redeemable warrant, exercisable at $23; and (iii) two-ninths of a warrant, exercisable at $23 provided that they are not redeemed in connection with a proposed business combination. It is this last element that is significant.

The one-ninth of a warrant is detachable on day 52 and this is a normal incentive for SPAC investors. However, unlike virtually all other SPACs where all warrants are detachable, two-thirds of the warrants issued to shareholders are not detachable, discouraging the arb community and encouraging long term investors.

Moreover, the investors do not even receive these two-thirds of warrants if they choose to redeem their stock prior to the closing of the acquisition, giving a significant amount of more certainty that the acquisition will close. And finally, as additional incentive to hold the securities through the closing, if a shareholder does redeem, their warrants are distributed pro rata to the shareholders who remain in the SPAC, hence the name “Tontine” holdings.

A tontine is an investment plan devised in the 17th century whereby each investor pays an agreed sum into the fund and thereafter receives a periodic payout with that payment devolving to the other participants upon the death of an investor.

But the most unique feature of this SPAC and the greatest departure from historical SPACs is the compensation terms for the SPAC sponsor, in this case Pershing Square Holdings. The normal historical SPAC sponsor will partly capitalize the operations of the SPAC by acquiring sponsor warrants giving them a participation in the upside of the company. But that is far from their main compensation. Typically, SPAC sponsors receive 20% of the shares in the SPAC for extremely nominal consideration. These founders shares compensate the sponsor regardless of whether the shares in the company appreciate or decline.

For example, in a recent SPAC sponsored by Goldman Sachs, they raised $700 million at $10 per share. They paid $16 million for warrants to acquire 8 million shares at $11.50 per share and received Founders shares for 20% of the company for $5,000.

On the day of the closing that $5,000 payment yielded them $140 million of stock assuming a deal closes.

Another example a little older but involving a peer of Pershing Square is Third Point’s 2018 sponsoring of Far Point Acquisition Corp. where it raised $500 million at $10 per share. In that situation, Third Point paid $12 million for warrants to buy 8 million shares at $11.50 per share and received its 20% of Founder shares for a nominal payment of only $25,000.

So, assuming a deal closes, Third Point receives $100 million of its shareholders’ investment regardless of whether the investment is successful or not. Moreover, under the Founders’ shares compensation structure, Third Point and Goldman Sachs still receive tens of millions of dollars of compensation even in a failed investment that loses half of its value.

In contrast, in Tontine Holdings, Pershing Square and its affiliates (including Tontine board members) are paying $67.8 million for warrants to acquire 6.21% of the company. This is much more consideration than the $16 million and $12 million that Goldman and Third Point paid and much less than the 9.1% and 12.8% of shares that Goldman and Third Point received.

Moreover, Goldman and Third Point’s warrants were exercisable at a 15% premium to the IPO price whereas Pershing Square’s are exercisable at a 20% premium, and Pershing Square has agreed not to exercise its warrants for three years after the closing of the acquisition.

Why it’s ‘groundbreaking’

But this is not the really groundbreaking feature of the Tontine compensation structure.

The truly remarkable departure from SPAC standard terms is that Pershing Square is not taking any founders shares.

By removing this egregious compensation element, Pershing Square really shows their allegiance to their investors. Pershing Square’s sole compensation for founding and capitalizing the SPAC and sourcing, negotiating and closing a $10B+ acquisition will be a 6.21% promote after the investors have already received a 20% return.

To put it another way, under Pershing Square’s warrant-only compensation structure, Pershing Square does not receive any compensation until after the shareholders receive a 20% return, whereas under the typical founders shares compensation structure (as illustrated by the Goldman Sachs and Third Point SPACs above), the shareholders do not see any return until after the company receives a 20% return.  Furthermore, Pershing Square paid $67.8 million for these warrants, money they do not get back if a deal is not procured and closed.

So, why did Pershing Square wait almost 10 years after its extremely successful Justice Holdings SPAC to do another one? The answer is market environment.

What’s different now

Pershing Square started working on Justice Holdings right after the financial crisis, when there was an extreme level of uncertainty in the markets. Uncertainty is the mortal enemy of IPOs — until the day of the IPO, companies are not sure what price they will get, how much money they will raise and if it will even happen during times of ultra-volatility in the markets.

Pershing Square patiently waited for that market environment to repeat itself, except this time in the form of a global pandemic and a presidential election. With COVID-19 surges coming or not coming and vaccines coming or not coming depending on the day, there is too much uncertainty in the markets over the next nine months or so for companies to risk an IPO, particularly a $5 billion IPO.

Isn’t it much easier to go public through a SPAC where you know exactly how much you are getting for your shares and have a contractual obligation from the acquirer?  Moreover, management does not have to deal with the loss of focus inherent in an IPO and all of the meetings, issues and road shows.

The only uncertainty in a SPAC is if the acquirer will approve it or if its shareholders will choose to redeem instead. Well, Pershing Square’s structure has taken a lot of that uncertainty away as well.

The transaction will not necessarily require shareholder approval, just board approval; and the possibility of redeeming shareholders was greatly mitigated because of the Tontine-style warrants, the fact that Pershing Square will be investing over a billion dollars of its own money and because unlike most SPACs, shareholders are not looking at a 20% dilution from Founders shares.

So, the $64 million question (or $5.5 billion question in this case) is what kind of company is Pershing Square looking for and when is it likely to happen.

Finding the right match

Pershing Square is looking for a minority position and we are assuming they will have $5.5 billion of capital. We also believe it will be just one large company they will be spending the money on. By prospectus, they have to spend at least 80% of their capital. If you assume they would want at least 10% of the company, that makes the target worth between $8.8 and $55 billion.

Pershing Square will look for a company with similar characteristics as its activist investments: a simple, high-quality, high return on capital business that generates predictable growing cash flows that can be estimated within a reasonable range over the long term.

The types of companies it will be looking at will be: (i) a high-quality, well-managed, large capitalization company that is looking for a better alternative to an IPO, such as Rocket Mortgage, which just recently filed for an IPO; (ii) a “mature unicorn” — a high-quality, venture-backed business that has achieved significant scale, market share, competitive dominance and cash flow that does not have as much private funding options as it used to due to the problems at Softbank and the ramifications to the venture market from companies like WeWork; (iii) large private equity portfolio companies that have become distressed due to their typically highly leveraged balance sheets and will require substantial equity infusions to withstand the impact of the current crisis; and (iv) large, high-quality, private family-owned companies that now are required to raise capital due to the economic downturn caused by the COVID–19 pandemic.

How long will this take? Well, by prospectus, they have 2 years to sign a deal and then six months to close thereafter. But it will not take nearly that long.

The crisis that has made this the perfect environment for this strategy will last for about another nine months. We expect Pershing Square to find the company by then. There are only approximately 150 companies that fit their parameters, so they likely already have their top ten wish list, including obvious companies that pop out such as Airbnb and Bloomberg.

The perfect opportunity

We believe this is a tremendous opportunity for several reasons.

First, Pershing Square will have little competition in finding this investment and negotiating the terms.

While its logical competition would come from large private equity firms, Pershing Square is looking to make a minority investment and private equity does not like minority investments. Who else has the ability and the willingness to quickly write a $5 billion check to a company that is looking for capital or liquidity?

Second, as a minority investor, Pershing Square will not have to pay a control premium. Much like in an IPO, the seller does not mind leaving a little money on the table for a minority of his company if he thinks the transaction and the partnership with Pershing Square will help boost the long-term value of the majority he retains.

Third, we believe Pershing Square will be a value-added partner. The firm has extensive experience adding value to companies as an activist investor which is very much the same skillset that they will need here.

See Pershing Square’s Activist History here

Pershing has already put together an all-star board that in addition to Bill Ackman, includes Lisa Gersh, co-founder and former president of Oxygen Media; Michael Ovitz, co-founder of Creative Artists Agency and former president of Walt Disney; Jacqueline D. Reses, the head of Square Capital, a wholly owned subsidiary of Square, and the former chief development officer of Yahoo!; and Joe Steinberg, chairman of the board at Jefferies Financial Group, and former President of Leucadia National Corporation.

This does not mean that all of these directors will be on the board of the surviving company, but we not only expect Bill Ackman to have a board seat given the size of his fund’s investment but believe that this could be an inducement to the seller of a large private company often turned off by the public markets.

With Ackman, the seller would get a partner with extensive experience navigating public markets allowing management to focus on operations and board members like Ackman to deal with the issues and obligations inherent in being a public company. Moreover, how better to activist-proof your company than partnering with one of the premiere activists.

In sum, for over two decades, large institutional investors have been paying a 2% annual management fee and 20% of all profits to invest alongside Bill Ackman. Even his fund’s special purpose co-investment vehicles charge a 20% promote on profits. Here you can invest alongside him in one of his biggest investments ever and effectively pay no management fee and only a 6.21% incentive fee that is only earned after a 20% return to investors.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.