Investors in the distressed arena are taking advantage of a financing vehicle whose popularity has risen meteorically since 2019: special purpose acquisition companies, or SPACs. Known formally as blank-check companies, a number of them have come to market with the goal of acquiring a post-reorganization business that has improved its capital structure through a restructuring, or even bankruptcy.

But distressed investors using SPACs as acquisition vehicles cannot wield the full arsenal of weapons normally at their disposal. So why are SPACs garnering interest from the distressed community, and what can a distressed investor do with one?

Motivators
SPACs operating in the distressed space most commonly search for acquisition targets among newly minted post-reorganized companies. Pat Collins, managing director in sponsor coverage and co-head of SPACs at investment bank Houlihan Lokey, says that "through the restructuring process these companies have deleveraged, right-sized their balance sheets, renegotiated contracts, leases, and supply agreements and have rejected unwanted obligations. That makes them attractive."

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As financially healthy as these post-reorganized companies may be, they often do not show up on investors' radar screens. That may be because they are now privately held. Or even if publicly traded, their market capitalizations may be too small to be followed by the analyst community. Or they may be ignored by investors because they — perhaps unfairly — still retain the taint of their troubled past. The result is their valuations may be cheap relative to comparable companies.

Seaport Global Acquisition Corp., a $145 million SPAC that went public in December 2020, has language in its Form S-1 registration statement highlighting the attractiveness of such companies. After stating its intent to focus its target search on post-reorganized companies, the document explains, "Given the inefficiencies that exist in the post-reorganization market, we believe a business combination within our target universe can be completed at a discount to its intrinsic value and publicly traded peers."

In addition to being cheap, the Seaport SPAC's S-1 says post-reorganized companies "often have underexploited opportunities for continued growth as a result of prior under-investment."

Viewed from the opposite perspective, owners of a recently restructured company would have good reasons to go public through a SPAC. For one thing, owning publicly traded stock would be a way to liquefy what might otherwise be an illiquid post-reorganized equity position.

For another, Collins of Houlihan Lokey points out that in many cases these cleaned-up post-reorganized companies "may have been playing defense for years, and are now poised to play offense," by acquiring other companies. This might be one of the "underexploited opportunities" Seaport's S-1 was referring to.

Collins continues: "Post-reorg businesses are often a perfect platform to roll up a sector. Going public through the de-SPAC process can often accelerate the roll-up activity because of both the new cash and the public stock's usefulness as an acquisition currency." [The "de-SPAC" process is the steps the SPAC takes to effect the merger with the target, including the SPAC's shareholder vote, if necessary, and offering shareholders the right to redeem.]

Collins adds that public companies might also be able to take on debt to fund their growth plans at lower rates than those available to private companies.

In the game
A search for SPACs that might be thought of as operating within the distressed space produces a relatively short list. Some are included because their offering prospectus specifically identifies their targets as post-reorganized companies. Others declared themselves as having very broad target markets, but their management teams include members with backgrounds investing in, advising or operating distressed companies.

The following is a list of "distressed SPACs" at various stages of their life cycle. Note that the list is representative of SPACs that may acquire a distressed company; it does not purport to be complete. Its data is taken from individual SPAC public filings. The quotes are taken from company filings, including S-1 prospectuses, 8-Ks and 10-Ks.

A SPAC that omits from its prospectus an intent to acquire a post-reorganized company is not prohibited from buying such a business, and in fact a number of SPACs have done exactly that. Skillsoft, for example, emerged from bankruptcy in June 2020 and in October announced a definitive agreement to be acquired by a SPAC, Churchill Capital Corp II (the transaction has not yet closed). While Churchill II's offering prospectus does not specifically express its intent to target post-reorganized companies, a member of its board of directors has significant distressed investment experience.

Playing SPAC investor
Distressed investors running large pools of capital often seek not just to profit from an investment in a company's securities, but to control the company once it has concluded its restructuring. A SPAC can facilitate that result by giving a distressed investor the currency to buy a post-reorganized company's equity.

But acquisition-minded distressed investors do not generally wait to acquire a company only once its restructuring is concluded. Most commonly, they appear as the target company's difficulties first become known and the price of its debt securities are falling. Their classic strategy would be to buy the discounted debt of such a troubled company in the market, use that debt to gain a seat at the table and negotiate a restructuring that awards a majority of the equity to their debt holdings, thereby winning control of the company.

A SPAC cannot do any of that.

According to Dan Fisher, partner at Akin Gump Strauss Hauer & Feld LLP and leader of the firm's special situation group, SPAC governance documents generally require that the SPAC purchase an operating business. In other words, distressed investors cannot use a SPAC's cash to buy debt in the leveraged loan or bond markets to gain their seat at the table.

Fisher notes that while a SPAC is not required to own 100% of the equity, it is generally required to acquire at least a controlling interest in the target business (though he points out that this does not necessarily mean the SPAC's stockholders will own the majority of the equity after the businesses combine into a single entity). But it cannot get there through the debt. "Acquisition of the debt, even if the plan would be to ultimately convert to equity, would not qualify," he says.

Fisher does not preclude SPACs from having any role in a bankruptcy. A company in bankruptcy might put itself, or a major asset or subsidiary, up for sale through a "363 sale," that is, a sale under Section 363 of Chapter 11 of the U.S. Bankruptcy Code.

"A SPAC could participate in a 363 process for a company or assets," he says. But he warns that "the SPAC's structure, for example the requirement for shareholder approval and associated SEC timing issues, might put it at a disadvantage versus other bidders."

The future of SPACs
Despite the recent waning in the popularity of SPACs, Houlihan Lokey's Collins believes it is only a matter of time before distressed-specific SPACs proliferate. Collins notes that businesses such as airlines, restaurants, movie theaters and travel agencies loaded up on debt through 2020 as receptive markets and Fed-powered liquidity opened the financing door wide for companies to build cash.

But the purpose of that cash was to enable the borrowers to survive for a finite period until their businesses recovered. That period was generally assumed to be only through early 2021. With the U.S. recovery having been delayed and perhaps only now arriving, and Europe dipping back into recession, Collins foresees another round of distressed opportunities in the coming months. If Collins is right, SPACs will find themselves in a target-rich environment.

For additional perspective on 2021, including other experts' expectations of a renewed distressed cycle, see After Rollercoaster 2020, US distressed debt pros ready for challenging 2021.

Postscript: SPAC basics
Special purpose acquisition companies are successors to notorious "blind pools" made famous by bucket shops in the 1980s. First appearing formally in the early 1990s, when they were often known as "shell" companies, their sole mission is to acquire a business. If the business is private, the resultant reverse merger enables it to go public.

A SPAC's offering prospectus often narrowly defines a SPAC's target market by expressing an intended type of target company. But generally — and often even with offering document language narrowing the target field — a SPAC can buy virtually any company in any industry.

A SPAC's documentation generally gives it about two years from its time of issue to find and close on a company it wants to acquire. During the period when an appropriate target is being hunted, the money sits in a trust account.

Once a target is found, the de-SPAC process begins. The necessary steps to consummate the business combination usually include a shareholder vote. Public SPAC shareholders who, for whatever reason, do not want to participate can require the SPAC to redeem their shares at roughly the issue price. That is true whether the investor bought in at the initial offering or on the secondary market.

A SPAC's target will frequently cost more than the cash available to the SPAC from its IPO. To bridge the gap, SPACs may raise additional equity from institutional investors through a private investment in public equity process, or PIPE. The PIPE and the acquisition would close simultaneously.

According to Collins, though a PIPE appears to serve the singular purpose of providing additional capital to fund the acquisition, since PIPE investors are typically sophisticated institutional investors, the PIPE also provides a "third-party price valuation, which SPAC investors have grown to expect to see." Failure to raise the additional PIPE capital might lead the SPAC's shareholders to conclude that the price was too high.

Collins points out yet another role the PIPE plays: if the SPAC's management is concerned that some SPAC shareholders might redeem and not go along with the deal — regardless of their reason — the PIPE can fill in for the cash paid out to shareholders who walk.