A special purpose acquisition corporation, commonly known as a 'SPAC' (and formally a 'development stage company'), is a corporation formed for the purpose of raising capital through an initial public offering ('IPO') of its securities, in order to fund an acquisition of an existing operating company or companies.Though the SPAC itself has no business operations, investors entrust an experienced founding management team to seek out and consummate a value-building acquisition of an operating business, often in a particular industry, sector or geographical area.The IPO's proceeds provide the target company with liquid capital stock and immediate capital, an advantage over various other structures.
Non-traditional corporate finance structures, historically focusing on reverse mergers and now including SPACs, have become an increasingly popular choice for Chinese companies seeking capital.Chinese reverse mergers have grown from twenty-six in 2004 to thirty in 2005 and seventeen reverse mergers were already executed as of August 2006.1 China is also one of the most attractive target sectors for founders of SPACs selecting a target sector in which to attempt to identify candidates for a business combination. This is due in part to the long term growth prospects for China as well as the ability to arbitrage the difference between private market valuations in China and public market valuations in the United States. This article will address the success of recent SPACs that have focused on China, while also providing a brief overview of issues that SPAC management teams should consider in connection with focusing their acquisition efforts on China.
Foreign direct investment ('FDI') in China exceeded $60 billion in each of 2004 and 2005.2In the first quarter of 2006, FDI in China was over $14 billion, a 6.4 percent increase over a weak first quarter 2005.3The United States has been one of the top five sources of FDI in China throughout this period.4In previous years, FDI in China has been concentrated in the manufacturing sector, as a result of restrictions on FDI in many service sectors. However, a recent loosening of restrictions on FDI as a result of China's commitments to the World Trade Organization has led to increased FDI in a variety of sectors, particularly banking and high-tech industries.5As a result, when coupled with recent annual economic growth of approximately 9-10 percent, China has become an increasingly attractive market in which to invest. SPACs have taken notice of this trend.
As of November 1, 2006, twelve SPACs that had filed registration statements since late 2003 have sought to consummate a business combination with a target business operating in China.6As of November 1, 2006, eight of these twelve companies had completed the SEC registration process.7,8,9
Many of these SPACs are proceeding to the acquisition phase of their life cycle. As of November 1, 2006, five of the eight companies that had completed the SEC registration process had announced plans to enter into a business combination with an operating business located in China. Four of these companies appear to be well on their way to completing business combinations.10Additionally, all of the announced acquisitions have involved a combination of cash and stock consideration, suggesting that larger offering sizes may be necessary to raise sufficient funds to acquire an attractive operating business in China.
The recent success of many SPACs in negotiating business combinations with Chinese companies may be largely a result of their attractiveness as potential buyers. In addition to being able to provide significant cash consideration in an acquisition without relying upon external financing sources (because the vast majority of the IPO proceeds are held in trust until a business combination is completed), most SPACs are also seeking a long-term investment, especially when compared with many other types of financial buyers that intend to resell their investment within a relatively short time period after the acquisition. Furthermore, SPACs may be willing to provide terms that are friendlier to the target's management than those offered by other types of buyers.
However, not everything has been rosy for these issuers. While these issuers have had an excellent rate of success in identifying potential candidates in China for business combinations, the acquisition process has been extremely slow for various reasons, including lengthy delays in SEC review of their proxy statements. The three companies awaiting SEC approval of their proxy/registration statements announced their planned acquisitions between September 2005 and February 2006. All three filed their initial S-4 registration statements between late March 2006 and mid-May 2006, but none have yet filed their final prospectuses.
There are several considerations that a potential acquirer should consider before consummating a business combination with an operating business located in China. In addition to exposure to risks of changes in government policies, weak protections of intellectual property rights, high energy costs, political instability, trade and geopolitical disputes with the U.S. and other Western nations, outside of 'Special Enterprise Zones' and 'Free Trade Zones,' foreign equity ownership in certain sectors is restricted under Chinese law. Chinese law also restricts land ownership by foreigners. Furthermore, while complying with Chinese regulations of investments, U.S. companies seeking to do business in China must also comply with a variety of tax and labor laws, as well as employee visa requirements. Thus, although labor rates may be lower, de jure and de facto requirements to maintain a large employee workforce may reduce some of the advantages of the cheaper labor cost.
China has become an attractive sector for U.S. investment in recent years, despite the numerous risks of doing business there. A SPAC is a particularly attractive vehicle for investment in China. It is worth keeping an eye on the several SPACs that have announced plans to enter into a business combination.
M. Ridgway Barker is Chair of the Corporate Finance & Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean G. Hedin is a Partner in the Corporate Finance & Securities Practice Group. Acknowledgement is given to Jeffrey A. Letalien , an Associate at Kelley Drye & Warren LLP, for his efforts in the preparation of thisarticle.