Valuation Issues Pertaining to Proposed Subscription Warrants, Study notes of Financial Management

Download Valuation Issues Pertaining to Proposed Subscription Warrants and more Study notes Financial Management in PDF only on Docsity! MIT Sloan School of Management Economics, Finance & Accounting 100 Main Street, E62 Cambridge, MA 02142 USA Hui Chen Nomura Professor of Finance Jasae Hinds Administrative Assistant II January 4, 2022 Mr. J. Matthew DeLesDernier Assistant Secretary U.S. Securities and Exchange Commission 100 F Street, NE Washington D.C. 20549 RE: Order Instituting Proceedings to Determine Whether to Approve or Disapprove a Proposed Rule Change to Adopt Listing Standards for Subscription Warrants Issued by a Company Organized Solely for the Purpose of Identifying an Acquisition Target (SR-NYSE-2021-45) Dear Mr. DeLesDernier, I am the Nomura Professor of Finance at MIT Sloan School of Management, where I have been teaching Options and Futures, Analytics of Finance, and Asset Pricing, as well as conducting academic research since 2007. Together with my colleagues and students, I have produced dozens of research publications and working papers on asset pricing. My main research interests include asset pricing, and its connections with corporate finance, financial constraints, credit risk, liquidity risk, robustness, and financial machine learning. In addition, I am a Research Associate at the National Bureau of Economic Research and an Affiliated Researcher of the MIT Laboratory for Financial Engineering, and Co-Editor of the Review of Asset Pricing Studies and the Annual Review of Financial Economics. I have also served on the editorial board of several other leading academic finance journals. Attached in the appendix is my CV. I am writing to provide my views on the valuation issues pertaining to the proposed subscription warrants referenced in the Proposed Rule, especially as they apply to the specific warrants that Pershing Square SPARC Holdings, Ltd. proposes to issue. I have been engaged by Pershing Square SPARC Holdings, Ltd., an entity affiliated with Pershing Square Capital Management, L.P. (“Pershing Square”), to assist them with this matter. I understand that the U.S. Securities and Exchange Commission (“SEC”) has published an order instituting proceedings to determine whether to approve or disapprove certain rule modifications by the New York Stock Exchange relating to SPARs.1 In this order, the SEC queried “how market participants would effectively value this novel listed security.”2 To help the SEC and other interested parties answer this and related questions, I have written the attached working paper. In this paper, I 1 Securities and Exchange Commission Release No. 34-93741; File No. SR-NYSE-2021-45 (“SEC Proceedings”) 2 SEC Proceedings, p. 11 MIT Sloan School of Management Economics, Finance & Accounting 100 Main Street, E62 Cambridge, MA 02142 USA compare the differences and similarities between subscription warrants and public SPACs securities. I show that, for the purpose of valuation, there is a close connection between subscription warrants and SPAC common shares. In addition, I propose a fundamental-based framework for how market participants can value subscription warrants. I am hopeful that my working paper and the fundamental valuation framework will help the SEC make an informed decision on approving this proposed rule. Thank you, /s/ Hui Chen 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 0 20 40 60 Year P er ce n ta g e % of US IPOs (equal-weighted) % of US IPOs (dollar-weighted) Figure 1: SPAC’s Share of US IPOs -8.1% for the common shares (-24.7% relative to the market) in the sample period from 2012 to 2020. Pershing Square SPARC Holdings has recently proposed a new IPO mechanism based on subscription warrants, which are issued by a company (dubbed “Special Purpose Acquisition Rights Company,” or SPARC) organized solely for the purpose of identifying an acquisition target.4 This new financial product has several features that are specifically intended to address the above-mentioned concerns for SPACs:5 1. no upfront capital contribution;6 2. no underwriting fees; 3. no conventional sponsor promote; additional sponsor warrants have an exercise price that is 20% higher than that of the public subscription warrants; 4. a sizable commitment of minimum sponsor investment through a forward purchase agreement; and 5. a 10-year maturity instead of 2 years. 4Pershing Square named their subscription warrants “Special Purpose Acquisition Rights,” or SPARs. See https://www.sec.gov/Archives/edgar/data/1895582/000119312521340602/d175920ds1.htm. 5My discussion in this paper is based on the subscription warrant proposed by Pershing Square. Some of the contractual features could vary across different sponsors. 6The warrant will be distributed for free to the existing SPAC investors of Pershing Square Tontine Holdings in initial placement. There will be a cost to acquire it in the secondary market. 2 In order to list and trade subscription warrants on the exchange, NYSE has proposed a rule change (SR-NYSE-2021-45) to the SEC regarding the listing standards for this new instrument.7 In response, the SEC has raised important questions regarding how to value subscription warrants, and whether the proposed rules are sufficient to ensure their orderly trading. In this short paper, I examine the economics behind subscription warrants. I discuss some of the main advantages SPARCs provide relative to SPACs and traditional IPOs. Relative to traditional IPOs, both SPACs and SPARCs take advantage of the price mechanism to aggregate information and identify potential IPO investors, which helps reduce marketing costs and makes investors better informed in their decisions to participate in an IPO. Relative to SPACs, SPARCs provide direct cost savings by removing underwriting fees and liquidity discount for the cash component of SPAC common shares. Moreover, SPARCs provide interesting solutions to the agency problem embedded in SPACs. The removal of sponsor promote not only reduces the dilution to public investors, but also reduces sponsors’ incentive to pursue unprofitable deals; the extended maturity largely removes the time pressure to complete a deal; the requirement of a sizable amount of sponsor co-investment in the merger serves as a credible signal of interest alignment to both warrant investors and target companies. Another interesting difference is that while SPAC investors have to “opt out” of a merger by redeeming their shares (i.e., the default option is to invest), SPARC investors have to “opt in” by exercising the warrants (the default option is not to invest). This “opt-in” feature can better protect retail investors in the presence of behavioral biases and informational frictions. I then analyze the pricing of subscription warrants. I show that subscription warrants are tightly connected to SPAC Class A common shares for the purpose of valuation. Specifically, a SPAC common share can be decomposed into a bond and a subscription warrant. Thus, the orderly trading of SPAC shares for the last two decades should lend us some confidence in successfully running a market for subscription warrants. 7See https://www.sec.gov/rules/sro/nyse/2021/34-93741.pdf. 3 Finally, I propose a fundamental-based valuation model for subscription warrants. The key part of the model is to compute the expected present value of the merger premium, which depends on the following factors: 1) how quickly the sponsor can identify a reasonable target; 2) the size of the surplus for taking a target public (determined by the size of the target and the net benefit of going public); 3) the share of the surplus that the sponsor can extract (determined by the sponsor’s bargaining power); and 4) the ratio of exercised warrants to sponsor investment. The rest of the paper is organized as follows. In Section 2, we examine the differences and similarities between subscription warrants and public SPACs securities, including common shares and warrants. In Section 3, we propose a fundamental approach for valuing subscription warrants. Section 4 concludes. 2 Subscription Warrants vs. SPAC Securities In this section, we briefly review the main features of SPAC securities and subscription warrants that are pertinent to valuation. For more detailed review of the contractual details of SPACs, see Gahng, Ritter, and Zhang (2021). For more details on subscription warrants, see the registration statement (Form S-1) of Pershing Square SPARC Holdings. A SPAC is a blank check company that goes public to raise capital by offering securities called “units.” A typical unit is priced at $10 and consists of a “common share” and a fraction of a “warrant,” which is a call option issued by the company on the common share, typically with a strike price of $11.50 per share and a maturity date that is 5 years after the completion of the merger. Each unit becomes unbundled shortly after the IPO (typically 52 days), so that the common shares and warrants can trade separately. The public common shares are also referred to as Class A common shares, to be distinguished from the Class B shares that are issued to the SPAC sponsor essentially for free (also known as founder shares or sponsor promote). The founder shares are typically 20% of all SPAC shares. The sole purpose of a SPAC is to find a non-listed operating company to merge with 4 Panel A. Bond component Receiving $10 Receiving $10 ITI ITI Vo or Je N7 NZ + + + al 0 t T T SPAC IPO ‘Target identified End of SPAC Term Panel B. Option component Figure 2: Decomposing the cash flows of a SPAC common share. Panel A plots the cash flows of the bond component of the common share. Panel B plots the cash flows of the option component in the event the option is exercised. coupon bond that pays the principal of $10 at a random maturity date, which is either at time T, the end of the SPAC’s pre-specified term, or at a random time 7, when the sponsor enters into a definitive agreement with a target, provided that the sponsor does so before the end of its term (i-e., 7 < T’). For simplicity, we have ignored the interest earned in the trust account in the illustration, which is typically small in practice. The option component of the common share is just like a subscription warrant. Panel B of Figure 2 shows that, if a common share investor decides to exercise the option at time T, or equivalently, when they decide not to redeem the share, they will pay the $10 exercise price in exchange for one share of the merged company. This is identical to the exercise of a subscription warrant with a fixed exercise price. For simplicity, we have assumed that redemption and warrant exercise occur at the same time when a target is identified as opposed to over a period of time (see Footnote 8). In addition, we have ignored the possibility that a proposed business combination might fail to go through after time rT. When combined, the exercise price of the option component at time τ is covered by the principal payment of the bond component, so that there is no net cash flow for the common share investor if they decide not to redeem at time τ . On the other hand, if the common share investor does not exercise the option at time τ , or equivalently, when they decide to redeem the share, the option component expires, leaving only the principal payment of $10. Thus, the combined cash flows of the bond and call option are indeed identical to those of the common share. Assuming no arbitrage, the value of a Class A common share at anytime t before the sponsor identifies a target (t < τ) should be the sum of the price of the bond and the price of the call option.9 The equivalence of the call option component in a SPAC common share and the subscription warrant implies that, conceptually, pricing a subscription warrant is no more difficult than pricing a SPAC common share. In light of this result, the fact that we have witnessed orderly trading of SPAC shares for the last two decade should lend us some confidence in successfully running a market for subscription warrants. The valuation of both securities crucially depends on the expected present value of the merger premium: the excess value of a share of the merged company over the strike price. We examine how to value this merger premium in Section 3. Since additional uncertainties about SPAC dilution costs (from the sponsor promote and the future exercise of public/private SPAC warrants) and the agency problem for the SPAC sponsor will add to the difficulties in valuing the merger premium, one could argue that the pricing of SPAC common shares is more challenging than subscription warrants. Liquidity discount for SPAC common share Since the value of the call option can never turn negative, it might seem puzzling that Class A common shares sometimes trade below their NAV. For example, by the end of 2021, the common shares of all but one of the top ten most active SPACs are trading at a discount to their NAV. This discount to NAV is partly because SPAC investors will discount future risk-free cash flows at a higher risk-free rate than the Treasury rate that the trust account earns 9Although the bond and option components are not separately traded to enable arbitrages between them and the common share, it still provides useful guidance for how to think about the relations among these financial claims. 8 (the difference is referred to as the Treasury premium; see e.g., Krishnamurthy and Vissing- Jorgensen, 2012). Another reason for the discount is the illiquidity of SPAC common shares on the secondary market. When an investor is hit by a liquidity shock but can neither redeem the common shares early nor sell them quickly in the market without causing significant price impact, they will be stuck with the shares and incur an implicit holding cost (see e.g., Duffie, Garleanu, and Pedersen, 2005; Chen et al., 2018). Ex ante, the expected future holding costs will result in a liquidity discount in the bond component of the common share, similar to what is observed for thinly traded investment-grade corporate bonds (see e.g., Longstaff, Mithal, and Neis, 2005; Chen et al., 2018). Furthermore, the less active the trading of SPAC shares, the higher this liquidity discount becomes. Since the activeness of SPAC security trading tends to be positively correlated with the value of the option component, when the prospects of a high merger premium become sufficiently dim, the total value of the common share can fall below the NAV. The cost of the liquidity discount is ultimately shared among SPAC investors, sponsor, and the target company. In contrast, by not requiring capital contribution upfront, subscription warrants can help investors avoid such a cost. 3 A Valuation Framework As explained in the previous section, for the purpose of valuation, a subscription warrant can essentially be viewed as a SPAC Class A common share minus a zero-coupon bond. It is also worth noting that SPAC common shares have been actively traded by investors for decades. Nonetheless, it is worth examining the fundamental determinants of both securities. In this section, I propose a fundamentals-based valuation framework. The core piece of the valuation framework is to compute the expected present value of the merger premium, which depends on a few factors: 1) how quickly the sponsor can identify a reasonable target; 2) how much surplus there is for taking the target public; 3) what is the share of the surplus that the sponsor can extract in its negotiation with the target; and 4) how 9 IPO (see e.g., Gahng, Ritter, and Zhang, 2021), the listing price will be essentially finalized as soon as the sponsor and the target company enter into a definitive agreement (there is non-zero risk that the proposed business combination may be rejected by the company, typically due to insufficient funds from the exercise of warrants). This could be an important consideration for firms that care about IPO timing, as shown in Pástor and Veronesi (2005). IPO timing can be particularly important when the public market valuation is volatile, or when the fundamental volatility of the target company is high. Another often-mentioned benefit of a SPAC IPO (which also applies to SPARCs) is that, like PE funds, the sponsor can use its expertise to help mentor and monitor the target firm. They might also be more capable at valuing companies that are more opaque to public investors (younger firms and firms in new industries). There are also some notable tradeoffs between a SPAC IPO and a SPARC IPO. While a SPAC might appear to have the advantage of a deeper pocket than a SPARC thanks to the cash raised in the SPAC IPO, which would be reassuring for the target, this signal becomes less credible under high expected redemption rates. For example, Gahng, Ritter, and Zhang (2021) report an average redemption ratio of 37% for completed mergers since January 2015; based on data from Citi, in the second half of 2021, the average redemption ratio was consistently above 50% and approached 80% in November 2021. In comparison, not having cash in trust will make sponsor reputation even more important for the success of SPARCs. The fact that the SPARC sponsor does not receive any sponsor promote, that it is under less time pressure to complete a deal, and that it commits significant amount of own capital to co-invest in the merged company, all help boost the sponsor’s credibility with both public investors and potential targets. Although there is evidence that the total costs of SPAC IPOs are considerably higher than those of traditional IPOs, there is reason to believe that firms that choose traditional IPOs are fundamentally different and may not be the natural targets for SPARCs. If we consider a SPAC IPO as the primary outside option for a target company of a SPARC, then the average total costs of a SPAC IPO can be used to estimate the average 12 total surplus of going IPO through a SPARC.10 This estimate is meant to be conservative, since the various advantages of SPARCs should result in better merger targets compared to SPACs. After that, we can estimate the share of the surplus that a SPARC sponsor is likely to extract from its negotiation with the target. This is admittedly the most subjective part of the valuation. As discussed above, the factors that can influence the sponsor’s bargaining power include the volatility of market valuation (higher volatility makes timely IPO through SPAC/SPARC more attractive), target company’s fundamental volatility (higher uncertainty about the fundamental makes it more difficult for the market to value the target), sponsor reputation (ability to identify, mentor, and monitor the target), the size of sponsor committed investment in the deal, and the size of the pool of potential targets relative to the number of SPAC/SPARCs searching for targets. Gahng, Ritter, and Zhang (2021) estimate that the median total costs of SPAC IPOs (defined as the difference between the market value of “outside” securities and the net cash received by the operating company and selling shareholders) to be 48.3% of the IPO proceeds and 14.6% of the post-issue market cap, which are quite substantial (see their Table 1, Panel A, which is reproduced in Table 1 here). It is also worth noting that there is considerable cross-sectional variation in the costs estimates. For example, at the 75th percentile, the costs of SPAC IPOs are 88.9% of the IPO proceeds and 27.9% of the post-issue market cap. Due to the optionality, such uncertainties about the IPO costs will further increase the value of the subscription warrants. 3.2 A valuation model Below, I lay out a dynamic valuation model for subscription warrants based on the key ingredients discussed above. • Consider Sponsor i. Let n be the total number of subscription warrants outstanding, which have strike price K and maturity T . Let X be the total forward purchase amount (committed + additional) from the sponsor. We will ignore the possibility 10Recall our earlier discussion that the time variation of this surplus can be estimated through the variation in public valuation ratios. 13 Table 1: The Relative Costs of Going Public This table reproduces Table 1, Panel A of Gahng, Ritter, and Zhang (2021). Quoting from its caption: This table “reports the costs, not including registration, legal, and auditing fees, of three different going public methods: merging with a SPAC, a traditional IPO, or a direct listing. For both SPACs and traditional IPOs, the costs are defined to be the difference between the market value of outside securities and the net cash received by the operating company and selling shareholders. For SPACs, outside securities are shares and warrants held by public investors, PIPE investors, and sponsors. For traditional IPOs, outside securities are the shares issued in the IPO. For direct listings, the costs are the fees paid to financial advisors. For traditional IPOs, our cost measure is equivalent to the sum of underwriting commissions plus money left on the table. We use 150 SPAC mergers (after excluding 3 deals in which no cash was delivered due to high redemptions and no PIPE investment), 677 traditional IPOs, and 7 direct listings between January 2015 and March 2021. For the denominator, proceeds refer to the net cash delivered after underwriting commissions and other costs. Market cap refers to the post-merger (or post-issuance) market capitalization valued at the first closing market price. For SPAC mergers, cash delivered includes the dollar value of the trust account and the proceeds from the realized forward purchase agreement (FPA) and PIPE investments. For the traditional IPOs, we exclude IPOs raising more than $500 million, those with an offer price below $5 per share, unit offers, ADRs, closed-end funds, natural resource limited partnerships, REITs, bank and S&L IPOs, and small best efforts offers.” SPAC (N=150) Traditional IPO (N=677) Direct Listing (N=7) Costs Proceeds Costs Market Cap Costs Proceeds Costs Market Cap Costs Proceeds Costs Market Cap 10th percentile 16.1% 4.6% -4.1% -0.8% - 0.1% 25th percentile 29.3% 8.3% 6.9% 1.1% - 0.1% Median 48.3% 14.6% 21.9% 3.2% - 0.3% 75th percentile 88.9% 27.9% 49.9% 7.1% - 1.1% of strike price adjustment and additional diluting sponsor warrants for now. • We model the arrival of potential target companies using a Poisson process. Let Nt be the number of target operating companies that the sponsor identifies up to time t, which follows a Poisson process with arrival rate λ. This means that the conditional probability that a new target will be identified between t and t+ ∆t is approximately λ∆t. The average amount of time between two arrivals is 1/λ. One could make the arrival rate sponsor-specific to capture the possibility that the market might expect a sponsor to find a target sooner than others. 14 • Notice that the expectation in Equation (6) is under the risk-neutral measure. Thus, to implement (6), we need to change the measure for the processes of θt and νt. • Next, we price a subscription warrant when the sponsor can repeatedly search for new targets until time T . Pi(t, T, θt, νt) = EQ t [∫ T t λe−(r+λ)(s−t) max ( nKβi,sθsBi,se xi,s X + nK ,Pi(s, T, θs, νs) ) ds ] , (7) The main difference between (7) and (6) is that when nobody exercises their warrants, the value of the warrant is not zero but Pi(τ, T, θτ , ντ ), which is the value of the warrant when a new search starts. This problem can be solved on a tree. • Pershing Square has proposed that those investors who exercise their warrants will receive a new subscription warrant for the next round. The pricing equation under such a feature is: Pi(t, T, θt, νt) = EQ t [∫ T t λe−(r+λ)(s−t) max ( nKβi,sθsBi,se xi,s X + nK + Pi(s, s+ T, θs, νs), Pi(s, T, θs, νs) ) ds ] . (8) The main difference between (8) and (7) is that the payoff from exercising the warrant now includes the value of a new warrant with a new maturity date s+ T . Notice that the value of the warrant should increase in its time to maturity, i.e., Pi(s, s+ T, θs, νs) ≥ Pi(s, T, θs, νs). Thus, the investors will prefer to exercise their warrants as long as the surplus is positive. Again, this problem can be solved on a tree. 17 4 Conclusion In this paper, I examine the economics behind subscription warrants, a newly proposed financial instrument for facilitating IPOs. I discuss their advantages relative to SPACs in providing a more efficient IPO mechanism. While technically a new security, I show that subscription warrant is tightly connected to SPAC common share in terms of valuation: the SPAC common share can be decomposed into a bond and a subscription warrant. I also propose a fundamental-based valuation framework for subscription warrants. There is rich economics in the new subscription-warrant-based IPO model. For future research, it will be worthwhile to more closely examine the agency problem for the sponsors in SPARCs vs. SPACs. It will also be interesting to study empirically the effectiveness of the price mechanism for aggregating IPO-relevant information. 18 References Chen, H., R. Cui, Z. He, and K. Milbradt. 2018. Quantifying liquidity and default risks of corporate bonds over the business cycle. Review of Financial Studies 31:852–97. Dimitrova, L. 2017. 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Journal of Political Economy 112:164 – 187. 19 Honors and Awards Arthur Warga Award for Best Paper in Fixed Income, Society of Financial Studies, 2019 Macro Financial Modeling Research Award, 2017 Best Paper Award, Red Rock Finance Conference, for “Measuring the ‘Dark Matter’ in Asset Pricing Models,” with Winston Dou and Leonid Kogan, 2013 The Chinese Finance Association Best Paper Award, for “Debt, Taxes, and Liquidity,” with Patrick Bolton and Neng Wang, 2013 Distinguished Referee Award, Review of Financial Studies, 2013 Smith Breeden Distinguished Paper Prize for the Journal of Finance, awarded for “Macroe- conomic Conditions and the Puzzles of Credit Spreads and Capital Structure,” 2012 TCW Best Paper Award, China International Conference in Finance, for “Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads,” with Yu Xu and Jun Yang, 2012 MIT Sloan Junior Faculty Research Assistance Program Award, 2010 Best Paper Award, the Caesarea Center 6th Annual Academic 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