First published on the BSPE blog
By Nikolas Huber and Luca Politi
Almost everyone, even when only distantly connected to the topic of shares and stock, has heard about IPOs. Summarized an IPO is a process for a private company to become a public one. But not every private company that wants to become a public company fulfils the requirements for an IPO. One very crucial requirement for an IPO is the actual processing through an investment bank, and these have rather high requirements that have to be met in order to get involved in an IPO. On the other hand, IPOs aren’t the only instrument for private companies to become public. This article provides deeper analysis and discussion about a potential alternative called “reverse merger” (also known as “reverse IPO, reverse takeover or back door listing” and often used interchangeably), its benefits and potential weaknesses and the main differences compared to IPOs. Finally, it outlines a basic framework for investors on how to instrumentalize reverse mergers for merger arbitrage.
In order to pursue a reverse merger the private company that wants to become public need the existence of a so-called “shell company”, which is a non-operating company listed on a stock exchange. These are often found with the help of a “shell promoter” which acts as a substitute for the bookrunner in conventional IPOs. The private operating company then merges with the dormant non-operating company or a newly founded subsidiary of that company. In the merger, the operating company shareholders are issued a majority stake in the shell company in exchange for their operating company shares. Post-merger, the shell company contains the assets and liabilities of the operating company and is controlled by the former operating company’s shareholders. The name, as well as the directors of the shell company, are replaced by the operating company’s. As a result of the whole reverse merger, the operating company’s business is still controlled by the same shareholders and managed by the same directors with the sole difference of being a listed company and contained within a public company. However, in most of the cases the shell promoter claims a certain percentage (up to 20%) of the merged company’s shares after successfully completing the transaction. As a result, reverse mergers are often accompanied by dilution of ownership. This effect can even be reinforced if the shareholders of the shell company manage to negotiate a certain stake in the post-merger company.
There are two possible reasons for the existence of shell companies. The first reason can be that it has been a former operating public company and for some reason ceased operations. The second reason is that it never had operations and was formed for the sole purpose of creating a public shell. The reason for the existence of a shell company also defines if there are publicly traded shares (yes if reason 1, no if reason 2).
Differences compared to IPOs
Having explained what reverse mergers actually are and how they work, it is now particularly interesting to highlight the main differences compared to classic IPOs.
When executing an IPO, an underwriter manages the sale of the newly issued shares of the company’s stock to the public. In addition, the underwriter helps to develop a liquid secondary market by facilitating the listing of the company’s shares on a stock exchange. To support that the underwriter helps to introduce the company executing the IPO to the investors. Conversely, a reverse merger is not a capital transaction. Therefore, no shares are issued and sold in exchange for cash (only in exchange for shares of the shell corporation). The shell promoter of a reverse merger receives a fee solely for processing the transaction and offers far less additional services compared to an underwriter in an IPO. As a result, the secondary market for shares after a reverse merger usually is underdeveloped and illiquid, and the shares of the newly public company are traded rather thinly. Additionally, the shares that actually are traded will probably do so on a significant discount. One can argue that a reverse merger, therefore, signals to the market that the company pursuing it has probably been passed over when searching for an underwriter for an IPO.
On the other hand, reverse mergers are often cheaper than IPOs partly because the shell promoter’s fee is by far smaller than the one for an underwriter. Additionally, reverse mergers usually are, mainly because of their lower complexity, faster than IPOs. Hence, there are logical reasons for companies to pursue a reverse merger even though an IPO might have been possible to execute as well.
Choosing to go public through the process of an IPO can be prohibitively expensive: roughly up to 22% of gross proceeds, namely between $1.1 million and $5 million. Contrarily, reverse mergers offer an expedited process that is much more cost-effective in comparison to an IPO, considering that it typically costs between $50,000 and $100,000. What makes reverse mergers more affordable is mainly the lack of an investment bank’s involvement, which often include significant fees and underwriter discounts.
A second important benefit of reverse mergers is timeliness. Usually, an IPO takes nine to twelve months from start to finish. A reverse merger lowers the length of the quotation process from several months to just a few weeks.
Reverse mergers are perceived as a safer variant than IPOs. This is because market conditions affect the reverse merger process far less due to its tighter timeline. For instance, a company could spend months to launch an IPO and only for market conditions to be worse than expected, prompting a delay to the launch. The result is a lot of wasted time and effort. Secondly, reverse mergers are not reliant on rising capital and therefore less dependent and exposed to the economic conditions and financial markets.
There may also be an opportunity to take advantage of greater flexibility with alternative financing options like PIPE.
PIPE is an acronym for private investment in public equity. In a PIPE offering, a listed company sells newly issued securities directly to investors in a private transaction (hedge funds are typical buyers of such issuances). PIPEs are often used in conjunction with a reverse merger in order to provide companies with not just an alternative way to go public, but also financing once they are listed. This partly solves the significant issue of reverse mergers mentioned earlier, namely that reverse mergers don’t provide additional equity and capital to the company pursuing them. PIPEs have emerged as an essential financing source for small public companies and has evolved into one major reason for executing a reverse merger. Private companies that tapped out their financing options can go public through a reverse merger and thereby obtain financing through PIPE.
Special considerations / Downsides
The potential unknowns the shell corporation brings to the merger represents one of the downside risks. There are many legitimate reasons for a shell corporation to operate, such as to expedite different forms of financing and to permit large corporations to work in foreign countries.
However, some are not reputable firms and may entangle the company in fraudulent situations. This includes everything from tax evasion to money laundering. Prior to finalizing the reverse merger, a thorough investigation of the shell corporation has to be led by private company’s managers to define the contingency of future liabilities.
An instance of an unlawful reverse merger happened during the financial crisis in 2008. Many Chinese companies sought to enter the U.S. markets via reverse mergers. Mergers were commonly set up with abandoned companies that were still listed on stock exchanges. Ultimately, it turned out these companies experienced revenues far less than claimed, and in some cases, the revenues barely existed at all. Based on these wrong filings investors heavily invested into these companies. As a result, it has been estimated that investors probably lost tens of billions of dollars by investing in these firms. This example shows how the reverse mergers can be misused for criminal activities.
The process is slightly different for a reverse merger with a special purpose acquisition company (SPAC). A SPAC is a shell company taken public with the intent of acquiring un unidentified non-listed company within eighteen to twenty-four months. From an operating company’s perspective, a reverse merger with a SPAC is a rare opportunity thanks to the possibility to receive a cash infusion deriving from the IPO proceeds and also enjoy share liquidity as a result of the already established trading market for the SPAC’s securities. It should be noted that similar to an IPO, an operating company has to pass through a gatekeeper (SPAC’s management team) in order to get forward with the deal. Hence, for many companies, a reverse merger with a SPAC appears unaffordable as it shares many requirements with conventional IPOs.
Even if the recent past examples were unrighteous, there are several notorious cases in which companies involved in a reverse merger went on to huge success. A very renowned example concerns Warren Buffet and how he took his investment firm Berkshire Hathaway public through a reverse merger. Buffet acquired the textile manufacturing company, Berkshire Hathaway, in 1965, but later liquidated the company’s textile offering and merged it with his already existing conglomerate gaining the prestigious name his firm has today.
Another famous example of a reverse merger is Burger King. In 2012, Burger King Worldwide Holdings Inc., a hospitality services chain that serves burgers in its restaurants, executed a reverse takeover transaction in which a publicly listed shell company called ‘Justice Holdings’, that was co-founded by the famous hedge-fund veteran Bill Ackman, has been acquired by Burger King resulting in the company we know today.
Other cases worth mentioning are the New York Stock Exchange (NYSE) and Ted Turner – Rice Broadcasting which later on became part of the Time Warner Corp.
Merger Arbitrage – Strategic Investment for PE funds
One exciting thought on how to make use of reverse mergers from an investor perspective (also for PE funds) is the potential for a merger arbitrage. Merger arbitrage is a strategy where investors usually sell and buy shares from two parties involved in a merger and bet on the success or failure of the transaction. This works since typically the share price of the buyer decreases while the share price of the seller increases with the announcement of the transaction. However, there still remains a certain discount in both directions that is based on the uncertainty of the success of the whole merger. There are many reasons why an individual transaction might fail – for example, approval through an authority.
However, since in the case of a reverse merger a private company is involved, no shares can be bought or sold regarding this party. Therefore, the potential for merger arbitrage concerning reverse mergers is limited to shareholders of the private company. And this is where PE funds join the ring. PE funds can actively invest in a private company, gaining a controlling majority of this company with the goal to pursue a reverse merger in order to ultimately make use of merger arbitrage potential. This strategy, however, is quite risky since many obstacles and uncertainties could cause the failure of the entire investment.
Summarizing the findings of this article one can say that reverse mergers are indeed an alternative to IPOs for private companies that wish to become public. However, in most cases the execution of a conventional IPO has many advantages over a reverse merger and should be prioritized if possible. Due to the higher requirements of such conventional IPOs, reverse mergers might pose a suitable alternative for those companies incapable of pursuing a conventional IPO. Ultimately, when executing a reverse merger companies have to follow specific guidelines and analyze their targeted shell company thoroughly in order to guarantee a frictionless and successful transaction.
Editor: Štěpán Koníř
Authors: Luca Politi, Nikolas Huber