HONG KONG’S special purpose acquisition companies, better known as SPACs, are currently in a slump. This is not only because of poor global market conditions, but also because of the restrictive listing requirements set by the Stock Exchange of Hong Kong. Change is urgently needed.
Here’s a brief discussion of the rules and practices related to warrants, as well as my recommendations for how they could be optimized and improved for all parties involved.
DILUTION RISK OF WARRANTS
The Exchange views warrants as a dilution risk, and initially set the dilution limit for warrants at 30% in its first SPAC Consultation Paper. The dilution limit for warrants was later raised to 50% in the Consultation Conclusions on SPACs after considering that “the proposed warrant dilution cap of 30% may not provide a sufficient commercial incentive for potential investors in a SPAC’s IPO”.
While the Exchange’s original intent was to control the dilution risk of the warrants, in practice, the cashless exercise of warrants (cashless basis) results in simple dilution of the share capital of the successor company.
Not only that, granting earn-out rights to promoters and the over-issuance of promoter warrants will have a further dilutive effect on the successor company.
CASH-BASED ALTERNATIVES
Naturally, besides the cashless exercise of warrants, there is also the cash-based alternative. With a cash exercise, the successor company can obtain financing from warrant holders at an exercise price that is higher than the SPAC listing issue price and the PIPE (Private Investment in Public Equity) investment price.
Normally, SPAC IPOs and PIPE investments are not considered dilution risks by the market, so warrants should not be classified as a dilution risk when exercised on a cash basis, but rather as a means of supplementary financing. U.S. SPACs have basically been operating on a cash basis since 2016.
HONG KONG SHOULD ADOPT CASH METHOD
I believe that Hong Kong SPACs should be encouraged to adopt the cash exercise method and increase the share issuance limit when warrants are exercised on this basis, which would bring higher expected returns to investors while allowing the successor company access to more supplementary financing.
The practice allows one warrant to be issued for one share of common stock. As such, a warrant exercise would result in a moderate overall equity dilution effect while also providing additional financing to the successor company.
Jason Wong is head of Norwich Capital in Hong Kong.
Image at the top shows Jason Wong