SPACs Under Stress

SPACs Under Stress

Matthew Guill

While 2021 inflicted market discipline and valuation contraction upon SPACs, 2022 is set to bring further challenges. Degrading unit economics on account of rising labor and input costs combined with rising interest rates will pressure many companies both “above and below the line.” 

Potentially compounding these stressors is another challenge – living up to projections made during the de-SPAC merger process. When a SPAC markets a deal to its shareholders, it will oftentimes provide forward guidance in an S-1 filing and other shareholder communications that project future financial performance should SPAC shareholders vote to accept a deal and merge with a target. For those de-SPAC’d companies that fail to hit their guidance, they will likely lose confidence of investors and require multiple quarters of more accurate guidance and execution to restore trust. Yet others who miss guidance could find themselves in a more perilous situation in which debt covenant compliance is jeopardized or liquidity is constrained. In either scenario, securing credit agreement amendments or obtaining incremental financing will become more difficult while management’s knowledge of their business and/or ability to forecast it is under question.

ATI Physical: A Real-Time Case Study

ATI Physical (“ATI”) is the nation’s largest single-branded provider of physical therapy (“PT”) services with nearly 900 owned clinics spread across 24 states. Previously owned by a financial sponsor, ATI agreed to go public in early 2021 through a merger with an existing SPAC vehicle. The merger closed in June 2021. 

In conjunction with marketing the deal to the SPAC’s shareholders, ATI projected full year 2021 revenue and EBITDA of $731mm and $119mm, respectively. In the company’s Q2 earnings call in July (approximately a month after close), it’s first as a publicly-traded company, ATI noted difficulty finding sufficient therapists to staff its facilities and implement the company’s growth strategy. As a result, management revised its guidance downward to $655mm and $65mm, respectively, representing a nearly 50% cut to the EBITDA forecast. In the two days following earnings, ATI’s shares fell by over 50%. Not long thereafter, the company’s CEO stepped down.

With depressed earnings guidance, lack of clarity on the company’s ability to execute on its business plan, and on the back of negative free cash flow in each of Q2 and Q3, it emerged on February 1 that ATI had hired counsel and bankers to consider strategic alternatives including a potential capital raise. Meanwhile, the company’s term loan holders also engaged professionals to evaluate a potential $200mm preferred equity offering.

In conjunction with Q4 and FY 2021 earnings published on February 25, ATI announced that had effectuated a global refinancing marked by:

  • A new $50mm revolving credit facility maturing in 2027,
  • Entry to a new $500mm term loan maturing in 2028, and
  • Sale of $165mm series A perpetual preferred stock accruing 12% per annum and payable in kind
  • Warrants for 5.5% of fully-diluted stock issued to preferred shareholders

Proceeds from the financing were used to refinance ATI’s existing $555mm term loan, pay fees on the transaction, and to add approximately $77mm of cash to the balance sheet.

Silver Lining in Grey Clouds

While ATI’s story unfolds, a number of other SPACs are facing operational issues that will impair their ability to achieve the financial guidance provided via proxy materials ahead of their de-SPAC merger. Whether those issues arise from unforeseeable or uncontrollable events (e.g., pandemic-induced store closures, supply chain issues, lack of labor supply, etc.) or simple inability to execute, managers will need to address liquidity shortfalls and looming maturities in the face of a difficult credit backdrop.

Despite that backdrop, SPACs in stress may benefit from the fact that on average, de-SPAC mergers tend to deleverage the balance sheet. At close of a merger, an infusion of cash from the SPAC and oftentimes incremental equity capital, the target oftentimes pays down debt. In fact, recent research from DoubleLine Capital studying select de-SPAC mergers suggested a reduction in leverage of approximately 1x – 2x. As an example, ATI’s marketing materials prior to consummating a merger suggested that the company would rapidly delever from 5.2x to 2.1x on the back of an infusion of equity capital to repay debt and growing EBITDA post-merger.

The deleveraging from new money proceeds of a merger could present an opportunity for a stressed SPAC to raise capital. If the SPAC were able to credibly demonstrate that margin compression on account of labor or cost inflation were transitory while instilling confidence in a go-forward plan, creative junior capital could be available (e.g., ATI’s preferred issuance). Potential solutions could range from paper secured by junior liens to structured equity. Whereas traditional bank lenders may not have great appetite, the size of the private credit market has doubled over the last five years to over $1 trillion of AUM which is anxious to be invested and may play a role in solving problems of stressed SPACs.