2020 was a phenomenal year for SPACs, which raised $83 billion (USD) through SPAC IPOs, which is 1.77 times more than the amount raised between 2009 and 2019. Just four months in 2021, and there’ve already been 299 SPAC IPOs which have raised $97.3 billion (USD), and it is projected that there can be more than 1000 SPAC IPOs this year, more listings than any time in history-traditional IPOs and SPACs combined. The SPAC boom isn’t restricted to the US and is spreading to Europe, where Amsterdam is positioning itself as a favoured venue. Indonesian startup giants- Gojek and Tokopedia are said to be considering using the SPAC route to list themselves in New York. Some of the most prominent names in the financial services industry such as Goldman Sachs, Credit Suisse, and Citigroup, have all underwritten SPAC IPOs in the past few years.
What are SPACs and how do they work?
SPACs or Special Purpose Acquisition Company are not a recent invention by any means as they’ve been around for decades. Over the years, they’ve been known by many names such as ‘blank check company’, ‘public shells’, ‘clean shell companies’, ‘blind pools’, and they got their current moniker-SPACs in the 1990s. SPACs are basically shell companies that go public to raise money to acquire an actual company/companies. SPACs have 18-24 months to find a private company to merge with, and the failure to do so will result in the money being returned to the investors. SPACs have usually been the last resort for companies that want to go public but are unable to do so due to various reasons like underwriters refusing to take them public or the lack of interest from the public markets.
The blank check companies are created by a ‘sponsor’; the sponsor can be an industry executive, a corporation, investment fund or a private investor. The sponsor usually puts in anywhere between $5 million (USD) and $10 million (USD) of his/her own money in exchange for a 20% stake in the SPAC. Later the sponsor pools in more money from other institutional investors by offering them warrants in addition to shares of the SPAC; the warrants allow the holder to buy more shares of the issuing company at a fixed price (usually USD 11.5) at a future date and the shares are priced at $10 (USD).
The blank check companies can choose between focusing on acquiring a target from a specific industry or geographic region or be generalists with no focus. Once the SPAC goes public, the money raised in the IPO goes into a trust, where it earns interest until the completion of the merger.
Soon after the listing, the SPAC sets out to find a private company to merge with (within two years), and during this period, the share price of the SPAC doesn’t fluctuate much as the investors don’t know about the target company.
There’s no limit on the maximum size of the target company, but there’s a limit on the minimum size; at least 80% of the funds in the SPAC trust should be used to acquire the company. Typically, the SPACs merge with companies that are worth two to four times the IPO proceeds so that the dilutive impact of the founder shares and warrants are reduced. If the companies are worth more than the money raised during the IPO, where does the rest of the money come from?
The rest of the money comes from PIPE or Private Investments in Public Equity. The SPAC’s institutional investors are informed about the target company before the retail investors under confidentiality agreements so that they can agree on whether or not to provide additional financing through PIPE. The money raised through PIPE flows to the target company’s balance sheet in exchange for an equity stake in the company.
The phase where the target company has been identified and has agreed to merge, but the merger is yet to be completed is known as de-SPACing. The SPAC has to obtain approval from the investors and awaits the US SEC’s (Securities and Exchange Council) review and comments. Altogether, this process lasts for 12-18 weeks.
If the investors are unhappy with the merger, they can redeem their shares at $10 (USD), but they still get to keep the warrants. This works in favour of early investors and against the retail investor’s interest as the SPAC shares are priced higher than $10 (USD) when they hit the public market.
Post-merger, the blank check company changes its name and identity to better reflect the acquired entity’s business operations.
Why are they popular now?
Many theories have been put forward to explain the rising popularity of SPACs:
- Chamath Palihapitiya, the founder of the venture capital firm Social Capital, is known to have kick-started the craze in 2017 when he raised $600 million (USD) for a SPAC that was used to acquire a 49% stake in the British spaceflight company Virgin Galactic.
- The quality of the sponsor teams coupled with celebrity endorsements like that of Jay-Z has helped kindle interest.
- The pandemic has also played a part, as IPO roadshows are harder to execute when working remotely, and the IPO process is lengthy. Startups that wish to ride the hype wave will favour the SPAC route as it’s relatively shorter than the IPO route.
SPAC vs IPO
When compared to IPOs, SPACs receive lesser regulatory scrutiny. Unlike IPOs, SPACs allow companies to provide future projections since SPACs are technically mergers, and it is pertinent that investors be informed about the future prospects of the merged entity. This enables sponsors to make promises about the company and boost the valuations without any legal consequences.
A shareholder who invests in a SPAC before the merger is essentially investing in the SPAC’s sponsor and their ability to choose the ideal target company. But in the case of an IPO, the investor is privy to all the relevant details about the company he/she is investing in.
Part of the SPAC boom is explained by the high fees charged by the investment banks and the low price at which stocks get listed:
- The fees charged by investment banks for IPOs has long been a bone of contention. Some of the market participants feel that the exorbitant fees – 5% to 7% of the capital raised, charged by the banks are not justified; the actual market-building activity does not add much value as the banks rely on the same clients to participate in every IPO.
- The banks are also accused of artificially setting the IPO price low, which leads the stock to ‘pop’; thereby enriching their clients at the expense of the entrepreneurs. The pop indicates money left on the table, money that could have accrued to the newly listed company but has instead gone to hedge funds and Wall Street insiders.
A common misconception about SPACs is that they’re cheaper than IPOs; that’s not true. A study that compared the SPAC dilution cost to the IPO pop cost and other fees associated with IPOs, such as underwriting fees, concluded that IPO cost amounts to 27% compared to SPAC dilution cost of 50.4%. Why so?
SPACs are less risky for the target company as the target company signs a deal with one person (the sponsor) for a fixed amount of money, and the deal will probably get done. But the IPO has a lot of uncertainties as the deal is announced before size or price negotiations take place, and things could go south as was the case with WeWork’s IPO. So the SPACs end up being riskier for the sponsor, which results in a higher expected return for the risks assumed.
The popularity of SPACs could ultimately be detrimental to it as there are so many SPACs looking for attractive companies to merge with, and the increased retail participation in SPACs can lead to increased scrutiny by the SEC. A rise in interest rates could lead to adverse consequences for SPACs and their investors. The SPAC boom is eerily similar to the dot-com bubble when pre-revenue businesses with insane valuations were going public with celebrities’ endorsements.
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