By Aaron Puthan
Special Purpose Acquisition Companies, or SPACs, have seen a meteoric rise in popularity, raising $76 billion in equity proceeds in 2020 – 59% of total US IPO capital raising! Why the SPAC surge? Quite simply, back in March 2020, a widespread concern emerged that the IPO market would be hampered by the Covid-19 pandemic and, consequently, emerging companies and venture capitalists began looking for alternative vehicles to bring companies public. Enter the SSPAC, or as some refer to them: “blank check companies”. These vehicles are designed to help bring new companies to market under quicker timeframes than a normal IPO, with some deals coming to market in just a matter of months. That being said, this isn’t a new idea. The first SPAC was created in 1993 and their popularity, and indeed reputations, have risen and fallen with equity market trends and regulation. But with another $16 billion already raised in the first three weeks of 2021 alone (vs. $4 billion across traditional IPOS), the topic deserves some attention.
So how exactly do they work? Should investors consider them as part of an overall portfolio? How do SPACs “win”? What are the risks?
What exactly is a SPAC?
A SPAC is a corporation that raises money through a public offering with the intent to acquire a business or asset, generally by merger, but also potentially by capital stock exchange, stock purchase, reorganization or asset acquisition. Important to note: when a SPAC initially raises funds, they have not yet identified the company they intend to acquire (hence the “blank check”).
The SPAC launches via an IPO and the shares are generally initially priced at $10 with warrants attached, typically exercisable at $11.50, which detach from the stock and can be traded separately after 45 days.
Once launched, the SPAC has two years to execute a transaction or otherwise liquidate and return funds to the investors. In the meantime, the assets from the IPO are invested in a trust that generates interest, generally from short-term government securities. The owners of shares have the right to redeem their interest via the warrant at the IPO price plus any interest, at any time prior to the winding down of the SPAC in two years. It is possible for the SPAC price to trade below $10 and this can create short-term yield opportunities for investors who redeem at the offering price.
If the SPAC identifies a merger target, the management team will create a prospectus for the SPAC investors and seek approval for the deal. All shareholders will vote on the acquisition and those investors that aren’t in favor will redeem their shares plus interest earned for cash, while also retaining their rights and warrants. If the acquisition is approved, the SPAC will begin the merger process with the private company, which retains the identity of the public SPAC.
In practice, most acquisitions are larger than the cash raised by the SPAC IPO, in which case the management team raises more capital via a Private Investment in Public Equity vehicle, commonly known as PIPE. At this stage, large institutional investors are able to commit significant investments in the deal, which is often not the case at the IPO. Historically most deals average around 4X the IPO raise.
Once the combination is complete, the SPAC will wind down, the ticker will change to the acquisition target and shareholders will own equity in the newly floated company.
It should be noted that we have seen significant dispersion of returns from post-merger SPACs. A joint study from Stanford and NYU found that the median twelve month return of post-merger SPACs launched in 2019-June 20220 was an excess of 9.7% over the Russell 2000. However the mean return was negative 36.3%. It is critical to invest in the right SPAC and significant due diligence should be conducted.
What are the risks?
The broad outline detailed above would seem to be an ideal investment vehicle: easier access to the expert off venture capital investing, downside protection via the warrant, an interest bearing trust and potentially uncapped upside. However, there are some risks that need to be highlighted.
The first risk is obviously opportunity cost. Investing in the SPAC and waiting for a target acquisition may take some significant time and may not even occur if not completed within 24 months. In 2020, that was generally not the case, but if equity markets are soaring during the waiting period, investors could miss out on potential gains elsewhere as they are essentially sitting in cash.
The second risk is the quality and experience of the SPAC management team. Shaquille O’Neal has a SPAC and so does Bill Ackman. We are not going to offer an opinion on the investment ability of either of these individuals, but investors may well have a view on the relative ability of these two managers to identify and value a target.
The third risk is valuation. This is really just a derivative of the second risk, but has the team correctly valued the target, is the PIPE significantly dilutive and are the prospects for the target accurately and fairly represented? One large deviation from an IPO is that a SPAC can give five-year forward projections for the target company’s prospects. This is forbidden in an IPO. Some may see this as an advantage, but others will ask, can we trust the forecasts?
In addition potential investors should be aware that Wall Street firms will not issue recommendations on SPACCs, until after a transaction with the target business has occurred. Incremental and hopefully objective investment information will be scarce for some time.
The final risk is the possibility of a bubble. Deal volume has been so outsized that 247 SPACs are currently looking for deals that will need to be completed in either 2021 or 2021 given the 24 month expiration. The urgency to find a deal is great because, realistically, investors do not want to have invested money sitting in cash. Some have suggested this wall of money seeking deals is simply unsustainable and will lead to SPAcs acquiring targets at unrealistic valuations.
Could this be systematic risk? In theory, a large amount of cash seeking a small amount of deals could lead to a scenario of seriously overvalued companies. A SPAC market collapse is a possibility and how systematic this would be is an open question. At this point, a lot of emerging companies are looking for investment, as evidenced by recent activity. However, if that need dries up , and we see wide retail investor participation in the market and greater levels of leverage, systematic risk will undoubtedly rise.
Should people invest?
For very sophisticated investors with large cash holdings, well diversified portfolios and experience in growth companies in certain industries, this may be an investment worth looking at.
For the average investor, however, the complexity of a SPAc and inability to invest in the IPO may well suggest that they look at more traditional investment alternatives.
SSPACs are here to stay, at least for the next couple of years. As the asset management world and clients generally become familiar with their structure and how they trade, we may see wide acceptance and adoption. But for now, these vehicles are only for those with a clear understanding of the methodology and risks. □
Work Cited
- Title image source
- Bentley, E. (2021, February 10). The spac boom, visualized. Retrieved March 15, 2021, from https://www.wsj.com/articles/the-spac-boom-visualized-in-one-chart-11612962000
- Blogs, M., Klausner, M., & Ruan, E. (2021, January 7). The spac bubble may burst-and not a day too soon. Retrieved March 15, 2021, from https://law.stanford.edu/2021/01/07/the-spac-bubble-may-burst-and-not-a-day-too-soon/
- Huddleston, T., Jr. (2021, February 24). What is a spac? Explaining one of Wall Street’s hottest trends. Retrieved March 15, 2021, from https://www.cnbc.com/2021/01/30/what-is-a-spac.html
- Kurutz, S. (2021, February 27). Anyone who’s anyone has a spac right now. Retrieved March 15, 2021, from https://www.nytimes.com/2021/02/27/style/SPACS-celebrity-craze.html
- Nathan, A. (2021, February 02). Report: The ipo spac-tacle. Retrieved March 15, 2021, from https://www.goldmansachs.com/insights/pages/the-ipo-spac-tacle.html
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