Understanding the SPAC Phenomenon
Special Purpose Acquisition Companies, or SPACs, have been in the limelight lately, be it on Wall Street, in corporate boardrooms, or in the media. Even celebrities and public figures like the famous singer-songwriter, Ciara, and the former US speaker of the House, Paul Ryan, are jumping on the bandwagon. Hell, even former President Donald Trump has launched his own media network, including a social media platform called 'TRUTH Social' in a SPAC merger.
To understand the quickly booming industry, take a look at the following figures: in 2019, 59 SPACs were created, with $13 billion invested; in 2020, 247 were created, with $80 billion invested; and in the first quarter alone of 2021, 295 were created, with $96 billion invested.
But what exactly is a SPAC, and why is everyone talking about it?
To put it simply, a special purpose acquisition company (SPAC) is a sort of shell company formed for the sole purpose of raising investment capital through an IPO. Such an arrangement allows investors to contribute money towards a fund, which is later used to acquire or merge with one or more unspecified businesses wanting to go public.
Even though SPACs are an active part of contemporary discourse, SPACs were fraudulent when they first appeared as blank-check corporations, in the 1980's. However, with the introduction of much-needed regulation for SPACs, for example, barrage on the use of the proceeds of blank-check IPOs until the mergers were complete, blank-check corporations could be successfully rebranded as SPACs, as we now know them.
An important feature of modern SPACs is the option for investors to withdraw from a deal after the sponsor identifies a target, which is to say, if investors don’t like the deal, they can choose to pull out, redeeming their shares for cash plus interest.
The sponsors of SPACs usually have two years to find a company to merge with/acquire and intimate the market on which industry they’re targeting. And when it comes to which industry they usually target, then as per recent trends, the hot areas seem to be EVs and Technology (consumer tech, biotech etc).
What makes SPACs better than traditional IPOs?
If I were to define SPACs with utmost precision, I’d say a SPAC is an IPO for ‘nothing’.
This is because, with a SPAC, the IPO is already done, you’re just left to negotiate with the SPAC that might acquire you, which makes the process a lot faster. You’re not even required to arrange for a roadshow, for the pool of funds is already available! Apart from greater speed, SPACs also provide higher valuations, lower fees, less dilution, more certainty and transparency, and fewer regulatory demands than traditional IPOs.
Most private companies go public years after the commencement of their operations, that is, when they achieve stability, thus depriving investors of an opportunity to experience the gains from their growth spurts. Many investors are interested in being part of a company’s journey but they’ve been frustrated because of being unable to access these companies as they’ve stayed private longer. And this is where SPACs come to the rescue! They usually enable investors to help a business grow from rags to riches, and reap the resulting rewards.
On the flip side though, some investors may be apprehensive of buying shares of a company going public through a SPAC because the amount of due diligence required for that may be lesser than a regular IPO.
A parallel between VCs and SPACs
A SPAC isn’t just a medium for a company to go public, it’s a medium for a company to raise new capital to deploy toward some business objective. So if we look at SPACs as an instrument of capital allocation rather than that of a go-public mechanism, they start to look a lot like venture capital firms.
A major criticism of the SPAC boom is that companies going public through SPACs are often initially low quality, because they have yet to generate any revenue. This is largely common in VC firm investments, which require dealing with the uncertainty of the value of future cash flows, that might be more than a decade away.
Moreover, just like VCs, SPACs enable investors to partake in the rewards arising out of helping a business grow from scratch, instead of an already stable base, in the case of most traditional IPOs.
Lastly, the SPAC market mirrors the venture capital market very closely in the sense that investors have to pitch companies to take their money. So it’s no wonder that while SPACs may compete against each other for targets, they also compete with VC firms as companies choose the best path for themselves.
The stakeholders in a SPAC
There are three main stakeholder groups in a SPAC, namely, sponsors, investors, and targets:
Sponsors: The SPAC process is initiated by the sponsors. They invest risk capital in the form of nonrefundable payments to accountants, bankers, and lawyers. Since SPACs don’t own any assets, it’s the sponsors that are the main attraction point. In essence, to investors, a SPAC is only as credible as its sponsors. If sponsors fail to create an arrangement within the deadline, the SPAC must be dissolved and all funds returned. The sponsors lose not only their risk capital but also all the time they invested. But if they succeed, they earn sponsors’ shares in the resulting company, often worth as much as 20% of the equity raised from original investors.
Investors: The investors in SPACs (mainly institutional investors and highly specialized hedge funds) receive two classes of securities: common stock (typically at $10 per share) and warrants that allow them to buy shares at a specified price (typically $11.50 per share) in the future. While warrants are considered to be incentives to subscribe, the greater the number of warrants issued, the higher the perceived risk of the SPAC. After the announcement of the target, the original investors choose to move forward with the deal or withdraw.
SPAC mergers often involve parallel funding by institutional investors, known as 'private investment in public equity' or PIPE. While the institutional investors in PIPE (mutual funds, family offices, private equity firms, pension funds, strategic investors) provide the company that’s merging some additional funds (locked up for six months), they get a chunk of the new company in return. Sponsors use PIPEs to represent a vote of confidence, increase the funding, and guarantee a minimum amount of cash should the original investors choose to pull out of the deal.
Targets: Most SPAC targets at this stage consider several options like pursuing a traditional IPO, approaching venture capital firms, raising additional capital, or selling the business to another company or a private equity firm. Due to the multiple benefits that SPACs offer, they can be an attractive alternative to the above-mentioned options.
SPACs seem amazing! What’s the catch?
Despite all the glitter, SPACs aren’t gold. They have a dubious reputation when it comes to fraud. Take, for example, the infamous case of Akazoo, the Greek streaming company listed on the markets in 2019. A short-seller named Gabriel Grego did some digging and asserted that the subscriber figures Akazoo provided were falsified. The company’s board launched an investigation, “eventually concluding that the company’s previous management had ‘participated in a sophisticated scheme to falsify Akazoo’s books and records,’” including the documents that had been given to the acquiring SPAC, according to the Financial Times.
Another analysis by the Financial Times of the SPACs from 2015 and 2019 found that the majority of the SPACs trade below their original price of $10 a share. And these aren’t very reassuring, or confidence-inspiring stories.
The bottom line
There are a lot of ways the events can unfold in this rapidly evolving story - the two most famous contenders being the SPAC boom emerging as a safe and sustainable bet or it ending in a bubble burst.
All we can do is wait, and watch how these SPACs unpack.
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