By Simon Tryzna, Chief Investment Officer
One of the most significant capital market developments of 2020 was the reemergence of Special Purpose Acquisition Companies or SPACs. These companies are often known as "blank check" companies that are created for the sole purpose of acquiring another company. Per SPAC alpha, there were 248 SPAC IPO's last year. For comparison, from 2016-2019, there were only 152. This development continued into 2021, with 296 SPAC IPOs year to date (as of March 29th) and an additional 248 filed to IPO. Chances are you have seen celebrities (Shaquille O'Neal), politicians (former House Speaker Paul Ryan), and hedge fund billionaires (Bill Ackman) decide to "sponsor" a SPAC. From an investment point of view, these investments are appealing because investors can access a privately owned company and even a venture-backed one before they go public. However, there are many nuances to these investments and considerations that need to be made. This is a quick guide on how they work, why companies could choose to go public using this method, and some of its investment risks.
How SPACs Work
A sponsor, or a group of sponsors, creates the SPAC entity and raises capital by selling units of the company on a publicly-traded exchange, typically at $10 a unit. Depending on the terms of the SPAC, each unit consists of a number of shares and redeemable warrants, which convert to shares at a future time at a pre-determined price (effectively a call option). A short time after the IPO, the units, shares, and warrants begin trading separately. The SPAC sponsor covers all of the administrative costs of executing a public listing in exchange for a 20% stake (via "Founder shares"), provided a merger is completed with a target company. This stake is the Sponsor's incentive to sponsor a SPAC and a primary reason for those with name recognition to become Sponsors.
After the SPAC goes public, all proceeds are placed in escrow while the Sponsors begin to look for a company to merge with / acquire. They have a predefined time period to do so, which is often within two years. Should a deal fail to be completed, the SPAC will liquidate, the escrow will return the invested capital to shareholders, and the Sponsor will lose their investment.
Within those two years, the Sponsor will look for a target company – often doing so publicly to increase investor interest. In its investment prospectus, a SPAC may identify an area of the market they will look for a company, but they aren't required to stick to that.
Once a deal has been agreed upon and announced, a record date is set, typically within three months. At this point, large institutional investors may look to purchase equity in the SPAC, driving the price of the publicly trading shares up. During this three-month window, SPAC Sponsors will engage in roadshows (marketing meetings where they meet with large prospective investors) with company management before the record date to give existing investors a better chance to understand the transaction and generate interest in the newly formed company. Within three to five weeks of the record date, the shareholder vote will occur. If the transaction is not approved, shareholders will redeem their capital. If the transaction is approved, the SPAC will close within a week and trade as a newly combined firm, often with a new ticker symbol.
Why a Company Could Choose to go Public This Way.
One of the benefits of the SPAC craze has been VC-backed companies' ability to go public via a SPAC merger instead of the traditional IPO. A couple of big reasons are timing and flexibility.
In a traditional IPO, the company has a long road to market. Between filing to go public, meeting with Investment Banks to begin discussions, doing a Wall Street roadshow to garner last-minute interest, and then going to market, the process could last 6-9 months. In a SPAC merger, the IPO process could be cut half in half.
During the negotiation process to acquire a company, a SPAC sponsor is heavily incentivized to get a deal done. In turn, to take advantage of the Sponsor's willingness for a deal, the acquiree's management company could paint a very rosy outlook of where the company is headed and show optimistic projections. In an IPO, a company cannot make any projections about its earnings as it could mislead investors with unrealistic forecasts. In other words, this could lead to a valuation of a company being higher than how it would have been priced during a traditional IPO. The SPAC and the acquiree would ultimately have their shareholders approve any valuation. In the process, the sponsors typically have more experience than the companies management to drum up Wall Street interest and can better manage communication to the Street and public investors.
Often, we forget that a company's primary reason to go public is to access capital via the public markets to help grow its business. Unlike an IPO, a SPAC guarantees them a precise dollar amount. By going public via a SPAC, a company can quickly access more capital and accelerate its business plans. They can also use the new funding to clean up their balance sheets and pay off existing debts, making them even more attractive to investors. If the Sponsor is well known in a specific industry, they could create new business opportunities for the company, making them an even more attractive investment.
Like any investment, SPACs carry their own set of risks. The best way to think about this is in terms of phases: in the SPAC timeline, there are three phases.
The first phase lasts from the creation of the entity to the announcement of an acquisition company. This is a low-risk phase as shares typically trade at or around $10 a share as the SPAC's assets are sitting in a trust account, invested in short-term treasury securities.
The second phase begins with the announcement of an acquisition target and lasts until the target goes public. Share prices can jump on the news and remain volatile as details get announced, and Sponsors make the case and work on terms. Investors jumping in late could lose a significant amount of money should a deal fall through (or not be voted on by shareholders), and the prices of SPAC shares fall back down to the $10 / share level.
The third phase is the listing of the newly merged company. At this point, the acquiree is now trading on the public markets with its new market cap. As mentioned above, a company may have a very inflated valuation from the get-go and, with subsequent quarterly reports, could see its share prices plummet.
Broadly speaking, investors need to analyze the investment objective of the SPAC and the motivation of the sponsors. The majority of Sponsors have a minimal track record and performance history. Because of that, it is challenging to determine if the SPACs will meet their investment objective. Each SPAC deal is different and needs to be evaluated on its own merit and not in relation to how other similar SPAC deals have performed. SPACs are also competing with traditional private equity investments, which could lead to unfavorable valuation terms.
Lastly, the existence of warrants could significantly dilute shareholder equity. Warrant holders can elect to convert them into shares and help drive prices down (the company's value would stay the same, but since available shares to trade are now higher, the value per share becomes lower).
SPACs are nothing new, as they were popular in the years leading up to the 2008 Great Financial Crisis. However, increased regulation and the success of a few of them in early 2020 have made SPACs into a trendy investment vehicle. However, it is not without its own set of issues. In a very combative piece for the New York Times, CNBC contributor Aaron Ross Sorkin wrote the following:
- "Some have called the SPAC a new, public form of venture capital. That implies big rewards and real risks. Most venture capital deals fail.
- The truth is that SPACs are rife with misaligned incentives between the Sponsor and other investors, particularly those who come after a merger.
JPMorgan Chase crunched the numbers and determined that sponsors, on average, earned a 648 percent return on their money over the past two years. Buy-and-hold-investors who bought in after an acquisition was made — known as a de-SPAC — made 44 percent, which lags the return of a standard market index fund.The misalignments are stark."
While this has great benefits to companies looking to go public and thus benefits the employees who are share/option-holders, it does have the makings of a bubble. Even in his recent earnings call, Goldman Sachs Chief Executive David Solomon said just as much: "You have something here that is a good capital markets innovation, but like many innovations there's a point in time as they start where they have a tendency maybe to go a little bit too far and then need to be pulled back or rebalanced in some way. And that's something my guess is we'll see over the course of 2021 or 2022 with SPACs."
In 2020, fueled by low-interest rates and government stimulus, investors were continuously on the hunt for growth. Now, with higher interest rates and the end of the pandemic ahead, I'm curious to see how the SPAC marketplace is affected. Clearly, it's a very useful tool but, as Sorkin writes, not a very efficient one, and not without its own risks.
If you have any questions or are interested in discussing this in more detail, please don't hesitate to shoot me a quick note.
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