Special Purpose Acquisition Companies (SPACs) have gone through a few boom and bust phases. When capital is cheap and plentiful, SPACs are fashionable. When capital dries up, SPACs are the object of scorn.
SPACs provide a different avenue for a company trying to go public. SPACs put a reverse spin on the conventional IPO model for raising money. In a regular IPO, a company raises capital for its business. For a SPAC, first you raise the money, then you buy a business.
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What’s a SPAC?
SPACS are shell corporations designed to take companies public. They are also called “blank check companies” or “blind pools.”
SPACs have a simple model: raise funds from the public markets as a shell. The money raised goes into a trust. The shell goes public just like any other company does. Then it finds a company to merge with. When the deal closes, the acquired company becomes publicly traded.
When they announce the merger, shareholders can either accept stock in the new company or redeem their shares at the original price of the offering (normally $10 a unit). Once a SPAC goes public, it typically has 24 months before it has to buy something or it must dissolve and return the money to investors.
How does it work?
I don’t want to bore you with the in-and-out of a SPAC. But if you understand the basics, you can see where the incentives lie, who benefits, what’s in it for investors, and what are the risks and opportunities.
Let’s take it from the founder (also called the sponsor) of the SPAC’s point-of-view.
Let’s say you wanted to form a SPAC. You (the sponsor/founder) would create a company, file to go public, find investors for $10 a unit (plus a free warrant), then the SPAC goes public and you keep 20% of the shares as a fee, called a “promote” or “founders shares. You have two years to find and complete an acquisition. Once a target accepts a deal, shareholders vote and agree to buy the company. The acquiree is now publicly traded and anybody can buy and sell units of the SPAC. Normally the unit price gravite around $10, the equivalent of the money in the blind trust.
However, the initial SPAC raise usually only covers about 25-35% of the purchase price. Here, the sponsors can ask existing institutional investors (like large funds or private equity firms) or new outside investors for additional money using a Private Investment in Public Equity (PIPE) transaction (they sometimes join in at a discount, e.g. $8 per share).
In addition to buying units, as a form of incentive, the investors in the SPAC normally get an out-of-the-money warrant to buy more shares in the future. The money raised is put into a blind trust, and is untouchable until the shareholders approve the acquisition transaction. The idea is that the sponsor doesn’t get to blow the money away while shopping for a company.
The SPAC’s promoters are incentivized to close a deal. If they don’t, they stand to lose millions ($2-$10 million on average) that they spent to set up the SPAC. Of course, if the founders do strike a deal, they stand to make several times their money on paper because of how the deal is structured.
Why would a company merge with a SPAC?
A private company looking to go public can decide to go down that route instead of a traditional IPO. A SPAC is a fast-lane strategy that speeds a listing while avoiding the usual disclosure requirements that come with an IPO. Going the traditional IPO route is time-consuming and expensive. Plus there’s no guarantee of success. With a SPAC the deal closes faster.
That approach was adopted by QuantumScape, a tech startup that claims to have a superior EV battery, decided to merge with SPAC Kensington Capital Acquisition Corp. At the time of the announcement, all we could do is trust the claims of the company and its partners. In this case, QuantumScape didn’t have any revenue, didn’t forecast any revenue for many years, and we have no evidence of a product. They are asking for blind trust. That’s a hard sell if you are trying to do an IPO. Considering what we know, we can see why merging with a SPAC is preferable than an IPO route.
SPACs get around the idea of listing requirements. It’s a backdoor way of getting listed and as a result have historically had a sub-standard reputation. It leans more on the speculative side.
Why would investors invest in a SPAC?
It’s been explained that a SPAC is a blank check company because investors “blindly” provide the money. Investors don’t know what the SPAC will buy, or if it will even find a deal to close. So why invest the money in a SPAC?
It’s possible that the sponsor has a very good track record. It could be that the sponsor has a history of superior post-merger performance. They have a knack for finding great businesses and they stick around to operate them. Some have less dilutive terms such as skipping the “promote”. The combination of a great sponsor with a great business might work out in the long-run. But this is more the exception than the norm.
Even if you find that high-profile sponsor, there’s no guarantee the investment will work out.
Famed investor Howard Marks from Oaktree Capital has a couple SPACs and I’m sure he would be an amazing investor to partner with. But his first SPAC is struggling and he’s trying to close out the second deal as I’m writing this. Bill Ackman has a $4 billion SPAC and he might have to liquidate. Reid Hoffman, co-founder of LinkedIn, had completed 3 SPACs out of 4 and all of them are in the tank. They are all trading at a fraction of their nominal value of $10.
A possible opportunity is looking into these crapped out post-merger SPACs on the cheap. Maybe the company wasn’t worth $10, but at $1.50 a share? You have to value each business individually.
It also seems that the real money is in shorting the post-merger company. Post-merger companies are particularly attractive to short because they have larger market capitalizations, making their shares easier to borrow, and because early investors in the SPACs are eager to sell shares to lock in profits.
Most SPAC investors that make money are mostly exploiting the SPAC structure and don’t stick around for the post-merger business. SPAC investors have rights that work in their favor. A big part of the current SPAC trade is the “riskless” yield play supported by the ability to redeem at $10 in advance of the deal vote. If a SPAC can’t find a deal, it liquidates and returns all IPO proceeds ($10 + interest) plus a free warrant option.
Another opportunity is when SPAC shares fall below their nominal value. SPAC shares maintain their $10 nominal value. But sometimes they fall below $10. The play is to buy the SPAC at low prices then either selling if shares rise, withdrawing before a deal is completed or getting their money back if no merger is done.
Investors are protected by the right to withdraw. Throughout the whole process, they can sell warrants or hold on to them. It can be seen as an alternative to bonds.
Basically it’s more about taking advantage of the SPAC structure than the post-merger business.
SPAC or IPO?
It depends. Each company is different. If a private company is exciting and needs funds for growth, a traditional IPO might be preferable. The process will give the company visibility and the ability to raise a lot of money. If the IPO market is cold, a SPAC will bring greater certainty of a deal. Also the opportunity for strategic partnership can be interesting. But as I mentioned above, a great sponsor doesn’t guarantee success.
There’s also less restrictions if you go the SPAC route. If a company goes public with a traditional IPO, there are restrictions on what you can say about future prospects. It’s a disadvantage if you are a young high-growth innovative company without much of an operating history.
The rules are different for a SPAC. A company with no revenue can make forward-looking statements, project outrageous kinds of metrics, and make outlandish claims. You can talk about the vision for the future. However, at the moment the SEC is looking into cracking down on the ability of companies merging with SPACs to make forward projections without suffering any legal consequences (safe-harbor protection, which limits the ability of investors to sue over financial projections).
IPOs do not have that safe-harbor protection, so they do not make forward-looking financial projections in their prospectuses or for 40 days after shares start trading.
SPACs are often explored by VCs and startups that would like to go public but don’t want to pay the expensive fees associated with traditional IPOs. SPACs have been considered an inferior way to go public. But they are a quick way to go public. You skip a lot of the traditional IPO steps.
I believe that a traditional IPO or direct listing is better for a company that needs to raise money. Going the IPO route has flaws. It’s slow and expensive. But there’s less financial engineering and more shareholder friendly.
Who Benefits?
The usual suspects: bankers (twice, as the underwriter and advisor), lawyers, auditors, sponsors. The stock exchange also benefits from having more companies listed. Listed companies pay a one-time listing fee and then a recurring annual fee.
Risks
Investors in SPACs don’t know what their money will be used to acquire. The investor does get his money back if there’s no deal, but the investor could have invested his money elsewhere during the time the SPAC was looking for an investment.
Some critics say investing in these so-called blank-check companies isn’t worth the risk. I’m with the critiques. SPACs have a negative reputation. There is this perception that companies that merge with SPACs weren’t good enough to go the IPO route. They were either small or immature.
When I read a SPAC announcement I’m skeptical of the company’s chances for success in public markets. The large majority of SPACs have been lousy investments. Many individual investors take losses on SPACs, while insiders benefit from discount stakes. The chart for almost every post-merger SPAC resembles a pump-and-dump.
The incentives are geared towards getting a deal done and not on finding a great company (a great company wouldn’t generally go the SPAC route). If the merger window is closing, many SPACs pursue low-quality companies to take public at improper valuations to stave off possible losses. The idea is that a bad deal is better than losing the millions in set-up fees.
You also have a lot of dilution when merging the SPAC with the target. When a merger occurs, dilution arises from the “promote”, that is paying the sponsor’s fee in shares (about 20% of the equity). Unfortunately there is no minimum return that investors in the SPAC must get paid. There’s also dilution from investors exercising warrants. That nominal $10 per share often becomes less than $7 per share after considering various forms of dilution.
Remember that SPAC shareholder right where you can vote for the merger deal but sell out on the announcements and get their money back (redemption). Well most investors are doing just that. High redemptions say the deal is not attractively priced. In the majority of SPACs, the valuations are not sustainable. The rising level of redemptions leaves the funding for the merger deals almost entirely up to PIPEs. Without these investors, deals aren’t getting done. If you find institutions to validate the transaction and its valuation, then any other investors may choose to leverage that due diligence to get comfortable with committing capital to it. But you are better off doing your own research. An institution’s commitment is not exactly a stamp of approval.
Summary
Most smart investors stay away. It’s just not worth the trouble. At its core a SPAC is a bag of money looking for a deal. While most SPACs should be painted with the same brush, they are rare exceptions. A promoter with a great track record and good terms is the gem in the trash can. Having said that, caution is warranted. And in terms of investments, there’s probably something better to do with your money. If there’s not, you are not looking hard enough.
