By Zaiim Fiaz Premji and Lucas Rimmer
Last year was notoriously damaging to people’s way of life with lockdowns throughout the world greatly restricting mobility. Despite this, markets soared after the initial COVID-19 wave in March 2020 with the S&P 500 reaching record highs. Additionally, the number of private companies merging with ‘Special Purpose Acquisition Companies’ (SPACs) also rocketed with 248 SPAC IPOs in 2020 versus 244 in the previous 12 years according to spacdata.com, making up around 50% of the IPO market share in 2020. This article aims to shed light on SPACs and their recent surge, why private companies are turning to SPACs to enter public markets and what the future could hold.
What is a SPAC?
SPACs, often referred to as ‘blank-cheque companies’, are shell companies created by ‘sponsors’ with the unique purpose of taking a private company public through a direct listing. Sponsors, often private equity firms, create a shell company and pay a nominal price for founder shares after which they are entitled to around 20% of shares. This initial stake is diluted upon the merger as the shares are combined with those of the target company. Sponsors use their initial investment mainly for operating costs while they find investors for the SPAC IPO. Due to the nature of shell companies, the process to take SPACs public is a quicker process (around 8 weeks) than companies with traditional operating activities. At the time of the offering, investors buy ‘units’ in SPACs for traditionally $10.00 each. Units consist of common stock and a fraction of a warrant. The search for a private company begins with the typical timeline being 2 years (this can be extended with the agreement of the shareholders). If the SPAC does not find a private company to merge with, it is dissolved and investors funds are returned.
However, if the sponsors find a suitable target, negotiations begin and after shareholder’s approval the SPAC merges with the private company, taking it public (known as the De-SPAC phase). After this process, the company the SPAC merged with is a publicly traded company with a price typically starting close to $10.00 a share. Within four days post-merger, a Super 8-K form is filed with the Securities and Exchange Commission which contains specifics regarding ownership and control of the company. They have ranged in value from less than $50 million in capital to $4 billion. (Bill Ackman’s Pershing Square Tontine Holdings Ltd.)
Advantages of SPACs over IPOs:
While SPAC activity during 2020 is hardly attributable to a single common motive, SPACs offer a plethora of advantages for target firms and investors alike. As Nate Nead from Deal Capital Partners, LLC pointed out;
Looking from the perspective of the investors:
- Stocks and warrants can be traded whilst looking for a private company to merge with and this enables investors to mitigate loss and sell their stocks.
- Warrants in SPACs offer investors compensation for investing in the SPAC and can result in healthy gains when the merger occurs.
- Investors funds are placed into escrow immediately, in turn limiting the downside risk. In the case a deal is not agreed upon in the 2-year period, investors funds are returned to them and if a deal does materialise, the risks are protected.
- The flexibility SPACs offer investors is also significant as investors can opt out of any deal and receive a reimbursement of their funds and this ability contradicts sharply with the ‘blind pools’ in venture capital whereby investors have no say in where funds are directed.
From the perspective of target firms:
- Public companies generally trade at higher multiples allowing the firm being taken public to receive a higher valuation and hence it can become more attractive.
- In addition, traditional IPOs can take many years to finalise with high costs, but SPACs require only 2-3 months to IPO and are a lot cheaper for the target company as the SPACs often accept the cost burden allowing the firms to deploy money in its business operations.
- The IPO price is agreed upon before the merger and so there is certainty and clarity for the target firm as well as SPACs generally being quicker and cheaper.
What does the future hold for SPACs?
2020 was a good year for IPOs, but it was a much better year for SPACs. Traditional IPO deals raised $67 billion, the best year since 2014 whereas SPACs raised about $64 billion – their best year on record. It is hard to predict what the future holds for SPACs for 2021 but as always, market conditions are the decisive factor. A bull market and an improving economy will be beneficial for SPACs. Paul Dellaquila, who runs SPAK, predicts that the profile of SPACs will only increase in 2021 as they are backed by major players. Until recently, SPACs were generally small-cap offerings but with large market-cap firms such as Virgin Galactic and DraftKings going public via SPACs, the instrument came to prominence.
SPACs have been mostly a US market phenomenon. Only 3 SPACs were listed in Europe last year and no SPACs have debuted in Europe in 2021 thus far (CNBC). However, this could begin to change very soon. A number of deals in Europe has not gained traction yet because they tend to be structured differently than in the US. Europe also accommodates far fewer publicly listed technology companies as the US does, making it harder for investors and analysts to draw comparisons and benchmark firms there. London is starting to make a move to change this. The London Stock Exchange is looking to attract more SPACs and thus, contacted law firms and banks to assess whether this is a viable strategy. The British stock exchange has launched a review into its listing rules to try to attract more technology firms to the market.
Why shouldn’t we be too positive about SPACs?
Despite the SPAC ‘frenzy’ over the past year, not all SPACs are successful or even the best route for target companies to go public. A recent study examining SPAC deals, published by Michael Klausner and Emily Ruan of Stanford University and Michael Ohlrogge of New York University in June 2020, found in around “25% of cases the Sponsor’s payout exceeded 12% of post-merger equity compared with a median stake of 7.7%.” However, according to the authors, SPACs led to a 3% decrease in value of the target companies after the first 3 months, 12% after 6 months and 33% after 12 months. Even ‘high-quality’ SPACs such as those run by Bill Ackman, Chamath Palihapitiya and private equity firms performed much better than traditional IPOs over the first 6 months but not after 12 months.
A sobering look at SPACs:
Generally, SPACs have been touted as a cheaper way to go public compared to IPOs, however this is an extremely high-level look and the story is much more complicated than this – at least for investors as highlighted by Alicia McElhaney from Institutional Investor. If SPACs are a cheaper way to go public compared to IPOs, then this is only so because SPAC shareholders are bearing the cost of SPACs and therefore subsidising targets going forward. On the assumption that regulation will soon force SPAC targets to bear the costs embedded in SPACs, we can compare SPAC and IPO costs and how changes to this will affect future lucrativeness of SPACs.
Further, the study of Michael Klausner et al. finds that “direct cost of an IPO is the underwriting fee, which is generally between 5% and 7%.”Adding up to this is the so-called “IPO pop”, an additional and much larger cost of IPOs according to the authors’ data. For example, new issue shares at $10 per share that “pop” to $13 per share on the first day of trading, can be considered to add a 30% premium. Over the years from 2000 to 2019, the average “pop” at offering date has been 14.8% while total IPO costs amounted to roughly 20-22% of the net capital received. Comparing this to the median of 50.4% in SPACs, the latter appears rather expensive. Accordingly, only because shareholders are not fully exposed to the dilution that SPAC structures generate, the cost of raising capital does not appear considerably higher than through traditional IPOs.
However, there are additional benefits often adduced to SPACs making them more attractive than the conventional path to the public market. Among those are a more effective communication of the equity story to investors enabled by the expertise of the sponsor. There is also the possibility to raise capital through a PIPE transaction at the time of the SPAC’s merger. An additional advantages is related to the expected higher certainty of the deal and the price. Nevertheless, as intriguing as this may sound, the same results can be generated even by cutting the costs associated with a SPAC. As the example of Pershing Square’s SPAC demonstrates, there is a less dilutive SPAC structure dispensing with the use of warrants. Similar approaches in a small number of deals could already be observed. Furthermore, given a target, Sponsors could simply focus on the going public process without using the costly structure of a SPAC.
SPACs have come to enjoy popularity in recent times, providing many investors and targets benefits over IPOs. This was highlighted in 2020 as firms looked for alternative ways to go public with the COVID-19 pandemic discouraging firms from going through the traditional IPO route. This trend is expected to continue into 2021 and beyond, but the real growth will come when European markets are able to crack their problem of having much fewer publicly listed technology companies. Eventually, investors might be able to extract the benefits of a SPAC listing by transforming it into a different vehicle that companies can use to go public without having to endure the high costs of a SPAC. Certainly, we are starting to see a shift, especially in the US markets, in the way companies are favouring to go public. As Chamath Palihapitiya puts it: “I think what’s happening in SPACs is really about the dismantling of the traditional capital market with respect to fundraising.”
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References:
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Institutional Investor. (n.d.). SPAC Costs Are “Far Higher” Than Previously Realized, Study Finds. [online] Available at: https://www.institutionalinvestor.com/article/b1pmdfb3gd69pw/SPAC-Costs-Are-Far-Higher-Than-Previously-Realized-Study-Finds#:~:text=When%20a%20SPAC%20does%20go [Accessed 3 Mar. 2021].
Browne, R. (2021). After U.S. SPAC frenzy, blank-check firms eye deals in Europe’s burgeoning tech sector. [online] CNBC. Available at: https://www.cnbc.com/2021/02/12/spac-frenzy-blank-check-firms-eye-deals-in-europes-tech-sector.html [Accessed 3 Mar. 2021].
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Ruan, E., Klausner, M. and Ohlrogge, M. (2020). A Sober Look at SPACs. [online] . Available at: https://corpgov.law.harvard.edu/2020/11/19/a-sober-look-at-spacs/ [Accessed 3 Mar. 2021].
Nead, N. (2014). Advantages of a SPAC. [online] InvestmentBank.com. Available at: https://investmentbank.com/special-purpose-acquisition-company/ [Accessed 3 Mar. 2021].
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