After more than two decades of being the “red-headed stepchild” of the IPO market, SPACs became an overnight sensation in 2020 and the first quarter of 2021. Investors were buzzing about them. Wall Street firms were minting money on SPAC IPOs. The Reddit bros of wallstreetbets were “riding them to the moon.”
In 2020, 248 SPACs raised $83 billion in initial public offerings (IPO) compared to a total haul of just $3.5 billion in 2016. The momentum continued in 2021, as 378 SPACs have raised another $115 billion, far outstripping the $85 billion raised by 236 companies with actual operations thus far this year. How is it that SPACs, which are essentially empty shells loaded with cash in search of a promising business, have become the darlings of Wall Street? And is the dominance of the SPAC a sustainable trend or a fleeting feat of financial engineering?
Crocker Coulson, an expert in the capital markets from Brooklyn, New York, explains how SPACs work, identifies some recent trends in the sector, and how the regulation of SPACs may influence its future.
What is a SPAC?
SPAC stands for Special Purpose Acquisition Company. A SPAC is a “blank check” entity that exists only to purchase private companies seeking to raise growth financing and achieve public status. SPACs are organized by “sponsors” who must put up the funds to cover the costs of going public and, in return, receive shares equivalent to 20% of the capital raised. However, these “promote shares” only have value if the SPAC completes a merger – otherwise, they expire worthlessly.
SPACs will often identify a sector or geographic region where they seek out merger targets but are not constrained to go outside those areas. And SPACs cannot engage in any merger discussions or choose their merger partner before the IPO. Hence the term “blank check” offering. Investors are literally giving sponsors a bank account to hunt for the best deal. The only catch is that if SPAC investors don’t like the deal presented to them, they can ask for all of their cash, which is held in trust, to be returned with interest.
Advantages of SPAC Mergers
For a private company, the advantage of merging with a SPAC is that a high-growth company can often access more capital via the public market, especially if they have already done multiple rounds of venture financing. Existing shareholders may also pressure management to provide them with an exit, especially if their venture fund is reaching the end of its life. Management may also retain more control of their business through a public listing instead of private equity transactions that can come with board representation requirements and onerous terms.
Relative to a traditional initial public offering (IPO), SPAC mergers have the advantages of speed and certainty of execution. A SPAC merger can close in four months versus nine months to a year for an IPO if a company is well prepared with audited financials and robust forecasts. Targeted companies negotiate their valuation and minimum cash requirements directly with the SPAC sponsor, rather than relying on the whims of the market down the road.
In almost all cases, SPACs will also seek to raise additional funds through a PIPE, or private investment in public equity, in which large institutional funds or strategic investors commit to putting additional funding into the deal. This helps to upsize the proceeds for cash-hungry companies and provides a minimum amount of committed capital at the closing of the merger. SPACs have proved particularly attractive to companies in frontier industries like electric vehicles, space travel, and artificial intelligence that must make considerable investments to realize their vision to transform industries.
Once the PIPE investors have been secured, the SPAC will make a public announcement presenting the new prize to public markets for inspection. If investors like the company’s prospects and think it is reasonably valued, the stock price may shoot up, which provides a solid indication that all the money in the SPAC will stay in the deal, and the company will reap the entire proceeds. If the stock trades down after the deal is announced and falls below the $10 threshold of the cash in trust, this suggests that the SPAC may experience significant redemptions, and the stock price may crash after the merger closes.
Successful SPACs must present a very compelling investment story when they first announce the deal and then create a stream of ongoing rich investor communications up until the day of the shareholder vote to maintain interest in the story.
Increased Regulation of the SPAC Market
One of the major forces in the surge in SPAC activity is that investment banks like Goldman Sachs, Citigroup, and Credit Suisse have all become significant players in underwriting SPAC IPOs. In addition, many top private equity firms and venture capital luminaries have launched their SPACs, further validating that the product has gone mainstream.
However, with the opportunity to make tens of millions of dollars on a single deal, SPACs have also attracted their fair share of snake oil salesmen and unscrupulous operators. High-profile SPAC mergers, including electric vehicle companies Nikola and Lordstown Motors, Chamath Palihapitiya’s Clover Health, and healthcare company MultiPlan have been accused of omitting essential information or even engaging in outright fabrication in their investor disclosures.
The SEC has shown increased concern over the sheer volume of SPAC deals and the potential for retail investors to lose money in deals that may have conflicts of interest. The Commission issued an investor alert urging shareholders not to rely on the involvement of celebrity SPAC sponsors – such as Serena Williams, Jay-Z, Shaquille O’Neal, Alex Rodriguez, and Colin Kaepernick — when considering the soundness of purchasing shares.
More recently, the SEC’s acting director of corporate finance sounded the alarm about the financial projections that some development stage SPAC deals use to forecast massive growth in revenues and profits in the years to come. SPAC mergers should not assume that they are immune from legal liability if these predictions turn out to be overly rosy, he said, countering the assumption that such statements were protected by the “safe harbor” that enables operating public companies to present the economic assumptions used when they make an acquisition. As if to drive the point home, a few weeks later, the SEC engaged in an enforcement action against a SPAC called Stable Road Acquisition Company that proposed to merge with a space transportation company Momentus, but neglected to disclose that its recent rocket launch was a failure and its CEO had a background that would prohibit the company from winning government contracts.
SEC Commissioner Gary Gensler spelled out that SPACs needed to be held accountable for disclosure lapses: “This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors.”
The Future of SPACs
While it is unlikely that SPAC IPOs will sustain the blistering pace of the first quarter of 2021, the transaction structure is very well suited to companies with specific characteristics. It offers rich rewards for dealmakers who can source and structure a winning business combination.
Although regulators are rightly concerned that SPACs have the potential for abuse by bad actors, the market seems to be in the process of sorting out substance from hype. Decisive enforcement actions where SPAC sponsors issue fraudulent information or fail essential due diligence, be more effective in reforming the market than new regulations.
On the positive side of the ledger, SPACs have democratized the investing market in several important ways:
- SPACs provide retail and small investors with an opportunity to invest in late-venture-stage enterprises that previously were the exclusive preserve of the most significant venture and cross-over funds.
- SPACs have encouraged companies to publicly share their long-range business strategy and financial models in a manner that is only made available to privileged institutional clients in a traditional IPO.
- SPACs have single-handedly reversed the long-term decline in the number of public companies due to industry consolidation and the loss of mid-sized underwriters in the IPO market.
- SPACs are pumping significant amounts of fresh capital into industry sectors that are likely to be at the center of the next evolution of our economy, with innovative products and business models that might otherwise be starved for funding.
With all those positives comes one crucial caveat. Development stage companies, even the supersized ones that make up many prominent SPAC mergers, come with the potential for both home runs and catastrophic failure. Venture capital funds recognize that most deals they invest in will not work out, but they rely on 20% of their positions to produce 90% of their returns. While SPACs may provide an exciting enhancement to investing, they are not suitable for the core retirement nest egg.
Crocker Coulson believes that SPACs will be a permanent part of the investment landscape. This uniquely flexible vehicle will continue to evolve in response to the financing needs of companies and investors’ attraction to their unique blend of the safety of capital before the merger with the opportunity to participate in the next enticing deal.
Interesting related article: “What does M&A mean?“