SPACs: Big winners of 2020?IPOs

Nowadays people interested in Business and Markets hear the word SPAC more often than not. Anyone who is someone in the Business and their first cousins are launching this strange vehicle and raising millions of dollars from the public markets. The Wall Street Journal dubbed 2020 as the year of the SPACs.

Source: Cantor

So what exactly is this all about, why is everyone going gaga over this route of getting into the public markets over the traditional IPO method.

What is a SPAC?

A special purpose acquisition company (SPAC) is a “blank check” shell corporation designed to take companies public without going through the traditional IPO process.The SPAC IPO has been around since the 1990s, but the surge in popularity is more recent.

In the 1990s, the SPAC had a reputation for taking small, immature companies public for a large fee, leading to high rate of company failure and lackluster stock performance which created a bad reputation among investors.Regulations enacted in the 2000s helped to bring SPACs back into the spotlight, but lost traction following some high-profile failures in 2008.

How the SPAC Process works?

Step 1: The sponsor — typically a person or team with significant Industry or Finance experience — decides to launch a SPAC.

Step 2: They create a holding company, then complete the normal filings associated with going public — but because the company doesn’t have any operational business, the filing process is fast and easy.

Step 3: The sponsor then goes on a roadshow, similar to traditional IPOs, to try to find interested investors. The difference here is that they are selling themselves, their team, and their experience, rather than a specific company.

Step 4: Once the sponsor has attracted enough interest from investors, they sell units in the company. Units are typically $10 each, and represent one share of the company and a warrant to buy more shares in the future. The money raised from the IPO is put into a trust, and is untouchable until the shareholders approve the acquisition transaction.The money can only be invested in US treasuries.

Step 5: The SPAC goes public and trades on an exchange like any other publicly traded company. The retail investors can now purchase shares on the open market, but the future acquisition is still unknown. Instead, these investors are buying on the strength of the sponsor or the promise of a strong future target acquisition.

Step 6: Once the SPAC is public, the sponsors start the sourcing process. There are no restrictions on the type of company a SPAC can acquire, though many will highlight a target industry before IPO in the prospectus.Typically, the sponsors have 2 years to find and announce an acquisition, or else the SPAC will dissolve and shareholders will get their money back.

Step 7: After the sponsors find a company, they then negotiate the terms of the acquisition with the target company. After both the parties agree to the terms, the “de-SPAC” process begins.

Step 8: The sponsors then propose the acquisition target to shareholders. The initial shareholders have the opportunity to vote on the acquisition, which gives them some recourse if a sponsor chooses a company they do not like. Even if the acquisition is approved, shareholders can then redeem their shares for their money back.

Step 9: Once the company is approved and all redemptions have been completed, the sponsor can move forward with acquiring the target company.However, the initial SPAC IPO raise usually covers 30-40% of the purchase price. The sponsors typically go to existing institutional investors (like large funds or private equity firms) or new outside investors for additional money through a transaction termed as a Private Investment in Public Equity (PIPE) transaction.

Step 10: Following the final capital raise, the SPAC can now take the target company public. Even though the SPAC is already public and has filed with and been approved by the SEC, the target company also needs to gain approval from regulators. Once approved, the ticker on the exchange changes to reflect the name of the acquired company and it starts trading as a typical public company.

Why are the SPACs doing so well now?

In the last couple of decades due to injection of record private capital, companies preferred to stay private and kept rotating from one Venture Capital to another and then to Private Equity firms and repeating the same there. Low interest rate from the Federal Reserve with cheap money available there was no need to go Public.

Now, the Covid-19 pandemic has injected uncertainty into the market.Private companies are reportedly less sure that they’ll be able to raise large rounds in the near future, but still need access to capital. Thus they have started looking towards the public markets.

However, given the volatility of public markets, the traditional IPO is less enticing, as companies have less control over how much money they are able to raise. The traditional IPO also takes years to complete, and the pressure to go public is pushing some companies to explore faster alternatives.

Benefits for Companies:

1. Speed: The traditional IPO is very slow and can take many years from start to finish. The SPAC merger process is much faster for the target company, taking as little as 4 to 6 months. This is attractive for companies looking to raise money and go public quickly.The company needs to be IPO ready to complete all legal and regulatory requirements in a short span of time.
2. Certainty: In a typical IPO, the company’s share price is not certain. It is determined by investor appetite and market forces as much as by the company’s underlying business valuation. Further, the traditional IPO price is determined by the IPO bankers, who often price it lower to appeal to institutional investors. A SPAC transaction is appealing because it avoids price uncertainty altogether. The company management team is able to negotiate an exact purchase price, ensuring that the company doesn’t leave any money on the table, though it pays a price for this certainty the valuation received may be lower than a company could receive through a traditional IPO, and the sponsor fees add additional costs.
3. Strategic Guidance: Strategic SPACs use sponsor experience and knowledge as a selling point for potential companies. This appeals to management of the target companies as they could learn from the guidance of the SPAC sponsors.

Source: The New York Time EY report

Benefits for Investors:

1. Limited Risk: Investors can redeem their shares if they are unhappy with the acquisition decision, and get their money back if a company isn’t purchased within 2 years.
2. Additional Profit opportunities: Pre IPO investors receive warrants, which allows them to buy more shares after the target company is announced for only slightly more than the initial purchase price. This provides opportunity to profit if the target is a solid company.
3. Retail Investors can invest: Retail investors are not allowed to participate in primary offerings in the IPO process but in SPACs they can buy shares of the SPAC and benefit from a pop up if the target does well post merger.

Benefits for Sponsors:

1. Easy access to capital: The SPAC process is relatively simple and faster in comparison to say starting a new Venture Capital or Private Equity fund.
2. Huge upside: SPAC sponsors normally receive 20% off the SPAC post IPO for a paltry sum. This can translate into huge gains even if the target company doesn't do very well post merger.
3. Manage public firms - Sponsors often end up getting board seat at the target company and thus help drive strategy in the new public company.

Challenges and risks of a SPAC:

1. Negative Stories: For a struggling company, a SPAC may provide a temporary lifeline that’s faster to access than the public markets. But due to their historical baggage of failures one bad story in the press could worry investors. For example the electric car company Nikola went public through SPAC without any revenue and saw a massive spike in share price post IPO leading to a SEC investigation.
2. Bear Market: No one knows how the SPAC world would be in a recessionary or bear market territory. Target companies could go for traditional IPO in such cases.
3. Post-Pandemic Normal -  In a post pandemic period SPAC could face greater scrutiny and competition. Direct listing if allowed to raise money could pose a challenge to SPACs.

Conclusion:

1. The future of the traditional IPO is not as gloomy as the current scenario shows. Some high-profile companies that are looking to go public in the coming years have rejected the SPAC option, opting instead to go public the traditional way. For example, Airbnb was reportedly approached by Bill Ackman’s $4B SPAC, but the company ultimately decided against this route, instead filing a traditional IPO for December 2020.
2. Today, sponsors are the big winners of the SPAC boom. However, as SPACs get more popular, sponsors also have more competition for deals, which could force sponsors to be more company- friendly to entice potential acquisition targets. For example to try to remove these incentives, Ackman forfeited the 20% founders shares. He also claimed that his hedge fund, PershingCapital, would invest $1B+ of its own capital to complete the merger. The IPO was very successful, with about 3X more interest in the offering than was available.