SPACs: fads or future of financial engineering?

In 2020, US markets saw the listing of 248 special purpose acquisition companies (SPACs) outperform traditional initial public offering (IPO) volumes. This represented a combined deal value of $83B, greater than the sum of the last 18 years combined. 

In 2021, SPACs have continued their hot run, with 232 achieving a public listing in the US, totalling $72B. Whilst SPACs as investment vehicles have existed since the mid 1990s, they have seen a recent explosion in popularity, with effects being seen in global markets.

Many will remember Bill Ackman’s Pershing Square Tontine Holdings, which raised $4B in July 2020, making it the largest SPAC deal to date. Many may also remember Virgin Galactic, DraftKings and Nikola, all of which were acquired by a sponsor-led SPAC. 

The emergence of such high-profile sponsors and backers, as well as successful acquisitions of high-profile targets, are fundamental reasons why US markets have experienced such a surge in SPAC volumes as of late. Median deal size is $300M, whilst the sectors gaining most attention from SPACs are technology, media and telecommunications, distantly followed by healthcare and FinTech. When combined, these sectors dominate current SPAC count.

What is a SPAC?

A SPAC is a ‘blank check company’, a corporation with no operations that is listed on a stock exchange for the specific purpose of acquiring or merging with an unknown (and usually private) company. It holds simple assets with low liabilities (if any). The SPAC is typically led by a sponsor, who raises capital from investors in the public market. Fundamentally, to prevent exploitation of backdoor listings, regulators maintain that the target must be identified after the IPO, although a certain sector may be targeted. 

As an investment vehicle, the SPAC has historically been, and remains predominantly so, a US product, but global public equity markets are warming to the idea. Although deal volumes have remained low in the United Kingdom and Europe, Southeast Asian exchanges seem set to explode.

How does it work?

A sponsor will launch their SPAC via an IPO. Investors funds will be held in trust. The sponsor will then have 24 months to acquire a target company, in which at least 80% of the value of the trust must be deployed. The sponsor in some cases may opt to use leverage when deal size exceeds the total funds held in trust. Upon acquisition, the sponsor will generally receive 20% of equity in the merged entity, but will be subject to escrow provisions (lockup of shares) for 12 months. 

Some sponsors will indicate that this period is subject to conditions regarding sustained outperformance, i.e. grant them the option of an early exit should the acquisition be successful. The sponsor will also usually receive special warrants (similar to a call option) that can be converted into common equity if the combined entity’s stock price exceeds certain thresholds. Clearly, the transaction is structured to maximise the sponsor’s potential upside.

However, as part of the standard investor protection regulatory framework, SPAC investors must vote to approve any deals proposed by the sponsor, although rejections are rare. 

If a sponsor has not closed a deal within the 24 month timeframe, the SPAC will be liquidated and escrowed IPO proceeds will be returned to the investors pro rata. Theoretically, the only loss that would be incurred would be the initial 2% underwriting fee, at the sponsor’s expense. Although seemingly a low risk is taken by investors, this has not historically been the case.

Where did it start and where are we now?

SPACs began to emerge in the late 1980s, historically used as investment vehicles for fraud, involving opaque acquisitions of penny stocks, with large commissions taken. There was also significant information asymmetries between investors and sponsors, compounded by lack of investor protection regulation and inefficient markets.

However, in recent times, the traditional IPO timeline has begun stretching further out, and listing requirements have become increasingly more complex, costly, and burdensome. Cleaning corporate structures, stripping the prospective public company of unnecessary liabilities, as well as establishing strict corporate governance and financial reporting standards are only some of the demands placed on the management team and wider organisation. The IPO process itself has also become quite risky, with uncertainty around pricing strategies having huge impacts on exit multiples of existing private investors.

And that gives rise to SPACs. SPACs avoid all substantial issues that a company would typically encounter at IPO. They have particularly gained popularity amongst private equity groups who may raise new funds without dependence on traditional institutional investors, and appreciate the improved flexibility with creative transaction structuring. More importantly, SPACs provide the public with access to private equity investments, which were previously unavailable. 

Who wins?

The main benefits of SPACs offered to sponsors concerns the fee structure. Listing fees paid to investment banks is substantially lower since there is no material risk of underpricing, which also represents the extent of the risk taken by the sponsor. Underpricing is the standard practice of pricing a company’s shares at a discount to their true value at IPO. This is done in order to compensate investors for taking on the risk of an IPO, to increase publicity on the opening day, to increase post-issue trading volume of the stock, as well as to create a cascade effect among informed and uninformed investors who are subject to information asymmetries. Access to public markets also provides a far quicker way to raise funds as opposed to the more traditional method of marketing roadshows intending to pick up clientele such as pension funds, wealthy venture capitalists, university endowments and other large institutional investors. 

Finally, a SPAC may be set up to purchase a portfolio company, in order to provide an alternate exit to IPO. However, to prevent a conflict from arising, independent directors would be necessary, and the SPAC’s prospectus would require quite extensive disclosure.

Fundamentally, investors at a SPACs IPO may theoretically exit at any time by liquidating their shares, taking on slight risk prior to an acquisition or redemption decision. They are also granted access to some of the world’s more notable fund managers, as well as deal flow that would not otherwise be available to them. 

However, investors typically know very little beyond the sponsor’s team, such as the underlying assets to be acquired, the solvency of the target, or future liabilities. Further, especially for smaller SPACs, trading volumes are quite thin, so investments are not as liquid as traditional blue chip public equities. 

There is also, evidently, no consistency in performance against the benchmark NASDAQ. Performance of the SPAC, and subsequent merged entity seems quite dependent on the skill of the management team at orchestrating a successful acquisition on favourable funding terms, and then managing the acquired firm’s profitably as a public company.

There is significant benefit gained by a target firm from going public via a SPAC, principally avoiding pain of a traditional IPO. Although it is uncertain whether, upon completion of the transaction, the sponsor’s 20% equity stake is able to be negotiated down, the risks are still lower than in an IPO.

Criticisms

However, SPACs remain heavily criticised amongst regulators, since they emulate backdoor listings (often called reverse mergers) which are commonly viewed as vehicles for fraud. In a backdoor listing, an already listed company that has typically ceased to trade is put through a corporate restructuring process, to cleanse the entity of liabilities. The residual ‘shell’ company is then able to merge with a privately-owned company, granting the private company access to public markets without the usual listing requirements and complex filings. 

There are also a series of post-closing issues, potentially arising out of mismanagement or failure to effect proper due diligence. Nikola is one such case. It is a pre-revenue, electric truck maker, which went public via SPAC acquisition in June 2020. The company denied reports of fraud issued by short-sellers, Hindenburg Research. Nonetheless, founder Trevor Milton resigned in September 2020 shortly after the Securities Exchange Commission (SEC) and US Department of Justice commenced investigations.

UK Perspective

Meanwhile, as SPAC listings in the US surpass traditional IPO volumes, the UK has not enjoyed such explosive growth. This is principally due to dissimilar regulatory frameworks, and lower risk appetite given historically poorer performance of SPACs in the UK.

Before the acquisition, the UK regulator does not allow for any share redemption arrangements, despite the possibility for a bolt-on feature. 

On the event of the acquisition, shareholders’ approval is not required by the sponsor. This leaves investors with substantially less control and emulates blind pool trusts, which are colloquially recognised as fraudulent investment schemes most prevalent in the 1980s. 

Finally, after the acquisition, shares are suspended until publication of a prospectus, inflating uncertainty. However, recent calls for the loosening of the London Stock Exchange’s listing rules may fuel a SPAC frenzy, despite more embedded structural issues.

Conclusion

SPACs are a fascinating piece of financial engineering, born out of investment fraud in the 1980s and 1990s, but harnessed by tighter regulatory frameworks. Globally, security exchange regulators remain divided on the issue. The US remains the clear leader, as the rest of the world looks on. However, many Southeast Asian exchanges such as South Korea, China, Hong Kong, Singapore and even Indonesia have begun listing SPACs.

The Australian Securities Exchange, however, is yet to show interest in loosening rules to allow for the public listing of SPACs.

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