What are SPACs?

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What are SPACs?

The use of Special-Purpose Acquisition Companies (SPACs) as a vehicle for raising funds in the public markets can be traced back to the 1990s. During this time, they were initially used by smaller companies. This allowed such businesses who could not use the traditional IPO, to gain access to the public market. However, their growth journey has not been a smooth one. The tech boom in the late 90s led to a decline in SPAC activities due to increased dependence on traditional IPOs. Later in the 2000s, they were hit again hit by the Global Financial Crisis. This event also led to investors losing a lot of money in mark-to-market losses. Most investors withdrew from SPACs.

However, SPACs later resurfaced, having undergone procedural and structural improvements to protect the needs of the investors. The modifications include the pre-determined acquisition timeframe and the option to vote for or against a proposed acquisition deal. Additionally, the idea of investing the IPO proceeds in a trust account works for the benefit of the investors. These amendments work in favour of the investors protecting their investments by minimising risks of losses. The improvements have attracted various famous entrepreneurs, underwriters and sponsors from different fields of investment. These sophisticated investors have led to an increase in market size and demand for SPACs in the present-day public market. For example, the IPO proceeds from SPACs in the year 2019, in the US alone, were $13.6 billion. This figure represents a large increase from the previous years.

This guide contains an in-depth look into the various aspects of SPACs. Starting from what it means, its formation to the most popular SPACs in operation today.

What are SPACs?

Special Purpose Acquisition Companies (SPACs) are companies formed to raise money from an Initial Public Offering (IPO) for the purpose of acquiring one or more existing companies within a specific timeframe. Such companies lack an operating history. Their sole purpose is to bring together investors who contribute towards a trust fund. Through the investors’ contributions, SPACs are listed in an IPO and the proceeds are used to acquire a private company.

How are SPACs formed?

SPACs are formed by entrepreneurs and sponsors in a particular field of investment. They brainstorm their investment ideas, putting into consideration the future of their industry. Their sole purpose is to acquire a viable asset or company related to their expertise. Since SPACs lack an operating history, the founders use their skills, experience, and contacts to identify potential companies to acquire. The sponsors’ expertise and reputation also attract potential investors. The founders use the Special Purpose Acquisition Companies as the shell company and they become the selling point to help source funds from investors. The starting capital of SPACs comes from the founder’s contributions and this gives them a right to acquire a stake in a company or asset.

Why are SPACs Formed?

They are formed to help the founders widen their investment portfolio by acquiring other companies or assets. When the founders come together to create a SPAC, they usually have an idea of their target company. They, however, do not disclose the details during the IPO process. Due to this failure of disclosure, they are commonly referred to as blank check companies. Investors here commit their funds without knowing which company they are investing in.

How do SPACs Work?

SPACs work as vehicles for individuals and entities to raise capital to facilitate acquisitions. An acquisition here is also called an Initial Business Combination. Through this, the SPAC merges with the target company, a process known as DeSPACing. It may seem unclear how a blank check company with no operational history can successfully acquire a private company. However, there are steps to how SPACs are formed and operated. Here is how they work.

Step One – Establish the SPAC

After the founders have established a SPAC, they then place it under an IPO. It is a basic rule for SPACs not to disclose the details of their target company pre-IPO. After the completion of the IPO, all the proceeds are placed in a trust account. The funds continue to bear interest as long as they are in the trust account. They are only accessible for purposes of completing the acquisition or returning the money to the investors if a target is not found, and as a result, the SPAC is liquidated.

The founders are required to purchase shares at the initial stages of the SPAC registration. They are also required to pay a nominal consideration for the number of shares that will give them a 20% ownership in the outstanding shares post-IPO. These shares are intended to compensate the management team, which is not entitled to any remunerations until after the completion of the initial business combination process.

Step Two – Issuing the IPO

For a successful IPO issuance, the SPAC’s management team looks out for an investment bank which they contract to handle their IPO. The bank charges a fee, usually about 10% of the IPO proceeds. SPACs offer their investors units of common stocks (founder shares) and warrants, which can be traded as separate stock units post-IPO. The warrants come as either a fraction (half, one-third or two-third) of a share or as a whole share.

These warrants are used by investors to get additional common stock in the future. The warrants are exercisable within 30 days after a DeSPAC transaction or 12 months following the successful completion of a SPAC IPO. The prospective investors focus more on the sponsors’ reputation and expertise rather than the company’s history, of which the SPAC lacks. In addition, the sponsor also purchases warrants to cater for expenses related to the SPAC’s IPO, such as the underwriting fee.

Step Three – Acquiring a Target Company

With the post-IPO proceeds now in hand, the SPAC goes ahead to complete its transaction. All the proceeds have a lock-up agreement in which they have to be deposited in an interest-earning account as they wait for the acquisition process to be initiated.

Basically, there is a set timeframe within which the SPAC needs to have acquired the target company, which is mainly 18-24 months. However, some companies may, through a vote by the shareholders, agree to extend this timeframe to suit their needs. If SPAC fails to meet its goal within the specified time, it should liquidate its trust account and redeem the investors’ money plus any interest earned. However, upon liquidation, the founder shares are not redeemable for cash and this motivates the sponsor to find a perfect target company.

After the successful identification of a target company by the sponsor, the shareholders then give their approval to complete the proposed business combination. Investors have a right to vote for or against the merger. Either way, they will still have their right to redeem their common stock. After the completion of the initial business combination, the SPAC offers the investors the option of redeeming their common stock for its original price plus any additional interest or selling it back to SPAC through a tender offer.

If a merger is approved, the sponsor obtains approvals for the required transactions. The merging process between SPAC and a target company is called deSPACing. Generally, the target company’s market value should be 80% more than the trust assets of the SPAC. After a successful acquisition, the founders are entitled a 20% share of the stake, while investors receive interest as per their capital contributions.

Are SPACs an Investment Opportunity?

Due to their rising popularity in stock trading, SPACs have captured the attention of many investors. However, most of them are not sure whether or not to invest in them.

As an investor, you should understand that no new venture can guarantee a 100% positive returns. The same case applies to SPAC investing in that success is no guarantee. However, given the rise in demand, it means that most sponsors will venture into SPACs. This allows you to invest in firms which you would otherwise have not been able to through a traditional IPO.

Over the past two years, the SPACs’ market size has doubled, accommodating more than 20% of the overall IPOs. This trend shows a steady growth rate, which may be used as a forecast of its future. Currently, most high-profile fund managers are channelling their funds toward this investment class. They are mostly attracted by the fact that the risk of losing your investment is minimal if a deal falls through. Therefore, SPACs can play a role in efficient cash management that provide low yield driven returns alongside deal-driven equity optionality.

SPACs are, therefore, a viable investment opportunity for investors.

What are the Risks of SPACs?

No financial instrument is perfect. Therefore, you should expect some drawbacks when trading SPACs either as a sponsor, investor or target company.

Risks Faced by Sponsors

Similar to any other IPO, SPACs face the risk of failed execution if the idea or business is not received as expected. Here, investors may reject a proposed form of a business combination. It is important to understand that sponsors spend a lot of time and resources looking for a suitable target company. Therefore, a rejection by investors means a waste of resources and valuable time. This risk, however, does not occur in standard or traditional IPOs.

Additionally, SPACs can face the risk of management and governance. This happens when the management teams of both parties disagree on the proposed terms. Sponsors are faced with a hard time trying to settle such differences.

Risks Faced by Investors

Investors place their funds in ventures anticipating to get returns within a specific timeframe. However, the fact that money has to lie in a trust fund account waiting for the right target company means that the investors do not get a good return for their money in relation to time. The funds could be generating income from other higher yielding investments.

If the SPACs liquidates and the investors redeem their money, they still stand the risk of losing the long term benefits they had anticipated from the investment.

Risked Faced by Target Company

Trading with SPACs gives the target company, mostly a small private company, a faster entry into the public market. This target company can also benefit from enhanced business scalability and high-end management if the merger succeeds. However, if the investors reject the sponsor’s proposal, the target company risks losing these benefits.

What are the Examples of SPAC Deals in Operation Today?

Over the past years, different industries have managed to undertake SPAC deals that have emerged successful. Some of them include:

Virgin Galactic Holdings (NYSE: SPCE) – This is a company that specialises in the production of spaceflights. SPCE was listed in the NYSE in 2019 after a successful merger with social Capital Hedosophia, a Chamath Palihapitiya’s venture. Chamath Palihapitiya, a venture capitalist, bought about 49% shares of the Virgin Galactic Holdings. During the first day of its listing after the acquisition, the shares closed at $11.5 and have continued to rise since then.

Nikola Motor (NASDAQ: VTIQ) – This merger occurred in June 2020, where it merged with VectoIQ Acquisition Corp. Nikola has been focusing on the production of zero-emission vehicles. After the acquisition, the two companies started operating under the trade name “NKLA.”

Wrap up

Special Purpose Acquisition Companies (SPACs) are increasingly used by companies to gain access to public markets over traditional IPO. Investors also benefit from being able to trade shares in promising new companies. The popularity is linked to the low risk of investment failure and the high Return On Investment (ROI). It is, however, important to note that before investing in SPACs, you should first research and understand how they operate, their benefits as well as the risks involved.