With the SPAC market red hot in 2021 and the largest ever SPAC announced yesterday (Softbank-backed Grab valued at ~$40 billion), we sat down with one of our coaches on OfficeHours to get his view on the alternative IPO vehicle.
What is a SPAC?
Special Purpose Acquisition Corporations, commonly known as SPACs, are all the rage in the public markets. Today, they are seen as the latest and greatest way for companies to go public without the typical IPO. The modern day SPAC was invented in 1993 by David Nussbaum, a banker, and David Miller, a lawyer, as a way to give private companies access to public investors. In 2020, almost 250 SPACs IPO’d, raising $83.4bn. Through March 2021, $99bn has already been raised from 300+ SPACs.
SPACs are blank-check vehicles that raise money from investors in a public offering, put the money in a trust, and eventually use the funds to buy a stake in an existing private company. The SPAC merges with the target (known as a “de-SPAC”) and takes it public. For the target company, this can be seen as a faster and easier alternative to a traditional IPO. The company can avoid IPO costs and a lengthy process, including a roadshow. Additionally, since the transaction is a merger, the company is not subject to the same SEC regulations and therefore can provide investors with forward-looking statements that would not be allowed in a typical IPO. Lastly, the price is pre-determined between the SPAC and the target, giving the company far more certainty in pricing.
How do SPACs work?
A sponsor creates a SPAC through a traditional IPO process. No target is identified at this point and the S-1 typically provides the credentials of the Sponsor, industries of focus, and details on the structure. Initial investors in the SPAC are a combination of institutional investors and retail investors. The initial offering consists of a combination of common shares and warrants sold together as a unit (discussed in more detail below). Importantly, most SPACs provide the Sponsor a 20% ownership stake in the SPAC for a minimal investment ~<$50k. This “promote” often comes in the form of a different share class with substantial voting rights. This promote is not subject to any hurdles and vests upon IPO. The sponsor will usually purchase a large amount of warrants as well.
Post-IPO, the SPAC becomes a publicly-traded company. The funds raised are held in a trust and managed by the sponsor. Typically, the SPAC has 2 years to close an acquisition. Otherwise, all funds are returned to investors and the SPAC is shut down.
After a target is identified and agreement signed, the deal must go through shareholder approval. Additional capital is often simultaneously raised through a PIPE from institutional investors. If approved, the merger occurs and the new company begins trading (under a new ticker). SPAC acquisitions are usually minority deals, with an ownership interest of ~30-40%.
Source: SPAC Insider
What are SPAC investors buying?
In its IPO offering, SPACs issue units (usually priced at $10), which consist of a common share and a fraction of a warrant (typically 1/4 – 1/3, with a strike price of $11.50). Post-IPO, these units trade on the public markets and can often rise above the IPO price, signaling confidence in the Sponsor or rumors of an upcoming transaction. At some predetermined point, the shares and warrants will start trading separately on the market and investors can buy/sell shares or warrants individually.
There are two important features that are unique to SPACs and impact how transactions work. The first is that after a target is identified and prior to close, all common shares are redeemable at the issuance price plus accrued interest. That is, after a SPAC announces a target, investors are able to decide if they want to hold the common shares through close or redeem. Though limited data exists, anecdotal evidence suggests that a large percentage of common shares are in fact redeemed. If a shareholder buys a unit at IPO for $10 and receives 1 common share and 1/4 of a warrant, the shareholder is able to redeem the common share for $10 and is left holding the warrant at no cost. Second, warrants are callable by the target, typically if the share price exceeds $18/sh and subject to other restrictions.
Once we account for IPO expenses and the sponsor’s promote, a common share is worth substantially less than the $10 issuance price. If the SPAC sees a high level of redemptions, then the remaining shareholders will bear a disproportionately large level of these costs, further reducing the value of a share.
Due to many of the reasons outlined above, the sponsor will raise a PIPE simultaneous to a transaction closing. These PIPEs are funded by institutional investors, who are the real gatekeepers to a SPAC’s success. If the sponsor is unable to raise enough PIPE capital, the entire SPAC and potential transaction is at risk of failing.
With the astounding number of SPACs created in the last year, and everyone from Bill Ackman to Jay-Z and A-Rod getting involved, they will be the center of attention for the next few years as they try to find acquisition targets. As competition heats up, SPACs are fighting to differentiate themselves and unique structures, particularly lower promotes, have started to pop up (see Ackman’s Pershing Square Tontine Holdings SPAC).
Large numbers of hedge funds, which have since been dubbed the SPAC Mafia, have been incredibly active in buying SPAC IPOs. However, evidence suggests that the SPAC Mafia frequently redeems their common shares, choosing instead to hold cost-free warrants, and increasing the amount of PIPE capital needed to cover the redemptions.
As more SPAC mergers close, investors are closely watching the impact on the PIPE market. Will there be enough PIPE capital to support all of the new and upcoming SPAC activity? Will PIPE investors be more discerning than SPACs and their public shareholders?
Yet despite all this hype, SPACs have not yet proven that they can outperform the broader market. $SPAK, an ETF that tracks both pre- and post-acquisition SPACs, has underperformed the S&P 500 significantly over the last year. Are SPACs a bubble? Or will we see continued demand from sponsors, targets, and investors?