SPAC ATTACK
Out of the 450 IPOs (Initial Public Offerings) that occurred across all US markets in 2020, 55% were Special Purpose Acquisition Company or “SPAC” IPOs. In 2021, the SPAC craze has reached new heights, with SPACs accounting for 78% of all IPOs (SPAC Analytics n.d.). From Fortune 500 CEOs like Virgin’s Richard Branson to professional athletes like Colin Kaepernick, it seems as though just about anyone with a public platform can become a SPAC sponsor regardless of their prior experience in the world of IPOs. So what is a SPAC? Why have they proved to be such a popular solution for companies seeking a public listing? As law professors Klaussner and Ohlrogge put it, a SPAC is “a publicly listed firm with a two-year lifespan during which it is expected to find a private company with which to merge and thereby bring public” (Klaussner & Ohlrogge, 3). The SPAC is championed by many as a “quick” and “cheaper” alternative to the IPO. However, one can argue that SPACs have become increasingly popular not because they provide private companies a robust, easy, and cheap path to public markets, but rather for the financial incentives they offer for the SPAC investors, sponsors, and gatekeepers of the public markets — investment banks.
Before diving into the specifics of SPACs, it is important to understand the alternative, tried and true traditional IPO process. While the answer varies depending on who you ask, most will say that the traditional IPO process takes somewhere in the range of 4 months to a year. The process begins with a company’s courtship of investment banks that would be willing to provide capital markets advisory services and assume the responsibilities associated with “underwriting” the deal. Such banks will perform extensive due diligence on the company and its principals, fully vetting the company’s suitability as an investment opportunity for the public marketplace. If all goes well, the company formalizes its relationship with supportive investment banks, and together they prepare comprehensive disclosure documentation, which must be reviewed and approved by the SEC before the company is permitted to solicit investors and access the public capital markets. Once the company’s disclosure document, or S-1 registration statement, has been blessed by the SEC, the investment bank and company embark on a capital-raising roadshow to gauge investor interest. If roadshow interest is strong, the deal is “priced”. More often than not, companies don’t even get this far, as investor scrutiny or volatile markets can kill even the most promising IPO deals. For those that pass through the gauntlet, the investment bank and company decide on the effective date of the IPO as well as specifics related to the number of shares and the initial offer price. Pricing is largely dependent on the success/failure of the roadshow. Generally, a successful roadshow will result in an oversubscribed IPO, leading to a higher IPO price and potentially more shares offered for sale.
The three main parties in a traditional IPO transaction include 1) the company, 2) the investment bank underwriter, and 3) the IPO investor. The company is incentivized to participate in an initial public offering because it receives cash for the shares issued and sold, allowing it to fund future operations and growth. The investment bank is incentivized by an underwriting fee, typically 7% of IPO proceeds, plus other market stabilization and trading incentives. The IPO investor provides the company with cash in exchange for shares in the hopes their shares will become more valuable at some point in the future. As we will see, a SPAC merger renders a similar end result, however provides IPO investors, underwriters, and a group unique to the SPAC process - “sponsors” - with greater financial incentives.
To reiterate from earlier, a SPAC is a special purpose acquisition company, created as a shell company with a two-year window to identify a target acquisition company that seeks to achieve a public listing. The SPAC company actually comes to life by completing its own IPO, raising the cash needed to support the acquisition of its to-beidentified target company. However, this IPO is much easier to push through the regulatory process since there is no operating or financial history that requires a complicated and time-consuming SEC review process. Much like any run-of-the-mill IPO, management works alongside fee incentivized underwriters to prepare an S-1 registration statement. However, instead of providing specifics on the business, its industry, etc. as an S-1 would do in the more traditional IPO process, this S-1 focuses more on introducing the management team and laying out the terms for investors. Upon completion of a successful SPAC IPO, underwriters earn 2% of the IPO proceeds upfront and 3.5% on the back-end when an acquisition is completed, typically a total of 5.5% of the IPO proceeds (Platt, Henderson, and Aliaj 2020).
In a SPAC IPO, investors generally purchase SPAC “units” for $10 a unit. A SPAC “unit” includes a share as well as a whole or fractional warrant. These warrants are usually exercisable, as whole warrants, at $11.50 a share. One whole warrant gives investors the right to purchase a share at $11.50 for a specific window of time. For example, if an investor purchases 4 SPAC units, with each unit including a share and 0.25 warrants, they have a total of 4 shares and 1 warrant. The warrants and shares, though sold as a unit, can be separated. This allows investors with warrants to participate in the potential upside of the deal without necessarily owning shares in the business. These warrants hold a time value premium, or the trading value of future opportunity, and increase in value as the share price nears or exceeds the $11.50 exercise price.
After the initial raise, the SPAC IPO proceeds are deposited directly into a trust that invests in short-term US Treasury securities. As stated earlier, the management team of the SPAC, or its ‘sponsors’, has a window of two years to find an acquisition. During this period, bankers are often pitching potential candidates to buy, in hopes of generating some M&A-related fees through the deal as well (Platt, Henderson, and Aliaj 2020). If an investment is not found, the SPAC liquidates and returns the invested capital to investors. This is not the ideal situation for sponsors for a variety of reasons. First, sponsors are expected to invest an amount into the IPO equal to the amount of the underwriter fees and legal expenses. Secondly, the SPAC structure positions the sponsors with 20% of post IPO equity or “promote”, which becomes extremely valuable upon completion of a merger. If there is no merger, then the entirety of the cash investment and the 20% promote are lost.
Distinctly different from a traditional IPO, a SPAC IPO gives its investors an opportunity to vote their opinion of the sponsor-selected target company. If investors don’t like the deal, they actually have the option to redeem their shares for a return of their initial cash investment, the full $10 per share, plus a nominal amount of interest income earned from treasury bonds while the investment was held in trust. Even if investors choose to redeem their shares, they still retain their warrants, essentially getting such warrants for free. Because warrants trade in the open market with a time value premium, they almost always carry meaningful value. This means an investor that chooses a total return of their investment still walks away with upside from the warrants. The initial SPAC IPO investment is essentially a risk-free investment that provides reliable upside from the warrants, and possibly greater upside if the identified acquisition is well-received by the public markets (which becomes obvious to the investor if the share price trades higher upon the announcement of the target). The mean annualized return for SPAC IPO investors that redeemed their shares was 11.6% - RISK-FREE (Klaussner and Ohlrogge 2020, 18). The only risk or cost attributed to redeeming investors is the opportunity cost associated with locking their capital up in a trust for a given amount of time. This option to redeem and collect a risk-free return has proved to be a popular play for many investors. The mean and median redemption rates among Klaussner and Ohlrogge’s 2019-2020 SPAC merger cohort were 58% and 73% respectively. The study also found that 25% of SPACs saw redemption rates of over 95%. With such attractive returns and optionality, this is certainly an incredibly attractive investment. Put plainly, the investor isn’t really committing to anything. These characteristics make the investment banks’ initial task of convincing investors to come into the deal all too easy. Through a SPAC process, investment banks earn a 5.5% fee from doing very little work, making the structure all the more favorable from their point of view.
What happens when too many investors redeem their shares and the target businesses’ capital needs are not met? Well, the arbitrage opportunities of the warrants, described above, have made redemption the norm, and not the exception. So investment banks have addressed this reality by inserting another capital raise into the typical SPAC process, an institutional capital raise referred to as a PIPE (Private Investment in Public Equity). Frankly, the PIPE mirrors the traditional IPO roadshow process, where the investment bank presents the deal to institutional investors. These institutions evaluate the merits of the target company’s business plans and decide on what terms, if any, they would like to invest. In 2020, for every $100 million raised through a SPAC, a corresponding PIPE added another $167 million (Picker 2020). The PIPE allows yet another opportunity for investment banks to earn a fee.
If you’re keeping track of the score, SPACs offer (1) sponsors with a 20% promote, (2) investors with an average 11.6% risk-free return, (3) investment banks with a very easy 5.5% of IPO proceeds, plus (4) potential M&A fees, and (5) a fee off the PIPE raise. In other words, the structure provides greater financial incentives for the collective organizers of the SPAC than they could possibly be paid through the IPO process.
Besides these fees and differences in financial opportunities for those involved, what differentiates the SPAC from the IPO? At present, the SPAC does have two regulatory advantages over the IPO. Unlike the traditional IPO process, the SPAC merger process allows for the release of an S-4 merger proxy. An S-4 contains forward-looking statements, allowing investors to gain better insight into how the company might fair in the near future. Additionally, SPACs are insulated from SEC section 11 liability, meaning they don’t face the same lawsuits that traditional IPOs often face when opportunistic (often predatory) trial lawyers look to exploit alleged misstatements or omissions (Huebscher 2020, 3). With so many companies going public through SPACs, many expect the SEC to make changes as it pertains to these differences, either allowing traditional IPOs to publish forward projects or revoke this privilege from SPACs. Aside from these differences, there is not much separating the regulation of SPACs from that of the traditional IPO process. As Ned Goss — a Director at PWC’s Emerging Company Solutions group in Boston and member of Wesleyan’s Class of ‘82 — said in an interview: “the requirements of the company going forward are pretty much the same… you still have to have those same controls and audits.” To put it simply, a few key actions from the SEC could render the SPAC the same as the traditional IPO from a regulatory standpoint. This week, the SEC tipped its hand, indicating its willingness to consider drastic accounting-related rule changes that would materially alter the SPAC structure. In one recently issued SEC bulletin, the SEC seems intent on changing its posture on the accounting of SPAC warrants, potentially requiring such warrants to be treated as liabilities and not as equity securities (SEC, n.d.). This would result in significant adverse impacts to the presentation of SPAC companies’ financial statements. These recent mumblings have put a damper on booming SPAC enthusiasm. Experts suspect the SEC has intentionally created confusion in the industry to slow the SPAC market, allowing the agency to catch up on regulatory audits and governance (Bertoni 2020).
As the SPAC has been promoted for its few technical advantages over the IPO, it will be interesting to see how SPAC popularity fares if and when regulatory guidance eradicates such differences. Will the SPAC continue to thrive, driven by the enthusiasm of its financial beneficiaries, or will the traditional IPO re-assert its place as the capital markets’ gold standard? While it’s hard to predict the future, what we do know now is that SPACs are extremely popular…but it seems they are popular for reasons that have little to do with the companies for which they provide a public path.
Sources
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