The New Kid on the Bourse - Part 1: SPACs

A look at SPACs, advantages, disadvantages and current trends…

Going public is a pretty big milestone for a company. The IPO is the traditional doorway to listing on the stock markets. There’s another avenue, however, that companies are now increasingly choosing to take — merging with SPACs.

What is a SPAC?

A SPAC is a Special Purpose Acquisition Company. As the name implies, it is a company incorporated with the sole purpose of acquiring other firms. A SPAC has no product offerings of its own and doesn’t have any customers. These companies are usually started by experienced and high profile investors, businesspersons, and experts. They are the SPAC sponsors. Once a SPAC is incorporated, the next step is to go public via a SPAC IPO. The capital thus raised will then be used to fund an acquisition of a private company with which the SPAC merges, thus taking the private company public.

SPAC IPOs, De-SPAC Transactions and PIPE Investments

SPAC IPOs are usually pretty quick since there’s not much financial information that needs verification for a company that has no operations so to speak. Investments in SPAC IPOs are based on investor trust in the sponsor and in their ability to make the right acquisition using the funds. IPO proceeds are kept away in a trust account until acquisition targets are identified and approved. SPAC management doesn’t get any remuneration unless the acquisition is complete.

The sponsors then set to work on finding a private company to take public, setting out a business proposal for the same once the target company is identified. Approval for the proposed business combination is sought from the shareholders of the SPAC via voting procedures. Once approved, there’s a review and commenting phase from the market regulator’s end. Following this, the SPAC invests the IPO proceeds in acquiring the target company, and this entire process is known as the de-SPAC transaction. The target company merges with the SPAC and automatically goes public. In case this process isn’t completed within the stipulated time post-IPO (~24 months), the proceeds are returned to the investors.

Investors can also choose to redeem their shares for cash before the completion of the de-SPAC transaction. This results in some uncertainty in the value of trust proceeds. Further, there’s no limit on the maximum fair market value of the company that the SPAC would merge with. The lower limit is 80% of the funds in the SPAC’s trust account. SPACs can and usually do target much larger ticket sizes in comparison to the size of funds they have.

Both these above aspects mean that the de-SPAC transaction might require additional capital to be executed. Some general ways of doing so include follow-on secondary offerings and rights issues. However, in the case of SPACs, the most common form is via PIPE investments. PIPE stands for Private Investment in Public Equity. Instead of taking the costlier route of underwritten secondary offerings, sponsors seek to raise quick capital by identifying investors and encouraging investments in exchange for a private placement of the SPAC’s public securities. The general public wouldn’t get to invest via this avenue.

According to venture capitalist John Luttig, “PIPE investments typically accompany the de-SPAC transaction, which essentially adds more equity leverage to the SPAC. SPAC sponsors coordinate the PIPE capital raise from hedge funds and PE firms, who are tagging along for the ride. The ratio of PIPE to SPAC money is typically between 2:1 and 3:1. This means that a $400M SPAC could effectively generate a total transaction size of $1.2–1.6B.”

A Deeper Analysis

A deeper dive into the benefits and disadvantages of SPACs merits a stakeholder-wise analysis. There are three main stakeholders here: Investors, SPAC sponsors and the target company

Investors

Advantages

• Those investing in SPAC IPOs receive units comprising shares of common stock and warrants. A warrant offers investors the option of purchasing additional shares in the future at specified prices, and this incentivizes SPAC IPO investments. In case share prices go up and beyond the price proffered by the warrant in the future, investors are in a position to gain.
• There’s an opportunity for one’s investment to land up in a market-outperforming company that could have otherwise not have navigated the traditional IPO channel.
• Investors can choose to vote out a particular acquisition proposal if they deem it unfit. They also have the power to offer the SPAC more time to execute the de-SPAC transaction. In case they don’t do so and the merger doesn’t come through, they would get back their investment along with accrued interest minus some bank fees and transaction costs. Individual investors can also choose to redeem their shares for cash at the time of the de-SPAC transaction (though there may be certain restrictions on the percentage that may be redeemed before completion of the acquisition).
• A peculiar facet of SPACs is that even if investors vote in favour of a business proposal, they can redeem their shares. This can immensely benefit majority shareholders, allowing them to get out their money while still maintaining good relations with the SPAC sponsor. However, this also means that a positive vote isn’t fully indicative of confidence in the business proposal.
• In addition to redeeming their shares for cash through the SPAC, investors can also trade their units on the exchange
• Before the de-SPAC transaction, the SPAC may need to raise more funds. There are arbitrage opportunities here, though this may not apply to all types of investors.

Disadvantages

• If you were to invest some money in an IPO, you’d be aware of which company you’re investing in, have access to various financial statements etc. However, while investing in a SPAC IPO, you’re investing in a firm that will eventually use the IPO proceeds to acquire businesses. Hence, there’s no knowledge of which company your money will eventually end up in.
• Once the acquisition is done and the private company goes public, there’s no guarantee of positive returns. Of the 89 SPACs that have completed their IPOs and mergers since 2015, only 26 have generated positive returns. However, recent SPAC acquisitions have fared much better in comparison to historical ones.

Average returns from the 89 SPACs that have completed their mergers. Source: MarketWatch

Average returns from the 21 SPAC mergers that have been completed from Jan-July 2020. Source: MarketWatch

• As founders cannot receive any compensation in the form of salaries until the de-SPAC transaction is complete, they would be incentivised to complete an acquisition. This may not always be in the best interests of the investor. However, there are a lot of investor protection options available in the form of redemptions and voting that the shareholders can exercise
• Institutional investors can potentially be favoured to retail investors under PIPE deals, and information asymmetry may be in play as well.
• Retail investors cannot adopt passive strategies due to the decoupling of the vote and share redemption. One would imagine that in the event of a bad proposal, majority shareholders would vote down the deal and in the alternate case, they would vote in favour. In both these cases, retail investors witness a good outcome even without doing anything. However, due to the availability of the option of voting in favour and yet redeeming shares, a passive strategy isn’t in favour.

SPAC Founders

Advantages

• Sponsors gain cheap access to ~20% of the common stock of the SPAC by purchasing founder shares at nominal prices. This is known as the ‘promote’. Post the merger, they automatically get converted to common shares. While this is a general structure for remuneration, one point to be noted is that not all sponsors adopt the same.
• SPACs offer sponsors greater access to a large pool of investors as opposed to launching a private vehicle for investments

Disadvantages

• Sponsors and management cannot collect salaries until the acquisition is complete. Though they have founder shares and warrants, these shares cannot be liquidated or traded before the acquisition (as there are quite a few restrictions here).

Target Company

Advantages

• The company can quickly go public. However, this means that their management should be ready to submit the necessary filings and reports, essentially be public-ready in much shorter time duration.
• They can avoid the public scrutiny associated with traditional IPOs. Further, since the purchase price is determined via agreements between the SPAC and the target company and prices can be locked in, firms can bypass the market pricing and valuation steps. There’s certainty around the capital that they would raise.
• Traditional IPOs are not too conducive to smaller companies and businesses that might be witnessing a downturn. Via SPACs, diamonds in the rough who potentially can’t afford IPOs can be identified and brought public too.
• SPAC mergers are much less expensive in comparison to traditional IPOs. If a company were to go public via a traditional IPO, 5–7% of the capital raised would have to be paid in banker fees. For a SPAC merger, a blended fee of 5–6% may be witnessed. However, this would be equity-rich, as compared to cash-rich fees in traditional IPOs. This, in a nutshell, can be classified as ‘less expensive’ for a private company in terms of cash outlays.
• There’s greater flexibility with SPAC IPOs that allow the company to determine various aspects of post-merger ownership
• They can publicise their shift to a public company and this is usually done to build and retain shareholder interest. SPAC sponsors are involved in this pitching as well. Traditional IPOs have strict restrictions around such marketing
• Companies get to receive guidance from experienced folks who run the SPAC
• They usually receive better prices on selling to SPACs. This would benefit PE and VC firms looking to exit companies

Disadvantages

• Companies generally wouldn’t be able to capture as much attention through a SPAC merger as through a traditional IPO
• SPAC mergers as a doorway to becoming public have traditionally not been looked upon favourably. More so, it’s been considered a sign that the company isn’t healthy enough for a regular IPO.
• As investors possess warrants that allow them to purchase additional shares at a specified price, in case the share price rallies, the target company wouldn’t be able to cash in on that effectively if they have to give out more equity at a lower price point.
• There is a need for target firms to choose SPAC sponsors appropriately, maybe those who have experience in similar industries. It’s these sponsors who determine the capital that the target firms would get. Bad choices could work against the firm.

Current SPAC Environment

SPAC IPOs are gaining in popularity. The number of SPAC IPOs in 2020 so far have outnumbered traditional IPOs. Not that this is a new concept, SPACs have been in existence for a while. However, they’ve been looked at with derision in the past, as an option that a company would take if it wasn’t fit enough for a traditional IPO. Part reason for the current rush is due to the association of big names as sponsors, a tech sector focus and high-profile firms going public via SPACs. The pandemic is accelerating this shift, with its lucrative offering of capital certainty and ease.

• 223 SPAC IPOs have taken place between 2015 and July 2020.
• 89 have completed M&As with private companies and have taken them public
• Overall returns since then don’t seem great though
• Returns of the recent SPAC acquisitions seem to be good, but that’s primarily because of a few high-performers (DraftKings, Nikola) disproportionately tilting the scales

SPACs in India

SPACs haven’t been used for NSE or BSE listings in India. Videocon D2H was listed on NASDAQ through a reverse merger with Silver Eagle Acquisition Corp., however, numerous regulatory hurdles serve as impediments to SPACs within the country.

• To incorporate a company, one needs to define the business objective. SPACs have no business objectives as such, they are instituted solely to merge with another firm.
• As per the Companies Act, if a firm has ‘failed to commence its business within one year of its incorporation,’ it can be removed from the register of companies. SPACs usually take 1.5–2 years to finish the de-SPAC transaction, and this automatically deems it unfit as per the Act.
• According to SEBI, to be eligible for an IPO a company must have, in each of the preceding 3 years, at least ₹ 3 crores in net tangible assets and a net worth of at least ₹ 1 crore. Further, the company should have had operating PBT of at least ₹ 15 crores in 3 of the preceding 5 years. This is not the case for a SPAC.
• To be listed on the NSE, companies must have positive EBDT (Earnings Before Depreciation and Tax) for the preceding 2 years, again, a requirement that SPACs can’t fulfil. (Garg et al., M&A Critique)

Conclusion

Alternatives to traditional IPOs are indeed being looked at by different stakeholders. 2019 witnessed the popularity of direct listings, and SPACs seem to be taking over that title for 2020. Despite some phenomenal gains and the recent trend around SPACs, one needs to exercise caution. According to Todd Lowenstein, managing director and equity strategy executive of The Private Bank At Union Bank, “The success of SPACs is a sign of excessive prices. Companies are being opportunistic and using their stock as currency to buy up other firms. SPACs are a fast-track IPO, and there is an insatiable appetite for new stocks. But all of this points to a frothy market.”