The Span of SPACs: What to Know

You may have seen the term SPAC in the news in announcements about new businesses backed by athletes, entertainers, and political figures (as well as in recent stories about SPACs suddenly cooling off as a hot investment). While they may seem to be a relatively recent development, SPACs have been around for decades.

The acronym stands for Special Purpose Acquisition Company, an entity seeking investment for the sole purpose of purchasing a private company and taking it public. A SPAC uses its funds to acquire an equity stake in the target company, with hopes of tapping into the firm’s potential and increasing its value, therefore providing greater returns to shareholders.

SPACs look to acquire a private company and help it go public without going through the stages of a traditional initial public offering (IPO). Due to the structure of a SPAC, the entity’s investors and sponsors will not know which company the SPAC plans to acquire when they invest and must trust the SPAC’s management team to determine the right course of action.

The rise in popularity of SPACs boomed in the last two years alongside cryptocurrencies, meme stocks, and other speculative trades as an easy way for startups to raise money and go public. Only two SPACs came to market in 2010, in contrast to 2020, when 247 SPACs (with $80 billion invested) were created. In just the first quarter of 2021, a record $96 billion was raised from 295 newly formed SPACs.

In 2022, however, some startups that previously agreed to go public with SPACs are calling off deals and electing to raise money privately. In July 2022, no new SPACs raised money, the first time that has happened since 2017. Still, many investors have been on 2022 summer vacations; the market may be waiting to see whether the government’s new energy and climate spending package will inject life into SPAC activity later in the year.

Who Are the Stakeholders?

SPACs have three main stakeholder groups: sponsors, investors, and targets. Each has a unique set of concerns, needs, and perspectives.

Sponsors. The SPAC process is initiated by the sponsors. They invest risk capital in the form of nonrefundable payments to bankers, lawyers, and accountants to cover operating expenses. If sponsors fail to create a combination within two years, the SPAC must be dissolved, and all funds returned to the original investors. The sponsors lose not only their risk capital but also the not-insignificant investment of their own time. But if they succeed, they earn sponsors’ shares in the combined corporation, often worth as much as 20% of the equity raised from original investors.

Investors. Most investments in SPACs to date have come from institutional investors, often highly specialized hedge funds. Original investors in a SPAC buy shares prior to the identification of the target company and have to trust sponsors (who are not obligated to limit their targets to the size, valuation, industry, or geographic criteria that they outlined in their IPO materials). After the sponsor announces an agreement with a target, the original investors choose whether to move forward with the deal or withdraw and receive their investment back with interest.

Targets. Most SPAC targets are start-up firms that have been through the venture capital process. Firms at this stage commonly consider several options: pursuing a traditional IPO, conducting a direct IPO listing, selling the business to another company or a private equity firm, or raising additional capital, typically from private equity firms, hedge funds, or other institutional investors. SPACs can be an attractive alternative to these late-round options. They are highly customizable and can address a variety of combination types. Although targets are commonly a single private company, sponsors may also use the structure to roll up multiple targets. SPACs can also take companies public in the United States that are already public overseas and even combine multiple SPACs to take one company public.

Blank Checks

SPACs are generally formed by investors or sponsors with expertise in a particular industry or business sector to pursue deals in that area. In creating a SPAC, the founders sometimes have at least one acquisition target in mind, but they don’t identify that target to avoid extensive disclosures during the IPO process. As such, SPACs are called “blank-check companies.” IPO investors typically have no idea about the company in which they will ultimately be investing. SPACs seek underwriters and institutional investors before offering shares to the public.

When SPACs first appeared in the 1980s, they were not well-regulated, and as a result they were plagued by penny-stock fraud, costing investors more than $2 billion a year by the early 1990s. Congress stepped in to provide much-needed regulation, requiring that the proceeds of blank-check initial public offerings be held in regulated escrow accounts and barring their use until the mergers were complete. With a new regulatory framework in place, blank-check corporations were rebranded as SPACs.

A SPAC is created by a sponsor—which could be, for example, a private-equity firm or a former corporate executive—who works with an underwriter to bring the blank-check company public. Money is raised in a public stock offering and the SPAC trades on an exchange with the intent of finding a target company with which to merge. If a merger is completed, the SPAC takes on the identity and stock ticker symbol of the target company.

Today, most SPACs focus on companies that are disrupting consumer, technology, or biotech markets. Some of these firms are speculative, have enormous capital requirements, and can provide only limited assurances on near-term revenue and viability. (Electric-vehicle companies often fall into this category.) SPACs have allowed many such companies to raise more funds than alternative options would, propelling innovation in a range of industries.

The funds SPACs raise are placed in an interest-bearing trust account. These funds cannot be disbursed except to complete an acquisition or to return the money to investors if the SPAC is liquidated. A SPAC generally has two years to complete a deal or face liquidation. In some cases, some of the interest earned from the trust can serve as the SPAC’s working capital. After an acquisition, a SPAC is usually listed on one of the major stock exchanges.

Why SPAC and Not IPO?

Going public through an IPO is a lengthy process that involves complex regulatory filings and months of negotiations with underwriters and regulators. This can deter a company’s plans to become publicly listed, especially during periods of heightened uncertainty (such as the pandemic years of 2020 and 2021) in which the risk of investors giving its IPO a frosty reception is much greater.

By contrast, SPACs generally offer a less arduous path for companies that wish to go public. A company can go public within months if it merges or is acquired by a SPAC. The owners of a target company may also be in a better position to negotiate a favorable price from a SPAC which has a limited time frame for an acquisition, compared with another buyer such as a private-equity firm, which may drive a hard bargain.

Advantages of SPACs

SPACs offer some significant advantages for companies that have been planning to become publicly listed. Firstly, a company can go public through the SPAC route in a matter of months, while the conventional IPO process is an arduous process that can take anywhere from six months to more than a year. The popularity of SPACs may partly be due to their shorter time frame for going public, as many companies chose to forego conventional IPOs because of the market volatility and uncertainty triggered by the global pandemic.

One of the main advantages for target companies—and, effectively, SPACs—is the ability to talk about the future and make predictions, which is restricted in the traditional IPO process. Future projection is a particularly attractive proposition for SPACs hunting for innovators and disruptors. Also, of interest to target companies is the lack of necessity for “roadshow” presentations (a key part of the traditional IPO process), which typically consist of several meetings with institutional investors and are meant to secure capital. With SPACs, capital is already raised by a sponsor in one vehicle, making the match process with a target company a bit easier.

Secondly, the owners of the target company may be able to negotiate a premium price when selling to a SPAC because the latter has a limited time window for making a deal. In addition, being acquired by or merging with a SPAC that is sponsored by prominent financiers and business executives can give the target company experienced management and enhanced market visibility.

​Risks of SPACs

An investor in a SPAC is making a leap of faith that its promoters will be successful in acquiring or merging with a suitable target company in the future. The reduced degree of oversight from regulators, coupled with a lack of disclosure from the typical SPAC, means that retail investors run the risk of being saddled with an investment that could be massively overhyped or occasionally even fraudulent.

Fee structures vary, but in general the sponsor’s equity stake amounts to 20%. After banking fees, the cost to public investors at the time of the SPAC’s merger with a target company can be much higher than traditional IPOs.

Despite offering a more efficient route to public markets, SPACs still carry a set of risks that investors should be aware of. Many have experienced significant bouts of volatility throughout their lifespans, with much stemming from excitement over a sponsor (be it a celebrity or well-known private equity firm), or hype over a potential merger. In both cases, some SPACs have seen their share prices triple in value in a matter of days or weeks, only to swiftly fall back to—or, in some cases, below—their IPO prices.

Rapid and large price swings warrant an extra degree of caution because of the lack of information associated with SPACs. Given that SPACs are purely aggregators of cash, price action cannot be tied to any fundamentals (such as earnings streams) until a merger is completed. This risk is one of the key reasons several SPACs have seen deteriorating performance; it reinforces the importance of performing due diligence on sponsors and the target industry of interest.

Another risk worth considering is a SPAC’s potential failure to fulfill its goal of finding a merger target—forcing it to liquidate. In general, SPACs have two years to complete a merger; if they don’t, they liquidate, and investors get their pro-rata share of the aggregate value of the SPAC. This is a rising risk, along with the inability of new SPACs to enter a flooded market. As of January 2022, $4 billion worth of deal value was aborted (per Bloomberg data), signaling investor exhaustion.

Lastly, the regulatory environment may pose some challenges in the future. With the pickup in speculative trading activity over the past year, the Securities and Exchange Commission (SEC) has sharpened its focus on SPACs. SEC Chairman Gary Gensler has been vocal about the need to potentially revise rules and disclosures, which may force existing firms to make structural adjustments, and may alter the processes for future deals. To some extent, this has already affected the SPAC market. An April 2021 report from the SEC hinted at changing the way warrants are accounted for—as liabilities versus as equities. That change alone pushed over 100 SPACs to restate past financial statements and caused a sharp pause in new issuance.

Returns from SPACs may be well below expectations when the initial hype has worn off. Strategists at Goldman Sachs noted in September 2021 that of the 172 SPACs that had closed a deal since the start of 2020, the median SPAC had outperformed the Russell 3000 index from its IPO to deal announcement; but in the six months after deal closure, the median SPAC had underperformed the Russell 3000 index by 42 percentage points. As many as 70% of SPACs that had their IPO in 2021 were trading below their $10 offer price as of September 15, 2021, according to a Renaissance Capital strategist. This dismal performance could mean that the SPAC bubble that some market experts had warned about may be in the process of bursting.

Conclusion: Buyer Beware

Moments of truth are likely to emerge this year for several companies that are still aiming to find merger targets. The redemption rate for SPACs—which measures the number of shareholders demanding their money back instead of funding mergers—exceeded 60% by the end of 2021 (per SPAC Research).

The “speculative exuberance” phase for SPACs looks to have ended, but that doesn’t discount the reality that many are still active in their search for target companies and interest among investors remains. The news website Axios may be reporting that nineteen companies have canceled SPAC mergers in 2022, but Forbes magazine notes that there are over 120 mergers still waiting to close.

As with any investment, risks associated with those SPACs—and the broader segment—should be carefully analyzed.

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