The SPAC Revolution
Updated: Dec 6, 2020
By Arthur Garnier
SPAC — it seems to be all that people talk about. Yet, like any "new" investment vehicle, it has been around for a while. In fact, the first modern SPACs appeared in 2003, when funding for Initial Public Offerings was wavering due to the tech bubble burst and stock market volatility. Since then, SPACs have grown every year at an increasing rate. In 2007, 66 out of 234 IPOs were done through SPACs, and these accounted for $12 billion of the total $54 billion raised. However, in 2009 after the financial crisis, SPAC was nowhere to be seen; it was a dying breed. In fact that year, only one company went public through a SPAC, raising only $36 million in capital.
However in 2013, they started making a comeback with a structure that was quite similar to the first ones seen during the early 2000s.
The table above published by SPACInsider looks at the increasing volume of SPAC IPOs since 2013. A trend has appeared: the ratio of SPAC IPOs to traditional IPOs has greatly increased. In 2013, 10 out of 222 IPOs were done through SPACs. In 2019, 59 out of 235 IPOs were done through SPACs. This trend is only increasing; in 2020, so far there have been 81 SPAC IPOs that have raised a record $33.1bn.
Looking at these trends, it seems as though investors are taking an increasing liking to these types of public offerings. So how come there has been this huge increase in volume over the years and is there any sign of it stopping?
A SPAC offers significant advantages to its stakeholders who are often the investors, the target company and the high-level executives managing the deal. In short, through a SPAC IPO, a group of individuals will create a "blank check" company that investors will purchase shares of once it goes public, often at a predetermined price of $10 a share. Then this company holds the invested money in a fund that can only be used to fund a merger with a private company. In turn, this private company will turn public as it merges with a public entity, and the shareholders of the SPAC will now be the shareholders of this target company. This allows the target company to bypass the long traditional IPO, which may take anywhere from six to nine months if handled properly.
The traditional IPO is not only time-consuming, but also represents a significant cost for the company going public. In almost all cases, a company looking to go public will go through an investment bank, which will help them structure the offering. The investment bank makes money through underwriting fees which, in countries like the US and Japan, can range anywhere from 7-11% of the total capital being raised. In fact, the OECD published in its 2017 "Business and Finance Outlook" report that the traditional IPO process fees were too high and were a barrier to more competitive and efficient financial markets. Through a SPAC, sponsors are able to create a hybrid deal with underwriters in which a fraction of these fees are paid on the initial IPO date, and the rest is paid when the SPAC merges with a target company. This means that investors and sponsors can offset their losses in the absence of a deal and gives them flexibility in the choice of pursuing a merger.
There are other significant advantages for the major stakeholders. One of the reasons why we have seen huge amounts of IPOs through SPACs in 2020 is also due to increased market volatility which traditional IPOs often fall victim too. In 2019, we saw the effects of this through the Uber IPO or the Peloton IPO, in both cases, shares were trading below the IPO price for a significant amount of time. Investors were limited by the increased market volatility due to the ongoing trade war between the US and China. Through a SPAC IPO, the sponsors set a unit price containing a share and a warrant that often amounts to $10 for simpler accounting. Deals are then struck between investors who are often high net-worth individuals or institutions and the SPAC sponsors on the amount of stock bought. Therefore, the performance of a SPAC, once public, is much less linked to stock market volatility, which explains their increased use in 2020 even as most public markets have seen record volatility. This is why from the target company side, more businesses are going public through SPACs as it reduces costs, and it means that the sponsors are responsible for finding shareholders and not the target company, which is often a painstaking and long process. Finally, once on the market, the owners of the target company are less wary of investor sentiment and market volatility.
Individual stakeholders can greatly benefit from SPACs, and chief among those are often the sponsors of the deal. In a traditional SPAC, the sponsors will often be experienced executives that will create the company and invest a portion of their own capital. Often this is around 3-4% of the IPO proceeds, or in some situations, a deal is created where the sponsors pay a lump-sum, usually of $25,000 for a guaranteed stake in the common equity of the company post-merger. This is called the sponsor at-risk capital. Once a merger is completed, the sponsors will usually receive 20% of the common equity in the SPAC through founder shares. This can lead to huge payouts for sponsors of successful SPACs. For example, in June 2020, a former Citigroup Investment Banker called Michael Klein collected $60 million when one of his SPACs struck an $11bn deal with a US healthcare company called MultiPlan. Mr Klein put in $25,000 of risk capital two years prior. No ROI calculations are necessary here to illustrate the potential profits from these deals.
Tying up sponsor equity into a SPAC also greatly increases investor confidence as they are more likely to invest in a venture that is controlled by individuals who have a large stake in its success. Of course, this huge potential for gain is offset by the fact that if the SPAC does not find a suitable target company during their acquisition phase (often 18-24 months), then all the money in the fund is returned to investors and the sponsors must make sure each investor retrieves the amount he put in. Furthermore, the risk capital put in is often used in part to cover operating expenses and underwriter fees. The bottom line for sponsors is that if everything goes to plan, you can potentially make a huge payout that can surpass the illustrious carried interest received by GP in traditional PE firms. This is due to the fact that the managers of SPACs payout are directly linked to the performance of the vehicle, and unlike PE companies where GP only receive carried interest after a certain hurdle rate of profitability is achieved, SPAC managers' profit or loss is directly linked to the investor's profits or losses. On the other hand, if no deal is reached, sponsors lose everything they put in.
One final advantage of SPACs is that often, the sponsors stay in the company after the merger and act as advisors or managers, further cementing the relationship between the two. This provides advantages for the target company, as they benefit from the resources and knowledge of these high-level executives that are often industry experts.
Investors also have incentives to invest in SPACs instead of traditional IPOs. One of the main reasons has to do with voting rights given to shareholders. In a SPAC, all acquisition decisions are voted upon and require a majority to go through, unlike in a traditional company where voting rights are often limited. Furthermore, investors can decide to take back all of their invested capital which will be distributed to them on a pro-rata basis: either after the merger has gone through, or if the fund is dissolved due to no deal being reached.
But what does all this mean…
Although SPACs are the cool new kid on the block and attract much hype especially due to some big names using these investment vehicles (Bill Ackman, Shaquille O'Neal, Richard Branson,), it is important to consider what is left once the dust settles. Now, findings get more interesting as there are plenty of examples of successful and unsuccessful ventures. However, trends are starting to appear, and they do not look good for individual investors.
Certain SPAC IPOs such as Draftkings received incredible returns, with shares trading at $48 down compared to the $10 unit price at the time of IPO. However, other stories are not as nice.
Sources: Financial Times and S&P Global Market Intelligence
A study done by the Financial Times showed that a majority of the "blank check" companies used for IPOs between 2015-2019 now trade at a price lower than their initial offer price ($10 is often the benchmark for SPAC IPOs). In fact, some important players have lost a lot of money, like the private equity firm TPG Capital who has three SPACs — none of them trades at a price higher than $10.20.
There are vast amounts of data that have yet to come out on the performance of SPACs as the volume of these deals keeps going up; nevertheless, initial returns are mixed.
Furthermore, results have not only been mixed from a financial point but also from a regulatory one. Part of what makes SPACs so attractive is their relative ease in taking a company public compared to the traditional IPO. Taking a "blank check" company public that has a very little history or assets is much simpler than taking an established company with a large history of financials and a complicated capital structure that must be thoroughly looked through by financial authorities. Yet this long process is there for a reason and ensures that there will be no financial misconduct of the sort since the public is now involved. In 2019, a scandal emerged when a Greek music streaming platform called Akazoo merged with a SPAC called Modern Media Acquisition Corp. which was listed on the NYSE. Investors started to dig into Akazoo and found no evidence that its supposed 5.5m subscribers existed. In the end, the $200m deal saw its share plummet, and every investor in Akazoo including celebrities such as John Legend lost all of their money.
This leads to the question: what is in store for the future of SPACs?
The large volume of SPACs has been due in majority to the abundance of free money due to low-interest rates. As soon as there is a hype around anything in Wall Street, the first question on everybody is simple: Bubble? There has been no shortage of investors raising awareness over this new trend chief among those is Lloyd Blankfein, former CEO of Goldman Sachs, who said that the abundance of free cash in markets is creating some bubble elements as capital allocations become less efficient and start to resemble more of a rolling thunder MO.
Despite this, there is no sign of SPAC IPOs slowing down in the near future as more prominent figures turn to these vehicles; individual investors will feel safer following in their footsteps. Furthermore, more media attention means that sponsors will have to be increasingly careful and will have added pressure to perform. Already we have seen the traditional structure of SPACs change. The traditional structure of sponsor at-risk capital in exchange for 20% of common equity is shifting, as higher net worth sponsors bring a halo effect to SPACs. Some SPACs have structures where the sponsor is just a normal shareholder and does not receive his founder share; yet in exchange for this, investors cannot remove their funds and have restricted voting rights.
All in all, it seems that SPACs are here to stay. In fact, some SPAC experts have stated that around half of the SPAC IPOs in 2020 were originally meant to be traditional IPOs in 2021 including DraftKings and Opendoor. As of now, there are 138 active SPACs currently seeking targets and a further 49 that have filed to go public. These are record volumes and show no sign of slowing. One of the biggest SPAC IPOs was recently announced by Alec Gores, who said his SPAC, Gores Holding IV (Nasdaq: GHIV), would buy a wholesale mortgage lender called UWM for $16.1bn.
There are a myriad of arguments on both sides either defending SPACs or calling them out. Some have raised concerns that there are now too many SPACs compared to target companies that are ready to go public, and that the pie is not growing fast enough to keep up with such high volumes. Others are stating that the time it takes a SPAC to find a target company has been gradually reducing, showing an increasing amount of opportunities.
In the end, a few things are certain; this will not be the last article you read about SPACs. Whether the next one you read will be about them taking over the IPO world or them being a temporary fling of 2020.
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