A comprehensive guide to understand SPACs and their 2020 surge
Over these past months, I’ve heard the word SPAC so many times, much more than the usual. And I’m not talking about the SPAC “Saratoga Performing Arts Center”, but about “Special Purpose Acquisition Companies”. Just take a look at US Google finance-related searches for the word “SPAC”:
2020 has actually been the best year for SPACs in terms of the number of deals and capital raised. The record of the largest SPAC has been broken twice: Churchill Capital Corp III raised $1bn in February, followed by Pershing Square Tontine that raised 4 times more. SPACs have actually never raised so much, already $34.4bn which is 3x bigger than 2019, and investments in SPACs actually represent 40% of all dollars invested in 2020 in the IPO market according to Renaissance Capital.
I was wondering why there was a sudden surge of SPACs and whether it was a good thing or not, so I decided to dig in it.
Here is what you should remember:
A SPAC, Special Purpose Acquisition Company, is a shell company that doesn’t have any operations, and whose sole purpose is to raise capital through an IPO so that it can acquire an existing company.
SPACs is an attractive way to go public for a company looking for money, speed and certainty, as itonly manages negotiations with one investor (the SPAC). However, this lowers the IPO price, at the benefits of sponsors for which SPACs are highly lucrative. For investors, SPACs are an easy way to deploy their money as they just have to trust SPAC managers.
But despite recent (so far) successful SPACs, they have been historically poor investments underperforming the market. Sometimes, SPACs must also return their funds as they don’t find any target company to acquire, resulting in a high opportunity cost for investors.
2020 is definitely a great year for SPACs, pushed by volatile markets, uncertain economic conditions, and also by famous managers creating such structures. The next few years will demonstrate whether SPACs are worth it or not.
What’s a SPAC and how does it work?
SPACs, Special Purpose Acquisition Companies, also called Blank-check companies are empty shell companies. They don’t have any operations, and their sole purpose is to raise capital through an IPO so that they can acquire an existing company.
Here is the 2-step process to launch a SPAC:
1- SPACs managers, called sponsors, create the legal entity, and like for any traditional IPO, they do a roadshow to raise funds and make their company public. Usually, SPACs distribute shares that are worth $10, but this is not always the case as illustrated by recent SPAC formed by Bill Ackman with shares at $20. At this stage, the SPAC doesn’t even know yet which company it will acquire, and neither do its investors. Not anyone can successfully create a SPAC as sponsors usually only raise capital based on their credentials and notoriety: Hedge Fund Manager Bill Ackman, Former House Speaker Paul Ryan, or the entrepreneur and investor Chamath Palihapitiya.
2- Once the sponsors have raised enough funds and made the company public, they have to find targets and acquire one of them. SPACs usually acquire companies that are much larger than them. The rest of the money required for the acquisition then comes from Private Investment in Public Equities (PIPE) deals. Bill Ackman will for example add $1bn to $3bn from his Hedge Fund to the SPAC investment (of $4bn), allowing to bring the total value of the investment up to $7bn. Note that the SPAC only acquires part of the company shares. For instance, the SPAC Social Capital Hedosophia acquired 49% of Virgin Galatic for $800m. Once the SPAC acquires the company, it usually takes the name of the company it bought.
The money raised by a SPAC can only be used to acquire a company. Yet, sponsors can still take a management fee, usually around 2% of the SPAC value, allowing to pay for the IPO- and the acquisition-related expenses. SPAC sponsors are also able to grant themselves some of the SPAC’s common stock, usually taking from 0% up to 20%.
On the other side, investors in SPACs have some protections as they can redeem their shares if they don’t like the acquired company or if the SPAC doesn’t acquire any company in a specific timeframe, usually 24 months. Investors can also control the risk as they get warrants, allowing them to buy more shares at a set price after the acquisition is made.
Why would a company go public through a SPAC?
Companies currently have 3 ways to go public. They can do a roadshow and raise funds through investors, that’s the traditional IPO. They can directly list themselves on the stock exchange without raising funds: Direct Listing. And finally, they can merge with a public company, and in this case, with a SPAC. But why would they choose this third way?
Going public through a SPAC is a quick way to go public as you only raise capital from 1 investor, instead of dozens. It indeed prevents the company to do a roadshow across the country, talking to hundreds of different investors. The IPO price then depends on the demand from investors and can change at any time of the process. Dozen of different investors will make their due-diligence on the company and the company will have to disclose much more information. The SPAC process is then much simpler & safer as the company only negotiates with 1 investor that would already have raised all the funds. Through a SPAC, the company “IPO” price is the result of a traditional M&A negotiated deal. As a consequence, going public through a SPAC is much quicker, approximately 2 months versus 6–7 months for a traditional IPO.
As a consequence of what has been previously said, SPACs are very attractive when it’s difficult to go public through a traditional IPO, because of bad stock market conditions, or a lack of attractiveness of the company itself! As the IPO price depends on stock market condition and its volatility, some companies must wait the right time to go public through a traditional IPO, or even cancel their IPO plans. But they don’t have this problem through a SPAC as the money has already been raised. For some companies, it’s not even possible to go public because their lack of attractivity would make negotiations with hundreds of investors too complex, but fortunately, SPACs offers an alternative. To give you a concrete example, American Apparel was in non-compliance with its current financing agreements and was subject to several lawsuits, making an IPO impossible. But the brand was finally able to go public through a SPAC as it could directly negotiate the agreements with only 1 party ensuring to manage efficiently its financial distress and lawsuits. This wouldn’t have been possible with dozen of investors. This is why WeWork might have been able to go public through a SPAC, while Nikola probably wouldn’t have been able to go public through a traditional IPO (or it would have been much more difficult).
Finally, the advantage of SPACs versus a Direct Listing is that the company will finance itself by raising funds.
SPACs have still disadvantages: the IPO price is lower, as the SPAC sponsor did all the work, took management fees, and granted itself part of the company stock. SPACs indeed pay 7.6% less than other bidders according to a 2007 study. Through a SPAC, the company is also not able to choose its investors, which often matters.
Why do investors bet on SPACs?
Investing in SPACs is an easy way to deploy its capital. Investors don’t have to make any due-diligence but to only trust the SPAC management. It’s is also a way to get on a potentially great deal before anyone else, with warrants making it even more interesting. My guess is that even if the total SPAC markets isn’t performing the market, there might be very good investments similar to what we see in capital risk: 1 success for many failures. This is also why some refer to SPACs as Private Equity investment that offer liquidity.
Yet, these advantages bring many risks for investors.
The first risk comes from the SPAC failing to find a company to acquire, resulting in a strong opportunity cost for investors, and this risk is actually very important: out of the 223 SPACs IPO since 2015, only 37% (89) have acquired a company, according to Renaissance Capital.
A second risk for investors is that they don’t like what company the SPAC acquires. As explained earlier, this risk is managed as they are able to vote for the company to acquire and to redeem their shares if they don’t like the chosen target. Yet this still represents an opportunity cost if they do, and some investors prefer to control what companies they invest in. Even worse, the investment could also don’t go through if too many investors pull off.
Finally, SPACs have historically poor performance! Since 2010, SPACs only returned 10% on average vs. 203% for the S&P500. Only 30% of the SPACs who have IPOed between 2015 and 2020 had positive returns, and the majority of 2019 & 2020 SPACs trade below their issue.
Why do sponsors create SPACs and what do they risk?
Creating a SPAC is very lucrative when successful, as sponsors can get up to 20% of the fund raised: their median returns are 1,900%, according to Jog and Sun 2007.
Nevertheless, launching a SPAC is very risky as the sponsor is the only one doing the due-diligence of the target company, and puts all her reputation with investors at risk, on only 1 deal. It’s not as if she would manage a hedge-fund with several portfolio companies allowing her to limit the negative impact when one investment turns bad.
Why are SPACs so popular in 2020?
First, let’s review the history of SPACS. They are not new as they have been around since the 80s. If you’re curious about the detailed history, you can take a deeper look at this research paper, but let’s just say that at that time, SPACs were not popular. SPACs had to wait until 2007 to become a considerable financing solution with 65 SPACs raising $11bn in the US, vs. 35 raising $3bn the year before. However, the 2008 financial crisis put an end to this growth as there have been only 2 SPACs created in 2009. However, SPACs gained some popularity again in 2017 as they raised 3x more money vs. 2016, and they reached levels of 2007 in 2019.
But the rise of SPACs really happened in 2020: As of August 2020, SPACs raised 3x more money vs 2019, and there are still 4 months left. But why?
SPACs are on the rise because of high market volatility in 2020, an uncertain economic environment preventing or delaying many companies to IPO, and an excess of capital. Sponsors with great credentials and recent successful SPACs also helped.
Recent famous and so far successful SPAC deals include Virgin Galactic, DraftKings, and Nikola. DraftKings has been acquired with Diamond Eagle Acquisition Corp for $500m and gained 270% so far. Another recent example is VectolQ Acquisition that acquired Nikola in June 2020 and gained 400%.
What are the consequences of this SPAC surge?
The rise of SPACs creates definitely more competition for sponsors, which will benefit companies looking to go public, as well as investors. Competition has indeed become very high, there are currently 125 SPACs with $40bn to be spent, and it’s now easier for companies to raise through a SPACs as they have more choice and can negotiate better terms and lower their cost of capital. SPAC managers must also compete to attract investments and therefore lower their fees and create a more attractive SPAC structure. For instance, Bill Ackman is taking no management fee, and will only get compensated if the merged company trades 20% above the offer price.
Conclusion
I’ll conclude by quoting A16Z, as they perfectly summarize the situation: “if you need money, speed, and certainty, a SPAC may be [the] best” way to go public. 2020 pushed by an excess of capital and volatile market, is definitely the year of SPACs. It’s going to be very interesting to see in a few years whether this “2020 vintage” of SPAC companies will outperform the market.
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What’s your personal view on SPACs? Where do you think this trend is going? Let me know your thoughts in the comments!
Note: all numbers are as of 09/08/2020
