Should SPACs Be Back? - Part One

A Special Purpose Acquisition Company (“SPAC”) is a type of shell company that is an increasingly common method used by firms to become publicly traded. This is a three-part series meant to provide a comprehensive overview of the U.S. SPAC boom that may quickly spread into a global phenomenon. The first part of the series is meant to serve as a primer to the topic for those who are largely unfamiliar with SPACs and provides a detailed look at the structure of SPACs. The second part of the series will provide a brief history of SPAC evolution from the 1980s to present as well as a discussion on why firms are increasingly choosing SPACs. The third and final part of the series will delve into how SPACs have performed over time and who may be the winners and losers in the SPAC world.

GOING PUBLIC: TRADITIONAL IPOS VS. REVERSE MERGERS

When a firm is “going public,” it is seeking to raise capital in the public markets by selling shares to the general population. These shares can then be traded on a stock exchange (e.g., the New York Stock Exchange and Nasdaq) making the firm publicly traded (AKA publicly listed). Historically, one of the most common methods for going public is through a traditional initial public offering (“IPO”).[1]

During an IPO, a firm issues new shares of stock which are typically underwritten by an investment bank (e.g., Credit Suisse, Citigroup, and Goldman Sachs). The investment bank helps the firm market to investors, identify the initial offer price, and buys shares from the firm.[2] However, the investment banks can charge significant fees for these services, often resulting in millions of dollars in expenses – ultimately reducing the amount of capital the issuing firm receives from the IPO. These underwriting fees are typically between 5 – 7% of the gross IPO proceeds.[3]

In addition to having costly fees, the IPO process can be extremely time intensive. For example, the Sarbanes-Oxley (“SOX”) Act of 2002 increased the requirements for all U.S. public companies – increasing both regulation and costs associated with converting from a private operating firm to a public operating firm. Further, firms that are highly levered (i.e., have significant debt outstanding) often face greater scrutiny and have more difficulty raising capital via a traditional IPO. Moreover, investors in private firms may want to “cash-out” some of their shares or ownership at the firm. However, IPOs are generally associated with lock-up periods that prevent shareholders from selling their shares for a given period following the IPO.[4] As a result of these drawbacks, many firms have sought to go public via alternative methods.

One of the most popular alternatives to the traditional IPO process is using a reverse merger (See Exhibit 1). In this type of transaction, a private (i.e., non-public) firm becomes public because they are acquired by a publicly traded company. In other words, an already public firm acquires a private firm, and the newly merged entity retains the public status of the acquirer, effectively allowing the previously private firm to trade shares on an exchange. The publicly traded company may be a natural company or a shell company. Typically, when a reverse merger occurs via a natural company, the acquiring public company is one that has gone bankrupt or has sold a large part of its assets, but at one point had its own operations.

In contrast, a shell company does not have its own operations.[5] The shell company raises capital when going public through its own traditional IPO. For a shell company, the sole intention of the public shell is to acquire a private operating firm, which it can then take public via the acquisition. Special Purpose Acquisition Companies (“SPACs”) are a specific type of shell organization. SPACs have garnered increased media attention over the last two years as the U.S. experiences a historic SPAC boom and other countries increase interest over this type of investment vehicle (See Exhibit 2).  

WHAT IS A SPAC?

SPACs are often referred to as blank check or cash-shell companies.[6] A SPAC does not have any specific business operations, and its sole purpose is to engage in a merger or acquisition of an unidentified opportunity. Upon formation, the SPAC does not have any assets other than cash, cash equivalents, and some nominal investments. The SPAC is formed to raise capital to finance the merger or acquisition within a specific timeframe, typically 18 – 24 months (See Exhibit 3).

The SPAC is formed by SPAC sponsors who found and manage the SPAC. These sponsors are generally high-profile and experienced individuals or entities that have a strong track record of success in finance or a specific industry. Though recently, there have been an increased number of celebrities jumping into the SPAC space, which will be discussed in more detail in Part 2 of our Should SPACS be Back series. SPAC sponsors typically invest nominal capital into the SPAC prior to the SPAC’s IPO and are awarded founder shares.[7] Generally, sponsors invest 2% of the total capital raised, approximately $25K, but because they are awarded founder shares this initial investment represents approximately 20% ownership after the SPAC IPO.[8] Given the minimal capital investment of SPAC sponsors, this creates a divergence in economic interests between the SPAC sponsors and other SPAC investors. This will be discussed in more detail in Part 3 of our Should SPACS be Back series.

Investors, both retail and institutional, can then purchase the remaining 80% ownership of the SPAC through an IPO by purchasing units of the SPAC, which typically represent one share of the SPAC’s common stock and some specified fraction of a warrant. These units are often priced at $10 per unit.[9] Individuals investing in the SPAC IPO do so because they believe that the SPAC sponsors will be able to identify and purchase a private company that will generate a positive return for investors. The proceeds raised during the IPO are held in an interest-earning trust account to fund the future acquisition of a private operating firm.

After the IPO, the units are separated into the common stock shares and warrants which can be traded in the public market to other investors who want to speculate on the SPAC’s future acquisition.[10] Typically, in the absence of extreme speculation, the SPAC price will remain around the $10 issuance price until the announcement of a merger target. SPAC prices are generally stable around the issuance price as the SPAC entities have no operations and, in the absence of a completed merger, investors would expect to redeem their shares for approximately the issuance price. It is important to note that, given the SPAC’s lack of operations, the stock price of the SPAC is not based on the valuation of business and does not necessarily indicate the ultimate success of the SPAC. Once the merger target has been announced, however, the SPAC stock price may be used as an indicator of the public’s perception of the potential value of the proposed merger. The stock price would change again upon completion of the merger. This will be discussed in more detail in Part 3 of our Should SPACS be Back series however Exhibit 4 displays two annotated examples of SPAC pricing.

In the U.S., during the SPAC IPO process, the SPAC fulfills the standard listing requirements for any firm that goes public.[11] As part of this process, the SPAC must file a prospectus – a legal disclosure document required by the SEC that contains information about the company and any related information that would be material to potential investors.[12] A prospectus for a SPAC is different than one filed for a traditional IPO of an operating firm. This prospectus will focus mainly on the SPAC sponsors as the SPAC itself has no financial performance or operations to report. This is a critical document for any potential SPAC investors to review in detail prior to investment. As mentioned earlier, the actual private firm to be acquired is unknown at the time of the SPAC IPO. However, a specific industry or area of interest may be targeted (e.g., space, healthcare, or sustainability). Exhibits 5 includes extracts from two prospectuses that discuss potential target search criteria.  It is also important to note that although the sponsors may identify a targeted industry, the SPAC is not required to pursue firms solely in that industry and the ultimate merger proposal may be for a private firm outside of the scope identified in the prospectus.

TRUST ACCOUNT

As mentioned above, the proceeds from the SPAC IPO are placed into a trust account. This account is held by a third party until a merger is complete and is generally comprised of capital that is 98% funded by public investors and 2% or more funded by the SPAC sponsors.[13] The funds held in the trust account earn interest while awaiting deployment and are generally invested in relatively safe and liquid investment instruments, such as U.S. short-term government securities (e.g., T-bills). However, there is no rule restricting how these funds can be invested and the SEC warns investors to “carefully review the specific terms of an offering” to ensure they understand how the funds will be invested while held in the trust account.[14]

The funds in the trust account are used for three primary purposes: 1) payment for the proposed merger, 2) redemption of common stock of the SPAC, and 3) payments of deferred underwriting fees associated with the SPAC IPO. Earlier, it was discussed that traditional IPOs are typically associated with underwriting fees of approximately 5 –7% of gross proceeds. The underwriting fees for SPACs are different. The investment banks often receive 2% of gross proceeds at the closing of the IPO and another 3.5% is deposited into the trust account to be paid only in the event of a completed transaction. These deposited funds are referred to as the deferred underwriting fees.[15]

DE-SPAC OR DISSOLVE

Typically, the SPAC has 18 – 24 months to find a target private firm to acquire and complete the merger. This process, assuming a successful merger occurs, is known as the De-SPACing process and is depicted in Exhibit 3 from above.

Following the formation and IPO of the SPAC, the SPAC sponsors will conduct searches for a target private operating firm. Once a target is identified, the SPAC will negotiate the terms of purchase.[16] Following negotiations, if an agreement is not made, the target search continues. However, if a deal is reached, it is often taken to the SPACs investors for a shareholder vote.[17]

Typically, the SPAC is required to obtain shareholder approval of the proposed merger. In the U.S., this approval must follow SEC proxy rules.[18] The SPAC investors vote to approve or disapprove the proposed merger in a proxy. Investors will also decide whether they would like to redeem their shares, liquidating their position in the SPAC. The proposal is approved, and the De-SPAC process moves forward, if 1) more than 50% of shareholders approve the merger, and 2) less than 20% vote to redeem their shares.[19]

If the investors vote down the merger agreement, then the target search continues again, or the SPAC may be dissolved. When a SPAC is unable to identify and complete a merger within the allotted timeline, the SPAC is unwound or dissolved. At that time, the SPAC IPO investors get their pro-rata share of the trust account along with accrued interest. Additionally, the founder shares as well as any warrants issued expire worthless.

If the investors approve the merger agreement, then the SPAC begins the De-SPACing process – under which the private target and the SPAC combine into a single entity at the completion of the merger. Once the shareholders approve the merger, and all regulatory hurdles are met, the merger will close or be complete. At this time, the acquired private firm becomes publicly traded, taking the place of the SPAC’s listing on the stock exchange, though typically under a different ticker than the original SPAC.

Once the merger is complete, the SPAC investors have the choice to exchange their SPAC shares for shares of the new merged company, essentially buying into the acquired previously private firm, or to redeem their SPAC shares from the trust account. Under some agreements, the investors may be able to cash in their warrants from the SPAC IPO after a brief period (often 30 days after the De-SPAC). Typically, the SPAC sponsors are given approximately 20% ownership of the merged entity, exchanging their SPAC founder shares at a 1-to-1 ratio for common shares of the combined company, which now includes the acquired operating firm.

SHARE REDEMPTION

There are several ways for SPAC investors to exit their investment position. Once the SPAC is public, the investors can sell their shares in the stock market just like any other public investment. Moreover, if the SPAC is liquidated, investors will redeem their shares. Further, investors have the option to redeem their shares if the SPAC sponsors seek to extend the period the SPAC has to complete a merger. Additionally, investors have the option to redeem their SPAC shares following the decision of a proposed merger proxy vote.

Until recently, SPAC proxy votes used to combine the right to vote for merger approval with the ability to redeem shares. Investors who voted against a merger transaction elected to redeem their shares, which returns capital in exchange for the shares they purchased in the SPAC. Investors who voted for the merger were unable to redeem or liquidate their shares. Now, these two decisions are separate – an investor can decide to redeem their shares regardless of how they voted on the merger decision which has attributed to the increase in recently approved mergers.

When an investor chooses to redeem their shares, the redemption value of the shares is based on the investors pro rata share of the trust account, regardless of how much the investor paid for the shares. This is particularly relevant for investors who purchased SPAC shares in the market, and not at the IPO. Exhibit 6 outlines three different investors who chose to redeem their shares assuming a $10 redemption value, equal to the initial SPAC IPO unit price. The interest earned by the trust account will also be distributed to the investors on a pro rata basis. Historical returns to SPAC investors will be discussed in more detail in Part 3 of our Should SPACS be Back series.

WHY SPACS?

We are experiencing the hottest market in SPAC history. JPMorgan noted that 2020 was dubbed the “Year of the SPACs” in the U.S., with SPACs accounting for more than 50% of the IPO market at more than $80 billion raised in over 230 SPAC IPOs.[20] At the end of the first quarter of 2021, SPAC deals in the U.S. already exceeded the total amount conducted in 2020, sitting at approximately 430 SPAC IPOs valued at approximately $128 billion. Further, Google Search trends over the last five years highlight growing interest in SPACs (See Exhibit 7).

The SPAC attack is spreading, with the trend catching on worldwide. JP Morgan’s Co-Head of Equity Capital Markets, EAMA noted that “2021 is going to mark the emergence of European SPACs… Scarcity value is attracting substantial U.S. and European investor demand for European SPACs.”[21] A March 2021 UK Listing Review report to the Chancellor, recommended “changes to the Listing Rules to remove a barrier which currently deters special purpose acquisition companies (SPACs) listing in the UK” in efforts to become competitive in the global SPAC market.[22] Singapore is also looking to boost the Singapore Exchange’s (“SGX”) position in the SPAC market, noting that “allowing SPACs to be listed on the SGX could be a good tool to revive investor interest in the SGX, which has failed to attract big-ticket IPOs over the past few years, particularly in the hot sectors such as technology.”[23]

These trends will be discussed in greater detail in Part 2 of our Should SPACS be Back series.

SUMMARY

Going public via a traditional IPO is associated with several drawbacks including a time and cost intensive process and limited ability for existing shareholders to cash-out a portion or all their ownership around the IPO. As a result, private firms have sought to find alternative methods to becoming publicly listed. A SPAC is one alternative method to the traditional IPO that will take a private firm public. Although SPACs have been around for decades, the use of SPACs has drastically increased over the last two years.

Investors in the SPAC IPO essentially make a blind investment, putting their trust in the skill of the SPAC sponsors to identify a winning acquisition target. While SPAC regulation has increased over the years, increasing transparency for potential investors, and adhering to certain minimum requirements, investors looking to get into the SPAC space should conduct an extensive review before investing.[24] Specifically, it is important to understand the unique feature of the SPAC of interest, focusing on the held equity interests and business background of the SPAC sponsors. There may be a significant divergence of economic interests between the investors and the SPAC sponsors, and careful attention must be paid to the potential conflicts of interests in each SPAC.

At present, SPACs are one of the hottest trends on the Street, quickly becoming a dominant method to take a company public in the U.S. However, there are many critics to the SPAC craze. In the continuation of our Should SPACS be Back series, we will discuss the origins and history of SPACs as well as why an increasing number of companies are choosing to jump on the SPAC train. Our final entry in our Should SPACS be Back series will discuss the financial performance of SPACs and provide insights on who appear to be the winners and losers in the SPAC world.

Sources:

[1] Following a recent rule change by the SEC, the U.S. has seen an increase in the number of direct listings (AKA direct public offerings). These direct listings are quicker and cheaper than traditional IPOs and do not require the use of underwriters. IPO Direct Listing vs. Traditional: Pros and Cons for Going Public (investmentu.com)

[2] While our series focuses on the underwriting fees associated with IPOs, issuances also experience a cost known as underpricing, which can be significant. Underpricing occurs when the IPO price of a company is below its realized value in the stock market. Underpricing can be deliberate or accidental. To the extent IBs purchase shares of an IPO, this increases the likelihood of misaligned interests as the IBs help value the IPO price and have incentive to undervalue the shares to increase profits on the shares they purchase.  

[3] Want To Take Your Startup Public? What It Actually Costs To IPO – Crunchbase News

[4] For additional information, see SPACs explained | Fidelity.

[5] In other words, the firm does not make or sell and products, nor does it sell any services.

[6] According to the SEC, “[a] blank check company is a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person.” Blank Check Company | Investor.gov

[7] It should be noted that the nominal payment for the ownership is meant to compensate the sponsors who are unable to earn a salary or commission until the acquisition of a private operating firm is complete.

[8] “In other words, if a Wall Street executive or celebrity raises $400 million from public investors, that person also gets a stake worth $100 million, regardless of how well the company performs after the merger.” Why SPACs Could Leave Investors in the Cold - The New York Times (nytimes.com)

[9] The warrants are exercisable for a ratio of common stock at a discount to the offering price. The ratio of warrant to common stock depends on things such as the investment bank assisting with the IPO and the size of the SPAC. Only a full warrant can be exercised, as such any investor that owns a fraction of a warrant cannot utilize the benefits of the warrant. These warrants serve as an additional compensation method for investors. Typically, these warrants are not immediately exercisable and generally can be used “30 days after the De-SPAC transaction [i.e., when the SPAC and private firm have combined] or twelve months after the SPAC IPO.” For more information see How SPAC mergers work: PwC.; A New Development in Private Equity: The Rise and Progression of Special Purpose Acquisition Companies in Europe and Asia (northwestern.edu); Special Purpose Acquisition Company (SPAC) - Overview, How It Works (corporatefinanceinstitute.com)

[10] “Following the IPO, the units become separable, such that the public can trade units, shares, or whole warrants, with each security separately listed on a securities exchange.” Special Purpose Acquisition Companies: An Introduction (harvard.edu)

[11] In addition to the standard requirements, SPACS must comply with additional regulations. These regulations were introduced following litigation surrounding fraud and blank check companies from the 1980s. Some of these regulations are discussed in more detail in Part 2 of our Should SPACS be Back series.

[12] Prospectus - Overview, Examples, Uses & What's Included (corporatefinanceinstitute.com)

[13] It is possible for the trust account to have more than 100% of the IPO proceeds based on the investment of the SPAC sponsors. While it is not a requirement for the trusts to hold 100% it is market practice to hold at least 100% so that, in the event of liquidation or share redemptions, investors will receive at least the $100 invested for each share of common stock. Special Purpose Acquisition Companies: An Introduction (harvard.edu)

[14] SEC.gov | What You Need to Know About SPACs – Investor Bulletin. The SEC also notes that “You should review the IPO prospectus of the SPAC to understand the terms of the trust account, including your redemption rights and the circumstances in which cash may be released from the account.”

[15] In the event the SPAC is liquidated, and no De-SPAC transaction takes place, the deferred underwriting fees are not paid to the investment banks and is instead used to repay SPAC investors as part of the redemption process. Special Purpose Acquisition Companies: An Introduction (harvard.edu)

[16] Sometimes a SPAC may realize the need for additional capital beyond what is held in the SPAC trust to complete a merger. In this case, the SPAC can issue debt or issue additional stock. One such method is using a private investment in public equity (“PIPE”) deal. See e.g., Private Investment in Public Equity – PIPE Definition (https://www.investopedia.com/terms/p/pipe.asp)

[17] As part of the shareholder approval process, the SPAC will file a proxy statement and possible a joint registration. This will include a description of the merger proposal as well as historical financial information about the target private firm and pro-forma financial information about the merged entity. How SPAC mergers work: PwC

[18] The target private company is not required to undergo an SEC compliant proxy process.

[19] SPACs explained | Fidelity

[20] What is a SPAC? (jpmorgan.com)

[21] What is a SPAC? (jpmorgan.com)

[22] UK_Listing_Review_3_March.pdf (publishing.service.gov.uk)

[23] SPACs: A Singapore perspective - IR Global

[24] The SEC notes that, “Whether you are investing in a SPAC by participating in its IPO or by purchasing its securities on the open market following an IPO, you should carefully read the SPAC’s IPO prospectus as well as its periodic and current reports filed with the SEC pursuant to its ongoing reporting obligations.” SEC.gov | What You Need to Know About SPACs – Investor Bulletin

‍