Fearless Girl on Wall Street
HOT TRENDS – SPACs
Only last year, around 200 companies went public as “blank check” investment vehicles known as SPACs (Special Purpose Acquisition Companies). This type of companies have been available for decades but were used mostly as a last option to go public.
What is a SPAC:
A SPAC is a shell company, created with the purpose of effecting a business combination with one or more businesses. The negotiation happens through a sponsor, usually a widely recognized investor and his team, that act as management of the SPAC at least until the combination is concluded.
The Sponsor usually provides the starting capital, he is also responsible for the marketing of the SPAC and raising additional capital through an IPO. The SPAC does not have any operation and usually, the only asset is the cash raised to complete the business combination. At the moment of the IPO the investors might not even be aware of which company has been targeted by the sponsor team, but rather a loose idea of the kind of company the Sponsor is looking for. For this reason, the reputation of the sponsor can be the main factor to convince the public into investing in the unspecified deal.
The funds collected through the IPO are kept in an interest-bearing account at a third party. They are used to conclude the combination or liquidated and redeemed proportionally to the initial investment, in case the business combination is not concluded within a specific time range (usually between 18 and 24 months).
In return for their capital, investors are given “units”, comprising a share of common stock and a certain fraction of a warrant to purchase more stock in the future. After the IPO, shares, and warrants can be traded separately in the public market. An investor has the possibility of being an early investor and try to buy a unit combination at the time of the IPO, or he could wait until the unit is dismantled, allowing him to have a more refined investment strategy, allocating his capital freely between shares and warrants.
At the moment of the combination, investors can choose to either have their investment converted in shares of the new company or to be returned their capital plus the interests accrued from the trust. Some investors might as well recoup the value of the shares and keep the warranted part of the unit, which allows the future purchase of shares at a certain price.
Once the combination is completed, the new entity will continue the operation of the combined company as a publicly traded corporation.
According to CNBC, the recent surge in these types of investments can be explained by the increase in market volatility. In fact, rather than risking a flawed public launch, private companies are now preferring SPACs mergers. They allow a more private negotiation over the valuation of the combined company and, overall, a faster process. As we said already, at the moment of the IPO, the SPAC company does not have any operation. This peculiar situation allows for skinnier documentation and faster due-diligence processes than classic stock market launches. Even SEC reviews are dealt with in a quicker manner, as they can be postponed up until the closing of the business combination.
It must be clear that, unlike the traditional IPO process, where the securities offered to the public are valued through market-based price discovery, the Sponsor is the solely responsible for the valuation of the private operating company and how much the SPAC is willing to pay for it. Many SPAC’s enthusiasts praise this characteristic as one of the main features of this asset class. According to them, investors are able to be partially covered from the market risk that they would incur in an IPO process. In fact, the price of the deal can be inferred from the size of the SPAC at an early stage, as well as during the negotiation process. Furthermore, the price at the time of the combination is set through the private negotiation, limiting the risk for shareholders to be exposed to market price fluctuations. On the other hand, in an IPO-style stock market launch, the market price of the company would be determined only at the moment of the IPO itself, while investors are bearing the full market risk.
The other two aspects often highlighted as strong SPAC selling points are the respectability and international stand of the Sponsor, as well as the cheaper costs from the less detailed legal structure of this type of company.
One of the main critics of SPAC combinations is the extreme power given to the sponsors. As investors accept to create a “blank check” company and to acquiescently remit their capitals to acquire an unspecified company, they are exposed to agency risk.
Critics also pointed out the inherent problem of dilution. Dilution occurs at the time of the merger in two moments: when the sponsor team obtains the “promote” (a management fee of usually 20-25% of the shares sold in the IPO) and when the warrants are executed. Another point that critics highlight is the difference in treatment between PIPE (Private Investment in Public Entity) and regular investors. PIPE are usually institutional investors that can bargain better deals to acquire a stake in the company, increasing further the dilution for the regular investor.
Despite all that, SPACs are sometimes praised as a tool of democratization in the markets. In fact, as SPACs become more and more trendy, retail investors are flocking in great numbers into these deals, as they offer the sought-out chance to participate in stock market launches. However, the increasing participation of smallholders is creating logistical problems for the SPAC market. Retail investors tend to be less versed in their shareholders responsibilities than institutional investors: a clear and dangerous example of that is their common absence at shareholders meetings. In the case of SPACs, the shareholders’ vote is necessary to validate the merger. When shareholders do not attend the consultation in a number large enough to reach a valid majority, the meeting must be adjourned multiple times, putting at risk the success of the business combination. Ça va sans dire, this is commonly the case when the majority of the shares of the SPAC are held by retail investors.
To Sum Up…
SPACs investing has some characteristic that makes it more challenging and complex than the trading of other kinds of assets available on the public markets. From the Sponsor’s respectability to the sophisticated investment possibilities offered by unit trading, to the dilution and lack of shareholders participation; there are many aspects that an investor might want to consider before entering into a SPAC deal.
Their presence in the stock market makes SPACs an extremely attractive deal for investors, hoping for mouth-watering returns. However, all that glitters is not gold, and investing in these companies can have downturns. As an early investor, your investment is no more than a bet on the Sponsor’s standing and his capacity to close a deal in the next one to two years. Plus, it is important to consider your opportunity cost, as your capital will be locked in a trust most probably at low-paying Treasury bonds rates. Finally, in the case of a successful deal, the investors will end up with his initial investment plus interest or with stock as risky as any other from a company entering the stock markets for the first time.
An interesting alternative for investors can be found in SPAC concentrated ETF. These funds allocate their resources over many of these companies, allowing investors to not be exposed to idiosyncratic risk.
Whether you are a SPAC or ETF investor, or if you are simply curious about the topic, always keep in mind that the contents on this site are provided for your personal information only and are not intended for trading purposes. Nor does it provide any form of investment advice, or make any recommendations regarding particular financial instruments, investments, or products.
Journalist at BSL Investment Club