If you look at the headline numbers, SPACs appear awash with cash. In 2021 alone, 436 SPACs have raised $126 billion, for an average of $289 million apiece, according to SPAC Insider. Today, over 450 SPACs are scouring the universe for an enticing private company target into which to deposit their bag of money.
When SPACs publicly announce a prospective merger, they highlight the headline proceeds to the private company “assuming no redemptions” and then topped off by a PIPE investment that may add 50-100% to the total funds raised. If you take a $300 million SPAC trust and kick in another $150 million private funding from institutional investors, that adds up to some serious walking around money — enough to give ambitious green energy, space transport, and biotech players the swagger that they can fully fund potentially world-changing technologies.
Except what if the cash isn’t there?
This summer, as SPAC mania fizzled, merger candidates received a rude reminder that SPAC shareholders retain the right to redeem their shares for cash, even when they vote in favor of a proposed merger. In recent months, redemptions on closed deals have averaged 50% or more, and in several cases, 90% of existing investors have opted for their cash to be returned. In one case, the undersea mining company The Metals Company experienced overwhelming redemptions and had its PIPE investors back out, leaving it with just $110 million out of an anticipated $500 million to fund commercialization plans estimated to cost billions. This was particularly disturbing since PIPE investors are supposed to "backstop" the newly public company’s capital needs as an ironclad commitment.
Highlighting this market reality, the SEC’s Chief Accountant recently provided guidance to audit firms active in the SPAC market that the proceeds from the public shares issued in a SPAC IPO should now be classified as temporary equity rather than permanent equity. This accounting change highlights that these shares, otherwise known as Class A redeemable shares, are more "maybe money" than committed capital since investors’ decision to redeem is outside of the issuer’s control.
Just how pervasive is the SPAC redemption issue?
According to a research paper published by professors from Stanford and NYU, over 90% of the institutions that invest in SPAC IPOs will either redeem their shares for cash or sell them to other investors before closing the merger. The paper, entitled “A Sober Look at SPACs,” posits that there is one group of investors who purchase SPAC IPOs – hedge funds uncharitably dubbed the "SPAC mafia"– and an entirely different group that ends up owning stock in the newly public company after the merger and de-SPAC have been completed. The paper contrasts the ability of the SPAC mafia to earn a riskless return by cashing out of the common stock and then trading the SPAC warrants with the fate of investors who buy into the SPAC merger and suffer from the dilution of the “promote” shares, warrants, and transaction costs associated with the SPAC structure.
Outsized investor redemptions can have dire consequences for companies as well.
The newly public company may not have sufficient capital to execute its business plan. This shortfall is ticklish because most SPACs have already disclosed projected milestone events and financial results contingent on raising a certain amount of capital and are "baked in" to the proposed valuation. Target companies include provisions for a minimum capital raise in the merger agreement, but in practice, companies often waive such conditions to get a deal across the finish line. This compels management to revise those public projections leading to a loss of investor confidence and a downward spiral in the stock.
Redemptions are a critical indicator of the long-term health of the SPAC market.
When stocks trade above the $10 mark after a SPAC announces its target, it signals that SPAC sponsors have accomplished their mission of finding an attractive asset that deserves to be public and valuing it appropriately. When the stock slumps below $10, redemptions are likely to follow, as investors conclude that they are better off taking cash than own stock in a company that is either unready or overvalued. If outsized redemptions become the norm, then the overall SPAC product is at risk of becoming permanently tainted.
So, how can SPAC mergers increase the chances that cash stays with the company and becomes permanent capital?
First, SPAC managers need to choose merger partners with the elements to succeed as a public company. The notion that one can take a venture-stage enterprise with a handful of employees, a development-stage product, and no revenues and throw it into the public markets has often ended in tears. Successful SPAC merger candidates should have demonstrated they can commercialize their products and have sufficient customers to support a credible ramp in sales. Management should articulate a clear plan for how the money raised in the transaction will dramatically change their growth curve and why being public is the right option for their business trajectory.
Second, SPAC targets need to have the management teams and systems in place to operate in the public realm. They need to report back to shareholders and regulators every quarter with reliable financial data. Preparation for a SPAC merger needs to be every bit as rigorous as for an IPO, and companies should consider operating as if they were already public from the moment that they announce their merger agreement. This includes holding professional-style earnings calls and having a regular stream of announcements demonstrating that the company is executing its business strategy. Early markers of success will convince investors that the team will continue to deliver after the deal closes.
Third, SPAC deals need to take full advantage of the ability to refine their story and engage in price discovery in advance of making a public announcement. SPAC mergers enjoy an enormous advantage over traditional IPOs; they can engage in detailed discussions with prospective investors on a confidential basis before finalizing the deal's terms. Successful SPAC mergers have included very sizable institutional investors and customers, and strategic partners who can help validate the promise of an emerging technology. However, in some cases, SPACs will seek to entice investors by providing free or discounted stock to lower the effective price to PIPE investors below the $10 mark. These "sweeteners" are likely to erode market confidence that the deal is valued appropriately. In the long term, companies are better off taking a haircut on their initial valuation to continue to raise financing at higher prices as the stock appreciates after the merger.
SPACs have enjoyed a meteoric rise in popularity the past few years, as they seem to have unlocked the secret to raising unlimited funds. But rising redemptions remind us they are nothing more than an alternative means to creating a new public company. The elements of a great public company – including superior products or services, the ability to execute a business plan, and robust financial reporting and governance practices – are no different from a traditional IPO.
When all those elements are in place, the SPAC’s cash will be there at closing as permanent capital as well.