The Year of the SPAC

With $40 Billion of Capital Available, Will SPACs Become a Viable Alternative to the Traditional IPO?

Amid this year’s white-hot IPO market, the SPAC, or special purpose acquisition company, has incinerated previous records for this once-obscure financing vehicle. Thus far, in 2020, 116 SPACs have been funded through initial public offerings, raising $40 billion. SPACs make up the single largest “industry” group in 2020’s crop of IPOs, accounting for 45% of the number of new issues and 44% of total capital raised. More "blank check" companies debuted on NASDAQ and NYSE in August and September than "real" operating companies. The financing vehicle has attracted a host of luminaries, from investment icons like Bill Ackman of Pershing Square and Peter Thiel, baseball savant Billy Beane of “Moneyball,” and former Speaker of the House Paul Ryan.

The enormous amount of investable capital sitting on the balance sheets of these entities, is leading even mature, venture-backed companies to consider if SPACs might provide a more efficient path to achieve public status and raise capital on favorable terms. Many SPACs have tremendous flexibility in the industries and geographic regions where they can complete a business combination, including a number that are focused on China or Southeast Asia. In some cases, the SPAC sponsors may be able to lend prestige and guidance on public company readiness that can help a less experienced management team be successful.

Investors’ willingness to shovel money into SPACs is intriguing, given their subpar returns. Year-to-date, SPACs have returned 5% on average to shareholders compared to a 36% average return for non-SPAC IPOs. Over a more extended period, the results are even more mixed, with a recent study by Renaissance Capital showing that out of the SPACs that have managed to acquire an operating business since 2015 had an average loss of 18.8% and a median loss of 36.1%. Numerous academic studies have shown a consistent pattern of value destruction by SPACs during earlier periods.[1]

So, what accounts for the overwhelming attraction for the SPAC format?

Something for Everyone

In theory, a SPAC provides public market investors access to juicy, privately negotiated deals typically only available to elite investment institutions and wealthy families — they’ve been dubbed a “poor man’s private equity fund.” A group of founders who are reputed financial or industry experts, known as the SPAC sponsors, form an empty shell company with the intent of sourcing and then acquiring or merging with an as yet unknown operating company. The sponsors retain an investment bank to raise tens of millions or even billions of cash that will sit idle for up to two years until the SPAC locks down on its target.

For investors, SPACS appear to offer the ultimate safe bet, as they are required to place at least 90% of the IPO proceeds in an escrow account. The sponsors cannot touch these funds until the SPAC acquires a suitable acquisition or merger candidate. Most SPACs now commit to locking up 100% of the IPO proceeds into trust, plus any accrued interest. At the end of 24 months, if the SPAC sponsors fail to secure a deal — or if the investors don't like the proposed target or terms — they can elect to get their pro-rata share of the trust refunded. To sweeten the deal, investors also receive a warrant to purchase an additional share or fraction of a share as part of the "SPAC unit." The presence of a warrant gives further upside and enables a range of trading strategies funds can use to lock in their profits.

For companies, SPACs can find a fast track to going public and accessing significant amounts of growth capital at arguably more favorable terms than what a private equity firm might offer. SPAC promoters will often argue that they provide a lower cost of capital by avoiding the underwriting discount of an IPO and the frequent underpricing that occurs to ensure an initial trading “pop” and reward institutional clients. SPACs may be happy to gobble up quirky companies that don’t align with the current appetites of the IPO market. A deal can be completed in as little as two to three months, assuming that the target has audited financials, instead of the more typical six months or more for a fully vetted IPO.

For SPAC sponsors, a successful acquisition can lead to meaningful wealth generation from a single transaction with a relatively low capital commitment. Sponsors typically receive "founder shares" equal to 20% of the post-IPO shares outstanding for nominal consideration. In some cases, these are literally "free money," although as the structure has matured, investors now expect founders to have "skin in the game" in the form of warrants or shares purchased through a private placement. This upfront founder investment covers the initial listing expenses, making it possible for 100% of IPO proceeds to remain in the trust.

Investment bankers have learned to love SPACs as they make substantial fees marketing off of essentially a set of founder resumes. While there are some minor differences in deal structure, most SPAC registration statements repeat essentially the same boilerplate; there are no operations to perform due diligence and no history of financial performance to analyze. If the SPAC closes on an acquisition it will generate an ongoing stream of advisory fees for bankers, lawyers, auditors, and other professionals — in short, something for everyone.

A Confluence of Conflicts

In reality, the SPAC's complex structure generates a confluence of conflicts of interests that may be at least partially accountable for the subpar performance of many of these deals.

When SPACs first became popular, the SPAC "unit" usually included one share and one or two in-the-money warrants. Sharp hedge funds realized that they could sell the warrants to book a profit, and then once a target was announced, withhold their vote on the deal unless the promoters agreed to buy out their shares above trust value. Such “greenmail” strategies led to all sorts of convoluted private negotiations, usually to the disadvantage of less-informed retail investors.

In a SPAC IPO, the investment bank will also set aside a portion of the underwriter's discount, pending an acquisition's successful completion. If there is no deal, the trust distributes those escrowed fees back to shareholders, creating a powerful incentive for banks to help SPAC founders make it across the finish line.

The reduced level of scrutiny that a company receives when merging with a SPAC, compared to the multiple rounds of SEC review in a traditional IPO, may also make the format more attractive to companies whose disclosures are less than impeccable. One of the most spectacular recent SPAC success stories was subsequently the subject of a short seller report that led to its CEO resigning and a collapse in its share price.

The mandate of SPAC founders is to find a desirable target for their shareholders, leading to long-term stock appreciation and enabling investors to exercise their warrants. On the other hand, if these sponsors cannot close on an acquisition, their founder shares and warrants become worthless, and their initial investment vaporizes. From a financial perspective, nearly any deal is better than no deal for SPAC sponsors. Indeed, they can realize rich returns (at a favorable capital gains tax treatment) even if the share price declines by 50% or more post-merger.

As these conflicts became evident, the SPAC structure has evolved to increase the probability of a merger or acquisition closing and motivate SPAC founders to land higher quality deals (so SPACs become an actual investment, rather than an arbitrage play).

The Evolution of the SPAC

The pedigree of the modern SPAC dates back to the “blind pools” of the South Sea bubble, in which 18^th Century investors subscribed to “an undertaking of great advantage but no-one to know what it is.”   The format resurfaced again with the rise of penny-stock “blank check” offerings in the 1980s, which ended with the SEC cracking down on the most prominent brokerage behind these deals and implemented Rule 419 to protect investors against abuses. The modern SPAC was born in 1993, and the format's popularity has waxed and waned over the years, before reaching a fever pitch in 2020.

Some of the most important recent innovations to the SPAC structure include:

• Fewer Warrants – Each SPAC unit used to be composed of a share and one or two in-the-money warrants. The warrants not only made the transaction highly dilutive to the target company, but they also created incentives that could be exploited by sophisticated hedge funds to achieve higher returns without staying in the deal. Most SPACs now offer only a fractional warrant with a strike price at a premium to the unit price and residual trust value.

• Skin in the Game – In the past, all of a SPAC's operating costs associated with public reporting and losing an acquisition would be funded out of the IPO proceeds, meaning that the sponsors had nothing to lose if they failed to close on a deal. Today, investors expect SPAC founders to purchase warrants or shares in a private placement with no claim on the escrowed funds. This investment enables the SPAC to keep all of the IPO proceeds in trust and presumably focuses the founders' minds on finding a successful deal, given that they have capital at risk.

• Bulge Bracket Banks – Several years ago, SPACs were nearly the exclusive preserve of specialized boutique firms like Earlybird Capital that floated relatively small deals and did little business outside the SPAC world. Today, SPAC underwriters include the largest names on Wall Street, with Goldman Sachs, Citibank, Credit Suisse, Deutsche Bank, and UBS lending their imprimatur to the format. Dedicated SPAC bankers have led less than 7% of this year’s deal flow. Banks must escrow a significant portion of their fees contingent on a successful business combination.

• Earning Founders’ Shares – The 20% founders shares, otherwise known as the "promote," are among the more controversial aspects of the SPAC structure. It can turn even a bad deal into a financial bonanza for the organizers. Some SPACs have introduced mechanisms where these founder shares are released from escrow only once the share price reaches specified share price targets after the deal closes. In this way, SPACs may evolve to be closer to the private equity model, where managers earn 20% of the profits earned for investors, rather than 20% of the capital put at risk. One highly prominent SPAC has gone so far as to eliminate founder shares. More frequently, SPAC founders may be willing to negotiate to reduce the size of their stake to secure a particularly desirable deal with manageable levels of dilution.

• Vote vs. Exit – Historically, SPACs needed to meet two critical thresholds to close on an acquisition or merger: The majority of shareholders needed to vote in favor of a transaction. No more than 20% of shareholders could elect to redeem their shares for the cash held in trust. The dual approval format provided investors with tremendous leverage to block a deal or extract rich payouts to purchase their consent to proceed. Most recent SPACs have made holding a shareholder vote discretionary by SPAC management, unless required by law, and have dramatically increased the threshold for redemptions needed to block a deal. Many SPACs restrict entities' or groups' ability, with over 15% of the shares outstanding, from exercising those redemption rights to reduce the potential for "greenmail." But excessive redemptions will still put a deal at risk since the target company will be reluctant to merge into a shell that does not contain sizable amounts of cash.
• Private Placements– Yet another wrinkle in the evolution of SPACs is to include a sizable negotiated private placement by sophisticated investors concurrent with the closing of the SPAC merger. The cash infusion may either serve to replace the capital of investors who chose to redeem their shares or upsize the deal to meet the target company's growth needs or both. While such a private placement can signal that "smart money" is endorsing the new public company, it can also lead to an even more complicated capital structure.

Will all these structural changes make the current generation of SPACs more likely generate positive returns for investors

What is certain is that there are now tens of billions of "dry powder" sitting in SPACs, all of which have a definitive end date to find an acceptable way to deploy it. And more SPACs are most definitely on the way. Forty-five new blank check IPOs have filed publicly with the SEC so far just in the month of September.

The End Game for SPACs

When everything from the economy's underlying health to the outcome of the election is up in the air, SPACs have an undeniable appeal. On the one hand, a SPAC is a safe place to stash money with a high probability that you can get it back if you need to. On the other hand, they could end up being a ticket to the future of space travel — anything is possible until the sponsors announce their merger target — the undertaking of great advantage!

Whether they overcome the taint of their past performance will depend entirely on whether they can source high-quality companies prepared for the rigors of the public markets. At least some voices believe that SPACs may be a viable alternative for venture-backed companies to get public at warp speed while leaving less money on the table than through a traditional IPO.

In a widely-read recent blog post, Bill Gurley, of Benchmark venture capital, argued that the plethora of funded SPACs puts companies in a unique position to negotiate favorable terms with sponsors and obtain “a much lower cost of capital versus a standard IPO.” He believes that companies can effectively negotiate their valuation and other deal terms effectively with a single sponsor, rather than waiting for large institutional investors to impose a massive discount through the traditional IPO book-building process.

It remains to be proven if SPACs offer a superior option to IPOs for mature venture-backed companies. To minimize SPAC's redemptions, shareholders still need to believe that the merger terms provide sufficient upside to forego opting for a cash payout. But he is undoubtedly correct that if there were ever a time when negotiating dynamics favored quality companies, it would be now with tens of billions in cash sitting idle and sponsors under the gun to “use or lose” the proceeds they have raised. Globally, hundreds of capital-hungry "unicorn" companies have outgrown the venture funding model and seek ways to access the public capital markets.

2020 is indisputably the year of the SPAC. If those stars align, 2021 may shape up as the year when SPAC investors finally start making some real money.

[1] In 2011, Jenkinson and Sousa looked at the 58 SPACs that completed mergers between 2003 and 2009 and found an average negative return of 24% in the first six months and 55% in the first year.