SPAC to investor: "Hi, I am raising money to buy equity in a private company."
Investor: "I'm interested. What are you buying? And how much are you paying for it?"
SPAC: "I don't know."
Investor: "OK, here's $200 million."
This approach to investing may sound suspect, but it's gaining in popularity. With names like Colin Kaepernick and Jay-Z getting in on the game, SPACs are reaching record levels of exposure. New issuance of SPACs has skyrocketed over the past year: Over $75 billion was issued in 2020, almost 7x times more than in 2019.
A Special Purpose Acquisition Company, or SPAC
A SPAC is formed and taken public in an initial public offering (IPO) with the sole intention of merging with a private company, thereby taking the private company public.
The SPAC does not have any business operations to start, but its purpose is to create the shell of a public company and raise a blind pool of capital. The SPAC's sponsor will then search for a private company looking for capital that also has an interest in going public. The sponsor will negotiate to make an equity investment in the target company and use that equity investment to essentially conduct a reverse merger, thereby taking the target private company public.
Usually, the investors in the private company will end up being the majority shareholders in the merged entity. In this roundabout way, the private company is able to raise capital and go public without going through the typical SEC regulatory process.
3 main benefits for a private company to go public through this process as opposed to the IPO route.
- The certainty of a private company knowing its valuation prior to selling equity.
- This process is often faster than the typical IPO.
- Most importantly, a private company is able to provide investors with more information such as projections and forward-looking statements, which are not allowed during the traditional IPO process.
People equate investing in SPACs with investing in private equity funds; however, there are significant differences.
- Investing in a SPAC does not provide diversification. It is an investment in a single company as opposed to investing in a private equity fund that invests in a portfolio of companies. Investing in a single company while it is still in its early stages of revenue generation and product monetization has a very high degree of risk.
- Private equity sponsors only earn their 20% fee if they generate gains on the capital they have invested, whereas SPAC founders have an incentive to put capital to work--even if they don't necessarily think the merger is a great investment at an attractive valuation.
Phase 1: A typical SPAC goes about its IPO
- The SPAC sells its shares as a unit offering consisting of one share and a warrant. The shares are typically priced at $10 and the warrant is usually convertible between one half to one share at $11.50. In consideration for setting up the SPAC and conducting the due diligence to find a private company to merge with, the sponsor of the transaction purchases 20% of the total equity of the SPAC for a de minimis amount. This is the first instance in which shareholders are diluted by additional equity. Effectively, this dilution in the IPO acts as a 20% up-front fee payable to the sponsors. In addition, the underwriters charge a 5.5% fee to sell the stock (often splitting the fee into 2.0% payable upon issuance and 3.5% deferred until a merger is completed). The net cash proceeds of the offering are placed in a trust and invested in short-duration fixed-income assets.
- The sponsor then has two years to identify and negotiate a merger with a private company. If at the end of the two years the sponsor has not announced a merger, the SPAC will be unwound. The IPO shareholders will receive a cash payment from the trust that is intended to be equal to the $10 purchase price plus accrued interest. However, investors should be cognizant that the interests of the equity sponsors may not always align with those of the shareholders. As the sponsors only paid a small amount for their shares, they will lose the economic value they would have realized from those shares being used to conduct the merger. As such, the sponsors have incentive to find a merger candidate before the two-year clock runs out.
- Shortly after the IPO, the units can be divided, and the stock and warrants then trade separately. During the period before the merger, the original buyer can sell the stock, which typically sells in the secondary market at a slight premium to the IPO price, and effectively retain the warrant for free.
The intent of this structure is to provide the IPO shareholders with the option to hold their shares and invest in the merger target if they think the business and valuation is attractive. Plus, the warrants act as an additional kicker if the stock price trades up.
If IPO shareholders do not want to invest in the merger candidate or think the valuation or potential equity dilution is too great, they then have the option to put their shares back to the SPAC. Yet, they retain their warrants as payment for the opportunity cost of being invested in the SPAC instead of a different investment.
Phase 2: Before the Merger
Once the sponsors have identified a merger target and agreed to a non-binding purchase agreement, they then make a public announcement. As part of the merger, if the cash consideration paid to the target is greater than the amount of cash raised by the IPO, the sponsor will raise additional capital through a private investment in public equity, or PIPE. A PIPE transaction provides the benefit of a third party affirming the valuation of the merger target with further investment, but, depending on the structure of the PIPE, this may further dilute the IPO shareholders.
At this point, the shareholders will conduct their own due diligence and valuation analysis to determine if they want to continue to hold their shares or require that the SPAC repurchase those shares. A significant part of this analysis is estimating the total number of shares that will be put back to the SPAC and the total amount of dilution the remaining shareholders will suffer.
Historically, a large number of shareholders have elected to put their shares back to the SPAC based on the amount of equity dilution that would reduce the value of their equity ownership.
Phase 3: After the Merger
Once the merger has closed, the SPAC will change its name and ticker symbol to reflect the name of the operating company. The shares will then trade based on the market valuation as applied to the now-public operating company.
Who Should Invest in SPACs?
SPACs are designed to set up a public funding vehicle to merge with a private company and take it public without going through the traditional IPO process. To compensate investors for the opportunity cost of earning only a risk-free rate, the structure limits the initial downside risk and pays the initial IPO investor with a free option on the valuation of the eventual merger candidate.
Investing in SPACs should not be undertaken lightly. Based on the required due diligence, the valuation of the eventual merger candidate, and the determination of potential dilution, investing in SPACs should be limited to investors with the skill set and time to properly analyze the myriad additional risks that are not inherent to investing in normal stocks.
In our view, investing in SPACs should be limited to those investors who have the financial wherewithal to take on greater risk and who are willing to put in the extra time and effort to properly evaluate the risks and rewards.
