All about SPACs: A primer

• SPACs offer investors opportunities to invest in firms before they go public, an option otherwise usually open only to private equity investors
• For public investors, an investment in a SPAC is essentially a bet that the SPAC will successfully find a suitable business to buy within 24 months
• Risks include a heavy reliance on SPAC founders’ reputations and potential dilution

Just what is a SPAC?

At their simplest, SPACs, or special purpose acquisition companies, are listed shell companies that are set up to raise cash from the public to hunt for a private company to buy and take public. Also known as blank cheque companies, SPACs are usually led by management teams comprising seasoned executives with experience in private equity and venture capital and they typically have two years to find a target and close the deal.

For a private company targeted by a SPAC, merging with a SPAC (an already-listed, non-operating company) is simply an alternate means of going public, instead of a traditional initial public offering (IPO). This is typically simpler, quicker and cheaper than a traditional IPO process.

What makes SPACs attractive?

SPACs provide a wide range of investors – including retail and small institutional investors – the opportunity to invest in companies before they go public. This access to companies at the pre-IPO stage is otherwise usually available only to private equity investors.

For target companies, going public via a merger into a SPAC typically means quicker time to market, more certainty of terms, and potentially lower underwriting fees compared to a traditional IPO.

A target company that lists via merger with a SPAC does not need to negotiate with underwriters, conduct investor roadshows, or prepare a prospectus to drum up interest and raise capital. Crucially, it is able to present forward-looking guidance to the SPAC and the SPAC investors, which is not allowed in a traditional IPO process.

Interest in SPACs has surged in recent months, with the number of SPAC IPOs rising to a record 248 in 2020, more than four times the number in 2019, and raising USD83 billion in gross proceeds. This year looks to set a record new high – so far this year, another 210 SPAC IPOs have already been announced as at 4 March 2021, raising USD68 billion. Over the past two years, SPAC activity has contributed about 30% of IPOs and 10% of equity capital market deal value, according to Dealogic data.

SPAC mechanics – how do they work?

SPAC founders, known as the sponsors, are a group of investors who set up the SPAC to pursue a deal – usually targeting an industry or market segment such as technology where they have expertise. Potential merger targets are not disclosed during the SPAC IPO process. This means that investors must rely heavily on the reputation of SPAC sponsors when choosing which SPACs to invest in.

The sponsors are compensated for their efforts via founder shares, known as the “promote”, which is tied to the amount of SPAC capital raised, usually 20% of the SPAC’s total equity.

Typically, units in a SPAC are offered to public investors via the SPAC IPO. Each full SPAC unit consists of two parts:

• A common share that can be redeemed forcash before the SPAC’s merger with a targetcompany is completed, if the SPAC investorchooses not to participate further; and

• A warrant that gives holders the option to buymore shares in the future, usually at a premiumto the share’s issue price (effectively a calloption offering potential further upside toinvestors)

Post-IPO, when the sponsor team is searching for a merger target and seeking shareholder approval for a deal, the SPAC units are listed on an exchange and traded publicly and the shares and warrants typically trade separately.

Once the SPAC has identified its target company and the merger has been announced – but before the deal closes – SPAC investors have the option to keep their shares and become shareholders in the post-merger company or redeem their shares for the full amount invested in cash, plus interest. Typically, SPAC shareholders can vote to approve or reject the deal brought by the sponsors. If a majority of shareholders approve the deal, dissenting shareholders can still opt to redeem their shares for cash. Even if they redeem their shares, they can keep any warrants they hold, thus retaining exposure to participate in the post-merger company in future.

Around the time of merger closing, SPACs may also raise additional capital via new investor commitments, known as private investment in public equity (PIPE) commitments. If a SPAC fails to find a suitable target or reach a deal within an allotted timeframe, usually two years, all capital plus interest is returned to the SPAC shareholders while the warrants become worthless.

What are the risks and costs?

At the time of the SPAC IPO, investors know little about the private company that the SPAC is targeting. As mentioned earlier, this means that investors must rely heavily on the reputation of SPAC sponsors. For public investors, an investment in a SPAC is essentially a time-limited bet that the SPAC will find a suitable, quality business to merge with successfully, within 24 months. If the sponsors fail to do so, the investment could realise sub-optimal returns relative to other investments that SPAC investors could have deployed their capital into during the life of the SPAC.

Additionally, the structure of the SPAC sponsors’ compensation – usually 20% of the SPAC’s total equity raised during the SPAC IPO – creates a powerful incentive for sponsors to find a target and get a deal done regardless of the performance of the post-merger company, which is a potential risk for SPAC investors. This risk is mitigated somewhat by the ability of SPAC shareholders to vote against a merger or redeem their shares for cash if they are unhappy with the deal brought by the sponsors.

For target companies, the full cost of merging with a SPAC are unknown at the start – the sponsors’ stake and investor warrants may be dilutive, and their impact can be magnified by SPAC shareholder redemptions.

Why the surge in interest now?

We believe the surge in SPAC activity over the past year is driven by several key factors, including ample liquidity in search of new sources of return amid a low interest rate environment. For private companies seeking to go public, SPACs offer an attractive alternative to the traditional IPO route, given the market volatility over the past year.

Conclusion

SPACs are set up by a sponsor group to raise cash from the public to hunt for a private company to buy. They offer investors the opportunity to invest in firms before they go public, an option otherwise usually open only to private equity investors. Investors are required to place a high degree of trust in the sponsors to find a suitable target and complete a deal, typically within two years. At the end of this period, the investor has the right to stay in the investment or redeem their cash in full. Essentially, the SPAC investor buys an option to participate in the sponsors’ hunt for a suitable target and the option cost is the opportunity cost of the capital that they could deploy elsewhere.