Understanding Special Purpose Acquisition Corporations
May 14, 2021. By Anthony Norris:
Similar to crypto currencies, Special Purpose Acquisition Corporations (SPACs) have been around for quite some time but have only recently become popular. With more than $100 billion dollars raised through SPACs in the last year alone, it has become evident that the traditional initial public offering (IPO) process is being disrupted. As such these vehicles are getting much more attention by investors and regulators. Before investing, however, it is important to have a solid understanding of the mechanics and risks involved.
The main objective of a SPAC or “Blank Check Company” is to merge with a private company and take it public thus bypassing the traditional initial public offering (IPO) process that companies are either unwilling or unable to participate in. Popular examples include Draft Kings and Space X. Prior to a company merger, a SPAC will raise capital that is placed in a trust where the shares are publicly traded. SPACs range in size from $30 million to $4 billion but typically are between $150-400 million. Once funded, the manager has 18 to 24 months to identify and acquire a company. If this is not achieved, the manager is forced to distribute the trust funds back to the common stock shareholders. In certain situations, the acquisition deadline can be extended a year upon shareholder approval. When a potential acquisition is announced, shareholders are given the opportunity to vote on the identified company, and any individuals not in favor of the acquisition retain the option to have their share of the capital returned.
Typical investor participation looks something like this: In raising capital, initial investors purchase units for $10.00 apiece. Each unit includes a common share and typically 1/3 of a warrant. The warrant gives the owner the right to purchase additional shares at a specified price (typically $11.50) and become callable once the share price reaches $18 or higher. Five years after the merger has been finalized the warrants will expire and become worthless. Should an investor choose, they are able to sell their units and still retain the warrants. Capital raised stays in an escrow/trust account that holds treasury bills that act as collateral for the shares.
SPAC mergers are a popular choice for private companies primarily due to the savings in time and money. The traditional IPO process takes 120-180 days after the initial S1 filing, while a SPAC can close a deal in matter of a couple months. SPACs also require far less documentation, offer flexible deal structures, and allow for easier processing in future cash raises. For a start-up in need of quick cash, this savings on time is invaluable. Furthermore, with less regulatory scrutiny in this structure, companies that would normally not pass IPO requirements can go public. This even includes companies that have not generated any net revenue at all. One example being Lucid Motors that was acquired by a SPAC without selling a single car. This exposes investors to riskier companies, and places immense trust in SPAC managers to choose the right companies based on their industry expertise.
To get a better understanding of the mechanics behind a SPAC, we need to look at the sponsors and their role. Sponsors or partners are the creators of the SPAC and will commit capital of roughly 4% of the total size of the SPAC. Operating costs, legal fees, potential liquidation costs, underwriting commissions, etc. are all taken from the sponsor contributions better known as “at risk capital.” No matter how large the SPAC gets, the sponsors takes 20% ownership which can be viewed similarly to the 20% performance fee seen on many hedge funds. In other words, where an outside investor buys in at $10 per unit, the sponsors cost basis is roughly only $2. As you can imagine this means sponsors stand to make significant returns but take on the risk of losing their entire investment should a deal not be consummated within the 18 to 24-month deadline. Thus, sponsors are incentivized to present a deal that will not only be approved by shareholders but also discourages individuals in exercising their option to have shares bought back.
Based on a person’s risk attitude there are several different ways to invest in SPACs. An investor can either be a primary buyer of the units or invest through the secondary market. One can then decide if they prefer to buy, hold, or sell either the shares or the warrants. Holding the shares provide more of a fixed income component, as they are backed by collateral and earn money market-like returns. Warrants, on the other hand, inherently carry more risk as they can expire worthless but provide leverage that can greatly increase potential return. Buyers of units that wish to marginally increase returns and de-risk will sell off their warrants and hold the shares in hopes that an announcement of a deal will cause the share price to spike. Many investors at this stage decide whether they will continue to hold the shares that now represent the underlying company or sell. Once the deal is complete the shares are no longer backed by collateral and can lose value just as any stock would. Another aspect to consider is the time remaining for a SPAC to make deal, and the opportunity cost of having your money invested elsewhere.
Just as with any investment, Special Purpose Acquisition Corporations carry risks that must be thoroughly examined and weighted appropriately in an investment portfolio. Investors should be aware that the recent popularity of these vehicles can cause speculative activity and unrealistic valuations which in some cases can ultimately result in significant loses that are not as heavily publicized as the gains. We are happy to further discuss how SPACs may fit into the investment objectives of our clients. If you would like to learn more, please do not hesitate to reach out.