Decoding The SPAC Boom

In 2020, SPAC listings have raised more than the combined SPAC IPO proceeds raised in the last four years.

As more and more Chinese startups line up for listings in the U.S., another notable trend emerging in U.S. stock markets is the recent spike in Special Purpose Acquisition Companies (SPACs) or ‘blank check companies.’

The number of SPACs listing in the U.S. has been on an upward trend for the past two years. In fact, one in four IPO offerings last year were through SPACs, which cumulatively raised US$13.6 billion through 59 IPOs in 2019, according to SPACData.

But 2020 has shattered all records and emerged as the year of the SPAC boom, with 104 SPAC listings that have raised over $40 billion to date.

What are SPACs?

SPACs are companies that are formed for the sole purpose of raising capital through IPOs, and have no commercial operations at the time of listing. SPACs attract investment from the general public as well as from established private equity firms.

These companies offer investors a chance to invest in a fund which is then used to acquire one or more businesses after the IPO. The target businesses are usually not identified prior to the IPO, to avoid extensive deal disclosures during the listing process. This is why SPACs are also referred to as ‘blank check companies,’ since investors participating in the IPO have no idea which company will ultimately receive their money.

The investment capital raised by SPACs through IPOs are held in a trust for the desired acquisition, which must be completed within two years, failing which the SPACs are liquidated and the funds are returned to the investors after deducting bank and broker fees.

How do SPACs work?

The Sponsors:

SPACs are established by a team of experienced investors and business executives who have expertise in a particular industry or sector, with a view to acquiring one or more businesses in the management team’s area of expertise.

These sponsors provide the starting capital – the cost of the IPO, including the up-front portion of the underwriting discount, and adequate amount of working capital. The management team is not allowed to earn salaries while running the SPAC until the acquisition of a business is completed.

The sponsors, however, purchase founder shares for a nominal sum during the SPAC registration, which gives them a sizeable share in the target company, usually 20% of the common stock.

Since SPACs are in essence shell companies, investors are generally drawn to the expertise of the management team, and essentially invest on the basis of the sponsors’ reputations.

The Listing:

To handle the IPO process, the SPAC’s management team usually contracts an investment bank, which typically charges 10% of the IPO proceeds as fees. Since the SPAC, as a shell vessel, does not have any financial or business history, the prospectus for the company focuses on the sponsors and their backgrounds.

The capital raised from institutional and retail investors in the IPO is held in a trust account until the SPAC acquires a company. In return for their investment, SPAC IPO investors receive units of the SPAC, with each unit comprising a share of common stock and a warrant to purchase more stock at a later date.

SPAC units are generally priced at $10, and become separable into shares and warrants after the completion of the IPO. SPACs have between 18 and 24 months from the IPO closing date, depending on the company and industry, to execute a business merger, failing which the SPAC is liquidated.

The management team can call a shareholder vote to approve an extension of up to 36 months from the IPO closing for the acquisition of a company, although public shareholders need to be offered redemption rights in case of such an extension.

SPACs must meet the stock exchange initial listing guidelines, both during the IPO and during the business combination.

The Acquisition:

Once a target company has been identified, the SPAC pursues and negotiates a merger or acquisition deal. The fair market value of the target company should be equivalent to 80% or more of the SPAC’s trust assets. However, in general practice, SPACs often combine with companies that are two to four times the size of the IPO haul.

While the SPAC uses the IPO proceeds to carry out the acquisition, if the SPAC requires additional capital for the business combination or other expenses, the sponsors loan funds to the SPAC.

Before signing the acquisition agreement, SPACs often arrange for private investment in public equity (PIPE) or debt financing. This serves to fund a portion of the purchase price for the merger or acquisition. The acquisition and the private investment are announced together once the deal is finalized.

Following the announcement, the SPAC convenes a shareholder meeting to vote on the deal, although, depending on the structure of the SPAC, it may or may not be necessary to obtain an approval to carry out the merger.

Shareholders are also provided with the choice to redeem their shares at roughly the IPO price paid, or accept stock in the new company. Upon completion of the business combination, the SPAC and the target company combine to become a publicly traded company.

In case of reverse mergers, where private companies acquire publicly-traded SPACs to go public without going through the hassle of traditional IPOs, the SPAC mandatorily takes the name of the acquiring company.

A surge in SPAC IPOs

This year has seen a massive SPAC boom, with the total number of SPAC IPOs reaching 104 as of September 21, equal to roughly the combined number of SPAC IPOs in the previous two years, figures from SPACData show.

More importantly, SPAC listings have also grown in magnitude, with the average deal size to date being $388 million compared to $230.5 million last year. This year’s SPAC listings have already raised $40.3 million, the largest haul in a year since 2003 and more than the combined gross proceeds from SPAC listings for the previous four years, according to SPACData. Nasdaq accounts for over 75% of all SPAC IPOs.

In February, Churchill Capital Corp III, a SPAC run by former Citigroup banker Michael Klein, raised $1.1 billion, and has already reached a business combination agreement with MultiPlan, a healthcare services firm, for $11 billion, which was the largest SPAC merger on record, until yesterday. Klein’s fourth SPAC also filed for a $1 billion IPO in July.

Yesterday, PE firm Gores Group announced the merger of its fourth SPAC, Gores Holding IV Inc, with United Wholesale Mortgage, whose enterprise value stands at $16.1 billion, and therefore, supersedes the Churchill merger as the largest SPAC merger to date.

Pershing Square Tontine Holdings, the SPAC established by billionaire hedge fund manager Bill Ackman, went public in July and raised $4 billion, the largest SPAC IPO to date.

In the same month, Therapeutics Acquisition Corp raised $135.7 million in its IPO. Curiously, the company’s shares jumped 22% on its first day of trading.

Last week, Social Capital Hedosophia Holdings VI, the sixth SPAC formed by the partnership between Palihapitiya, the Founder and current Managing Partner of Social Capital, and Ian Osborne, a Co-founder and the current CEO of Hedosophia, filed for an IPO on Nasdaq aiming to raise $1 billion.

Palihapitiya and Osborne’s first SPAC merged with business magnate Richard Branson’s space travel company Virgin Galactic, forming a publicly traded company with a valuation of $1.5 billion last year, while their second SPAC recently announced a merger with real estate startup Opendoor, at an enterprise valuation of $4.8 billion.

The SPAC frenzy has also spread to Asia, with a growing number of sponsors in the region. China-based CITIC Capital launched a SPAC in February that netted $240 million in an upsized IPO.

Last week, Distoken Acquisition, a SPAC focused on the Asian tech sector, filed for a $40 million IPO. The SPAC is led by CEO of Hangzhou Hechuang Investment Management Co, Jian Zhang.

A total of 16 SPACs filed for IPOs last week, while 9 SPACs raised close to $2.4 billion in IPO proceeds worldwide, according to SPACResearch data.

Among startups that went public through a reverse merger with a SPAC, the most notable is electric truck maker Nikola, whose stock prices doubled on the first day of trading, and have subsequently crashed following recent allegations of fraud and the resignation of its founder.

Other companies that have followed the same path to go public include Chinese co-working space operator Ucommune, which combined with Orisun Acquisition Corp. at a valuation of $769 million in July, after its initial IPO failure last year.

Hong Kong-based Diginex is merging operations with 8i Enterprises Acquisition Corp, whose shareholders vote approved the acquisition last week, and is on track to start trading on Nasdaq later this month. This would lead to its cryptocurrency exchange EQUOS.io to become the first publicly-traded crypto exchange in the U.S.

Peter Thiel-backed startup Luminar is also going public after merging with Gores Metropoulos Inc, at a post-deal valuation of $3.4 billion, along with Bill Gates and Volkswagen-backed EV battery maker QuantumScape, which aims to list on the NYSE through a reverse merger and is seeking a post-merger valuation of $3.3 billion.

Impact on underwriters

The recent uptick in SPAC listings has also increased fee income for underwriters. Credit Suisse climbed the underwriter ranks to become the top investment bank for SPAC IPOs in the first 6 months of 2020, followed by Goldman Sachs and Citigroup, according to data from SPACInsider.

Moreover, the investment banks that have helped SPACs with their initial listings, are not the big names that popularly usher in the latest tech IPOs. Canto Fitzgerald, a mid-size New York investment bank, was the top SPAC underwriter in 2019, followed by Deustche Bank, data from SPACInsider show.

Nevertheless, well-known investment banks like Morgan Stanley and Goldman Sachs are racing to make the most out of the latest SPAC trend, with some even rearranging their equities team to facilitate SPAC listings.

Additionally, some of these investment banks, including Goldman Sachs, have also sponsored SPACs in recent years, in addition to seeking investors who can front their own SPACs.

What’s behind the SPAC boom?

Low-risk investment:

There are several reasons driving the recent SPAC listing spree. According to a PitchBook report, the pace of traditional IPOs has slackened due to market volatility caused by the global pandemic.

SPAC listings, which depend less on the performance of the market and more on the reputations of the sponsors, are therefore gaining popularity among investors. Since the investment is protected in a trust account that can only be used for acquiring a target company, SPACs are perceived as lower-risk investment vehicles.

Since shareholders can redeem theirs shares at their original IPO price at the time of business combination, investments in SPACs also offer a downside protection with guaranteed return of initial investment, thus protecting the principal investment against market volatility.

At the same time, investment in a SPAC offers an opportunity to the investors to get in at the ground-level of a potentially profitable deal that could fetch big returns.

In the current pandemic climate, PitchBook also found that valuations of companies around the globe are down, providing an opportunity for SPAC companies to acquire businesses at lower valuations.

A faster way for startups to go public:

Not only have SPACs proved popular with businesses in traditional industries, they could also become a viable option for startups looking to raise public capital in today’s tricky market conditions.

Startups whose listing plans were derailed or hampered by the pandemic and its widespread effects, and who have raised million in venture capital before, need a relatively easier way to go public. A TechCrunch report suggests that in such cases, investors are likely to support SPAC listings.

Being acquired by a SPAC is a faster and frictionless process for companies planning to list, since the regulatory standards for SPACs are lower than for traditional listings. It can also be a good way for startups to take advantage of sudden market trends. This process of going public is also referred to as ‘backdoor listing.’

Moreover, for Chinese startups, SPACs offer a relatively easy way to get listed in the U.S. amid brewing U.S.-China trade tensions and the tightening of listing regulations.

Increase in retail investors:

The pandemic has triggered a huge surge in the number of retail investors opening accounts and trading on stock exchanges across the U.S, driven by tumbling stock prices and better chances of returns in future. This has also impacted SPAC IPOs, as more and more retail and amateur investors are becoming cognizant of what they are and how they work.

With worldwide lockdowns in force, mobile trading surged as people went online to trade while being bored at home. In fact, online communities devoted to trading in SPACs have now cropped up on Twitter and Reddit, indicating the increasing interest of retail investors in SPACs.

Higher quality SPAC sponsors:

The quality of SPAC sponsors has increased significantly and is attracting newfound attention to SPACs, Goldman Sachs Executive Olympia McNerney said in a podcast last month.

A number of well-established companies going public through SPAC merger deals have encouraged a slew of former CEOs, dealmakers, and financiers to raise new SPACs, who in turn are better equipped to source and finance their own high-quality transactions, Benjamin Kwasnick, Founder of SPAC Research told Crunchbase news in an interview.

The Crunchbase report adds that while serial SPAC issuers dominated the field in the past, this year has seen participation from a significant number of new players.

Among the new players joining the field is Baseball Executive Billy Beane, who was portrayed in the movie ‘Moneyball’ by Brad Pitt. His sports-dedicated SPAC RedBall Acquisition Corp recently raised $500 million in its IPO.

Former Trump administration Advisor Gary Cohn and aforementioned billionaire Richard Branson also want to set up their own SPACs.

What to expect from this latest trend?

There are several risks associated with SPAC investments, and their performance is usually a mixed bag. In July, Goldman Sachs revealed a report which indicated that in the 3-month period following the acquisition announcement, the average SPAC outperformed the S&P500 by 11%.

The report further stated that 75% of SPACs outperformed the S&P 500 by 22% in the 12 months following the merger while the remaining 25% of SPACs lagged by 69%, thus ringing a cautionary bell for SPAC investors.

According to another study by Renaissance Capital, of the 223 SPAC IPOs conducted between 2015 and July 2020, only 89 have completed an acquisition, and have delivered an average loss of 18.8% and a median return of -36.1%, compared to the average aftermarket return of 37.2% for traditional IPOs since 2015. Only 26 of the 89 SPACs had positive returns as of late July 2020.

Moreover, the report also found that larger SPAC mergers have outperformed smaller transactions, with healthcare and tech-focused SPACs leading the pack. Therefore, investors looking to invest in SPACs should be wary of mixed performance.

According to a report by Bloomberg, SPACs have also paved the way for companies that are yet to generate their first revenue to go public. These companies, the report says, are selling a vision, rather than a proven track record of financials, making SPAC investments highly speculative and adding to the risk of investing in them.

For example, both Virgin Galactic and Nikola, which became public through SPAC mergers, are yet to generate profits or commercial revenues. SPAC investments, therefore, offer investors a ground level seat at a futuristic company, but investing in them is not for the faint of heart, Bloomberg warned.

While the risk of investing in such early-stage or underdeveloped ventures might eventually pay off, the chances of the startups failing to generate revenue or profits are significantly high.

Moreover, there is an inherent risk when it comes to companies going public before they are ready. In a Bloomberg report from just last week, Nikola Board member Jeff Ubben admitted that the company went public too early.

Besides, a report by Private Equity Insights suggests, that the growing base of SPAC sponsors and the recent boom in SPACs have led to an oversupply of capital devoted to the sector. Currently, there are 135 SPACs seeking acquisition targets with a cumulative capital of $45 billion in trust assets.

While there are thousands of potential target companies, not all of these SPACs will engineer home-run deals or complete acquisitions before their deadlines, the report stated.

In June and July of this year, the mere announcement of a SPAC merger deal sent stocks soaring regardless of what the deal was. However, this phenomenon has waned since then, with declining excitement around acquisition announcements. The Financial Times also reported that the SPAC frenzy could lead to the acquisition of overpriced targets and approvals for bad deals.

Moreover, according to DraftKings CEO Jason Robins, SPACs are good investment vehicles, but may not be right for every company. It worked for DraftKings, which went public with a reverse merger in April, and experienced a valuation swell from $3 billion to over $13 billion in less than five months, but it might not be the right recipe for every company.

While SPACs have their pros and cons, the popularity of SPACs is likely to continue to build in the near-term. While a capital-raising method that seems almost purpose-built for the current era of volatile markets and geopolitical tensions, it is nonetheless still a complicated financial process that startups ought to consider carefully before diving into.

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