Deconstructing SPACs

If you’ve been hearing the term SPAC mentioned a lot recently but aren’t too sure what these are, it might be worth spending some time getting your head around these. SPACs have been around for some time (since 1990s) but there have been a frenzy of SPAC new offers in the US of late, with a record number of launches in 2020 and this has already surpassed in the first few months of 2021. But SPACs are somewhat controversial and in recent months the SPAC market has wobbled.

 What is SPAC ?

A Special Purpose Acquisition Company (“SPAC”) is a publicly listed firm with a two-year lifespan during which it is expected to find a private company with which to merge and thereby bringing the private company to public markets. It is a cash rich shell company with no operations.

SPAC’s unique feature is that when a SPAC proposes a merger, SPAC shareholders have an option to redeem their shares rather than participate in the merger and get back their full investment with an attractive return. If a SPAC fails to complete a merger within 2 years, it liquidates and returns all funds to its shareholders with interest.

What are the steps involved in creating and funding SPACs ?

• Creation of an SPAC begins with a SPONSOR who works with an underwriter (e.g. investment banks) to take SPAC public via an IPO route.
• Sponsors typically comprise of prominent and very wealthy figures from the world of private equity, venture capital, hedge funds and banking, former S&P 500 CEOs, entrepreneurs, as well as famous celebrities with no particularly relevant background.
• Prior to the IPO (for SPAC), the sponsor acquires a block of shares at a nominal price that will amount to 25% of IPO proceeds (or, equivalently, 20% of post-IPO equity).
• This block of shares, known as the sponsor’s “promote,” is the sponsor’s compensation for work it does for the SPAC.
• In addition, concurrently with the IPO, the sponsor purchases SPAC warrants, shares or both at prices estimated to represent fair market values.
• The proceeds of the sponsor’s investment covers the cost of the IPO and operating costs while the SPAC is searching for a merger target.

What are SPACs used for ?

SPACs, also colloquially known as blank cheque companies, have been touted as a cheaper way to go public than an traditional IPO route which is a longer, tedious and costlier process. Often not available for an early stage or start-up companies.

What is the difference between SPAC vs IPO route to listing ?

Most importantly, SPACs and their merger targets can avail themselves of a safe harbour against liability under the securities laws for disclosing financial projections and other forward-looking statements. Companies going public in an IPO, however, are not covered by this safe harbour and rarely provide such information.

What are the permitted usage of funds raised by SPAC through an IPO ?

• The proceeds of a SPAC’s IPO are placed in trust and invested in Treasury notes.
• Under the SPAC’s charter, cash in the trust can be used only

a.   to acquire a company,

b.   to contribute to the capital of a company with which the SPAC merges,

c.   to distribute to shareholders in liquidation if the SPAC fails to consummate a merger, or

d.  to redeem shares, as discussed below.

What is redemption and what is the redemption Process ?

A key feature of SPACs is their generous redemption right. At the time a merger is proposed, shareholders can redeem their shares for the $10 price of units sold in the SPAC’s IPO, plus interest—and keep their warrants and rights. This redemption right raises the possibility that, when a SPAC merges, it will have to obtain new equity to meet a target’s cash needs, which generally happens through private placements (often called as PIPE).

The SPAC has roughly two years to identify a merger target and to complete a merger. Subject to shareholders voting to extend either the SPAC’s search period or the time it needs to consummate a merger already announced. If the SPAC does not merge within two years, it liquidates and distributes the funds held in the trust to the public shareholders. In the event of a liquidation, the sponsor loses its investment.

What is the Redemption Price ?

The redemption price is the IPO price of the SPAC units plus interest that has accumulated in the trust.

What is SPACs life cycle ?

To summarise SPAC’s lifecycle beginning with the IPO:

1. public investors buy units consisting of shares and warrants in a SPAC’s IPO;
2. within two years, the SPAC proposes a merger by which a private company would go public;
3. often, well over two thirds of the SPAC’s shares are tendered for redemption;
4. contemporaneously with the merger, the sponsor itself and/or third parties purchase shares in private placements (PIPEs) to replenish some of the cash the SPAC paid out to redeem its shares;
5. the merger proceeds;
6. the SPAC’s remaining public shareholders own a small slice of the post-merger company’s equity; and
7. the SPAC sponsor and third-party private investors similarly own small slices of the company’s equity

Note: Diagrammatic representation of SPAC life cycle

What is the role of the Investors in SPACs ?

• The primary role that investors in a SPAC’s IPO play is to get the SPAC up and running, and ready to bring a private company public in a later merger for which new equity is raised.
• SPAC’s IPO shareholders are well compensated for this role. They have the right to redeem their shares before a merger at a redemption price equal to the price they paid for the full units plus interest, and they keep the warrants and rights that were included in the units.
• Most shareholders take this deal and redeem their shares, and most of those that do not redeem their shares, exit the SPAC by selling their shares on the public market when the market price is higher than the redemption price.

HARD FACTS demystifying the SPAC boom: Research & analysis done by Stanford University, of about 47 SPACs that merged between Jan 2019 to June 2020, reveals following:

• he SPAC structure results in substantial dilution of the value of SPAC shares
• Although SPACs issue shares for roughly $10 per share and value their shares at $10 when they merge, as of the time of a merger, the median SPAC holds cash of only $6.67 per share.
• SPAC dilution amounts to roughly 50% of the cash they ultimately deliver to companies they bring public. These costs are much higher than those for IPOs.
• SPAC shares tend to drop by one third of their value or more within a year following a merger. This suggests that it is the investors that hold shares at the time of SPAC mergers, and for a period of time thereafter, that are footing most of the bill for SPAC costs.
• From the perspective of companies going public, therefore, SPACs have indeed been cheap. But it is questionable whether this is a sustainable situation. It is hard to believe that SPAC shareholders will continue to take these losses.
• Some SPACs produce positive post-merger returns for their shareholders.
• It is observed that SPACs sponsored by large private equity funds and former Fortune 500 CEOs and senior executives are, on average, more successful than others.

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