People like to say “you don’t invest in a company, you invest in the management.” When it comes to special purpose acquisition companies (SPACs), you don’t have a choice. Unlike a standard corporation — which comes with assets, personnel, products, revenues and other accoutrements of a viable entity — SPACs are a publicly traded corporate shell whose entire purpose is to raise capital to eventually buy an ongoing enterprise. The SPAC goes through the IPO process before it purchases a fully formed business, which is how it raises capital. This public listing is possibly the SPAC’s most important asset, because after it acquires or merges with a target company, the acquired firm takes over the SPAC’s listing on the exchange. It is a method for the acquired firm to go public without the cost or time involved in a traditional IPO.
SPACs have been dubbed “blank check” companies because investors typically have no idea what company the SPAC will buy, and so they have no idea what company they will eventually have in their portfolio. SPACs usually specify the type of company they will be looking for, but that description is not binding.
How many investors could possibly be willing to invest in a company whose sole purpose is to raise capital so it can (hopefully) find and acquire another company after it finds out how much capital it has raised? How attractive could an empty shell company with no specific purpose or business plan possibly be? Well, at least in the very strange year of 2020, the answer is, “Very.”
According to SPACInsider.com, 218 SPACs had initial public offerings (IPOs) in 2020, as of Dec. 9. That is about 3.7 times the number that went public in 2019. In fact, it previously took nine years of aggregated IPOs to reach that total. Capital raised has increased even more significantly. During 2020, SPACs raised more than $74 billion. This compares to $13.6 billion in 2019, and only $47.1 billion in aggregate since 2009.
HOW WE GOT HERE
If you were an investment manager in the 1980s and 1990s, who just woke up from an epic Rip Van Winkle–level nap, you would be gobsmacked at the rise of SPACs. When you left the scene, SPACs were typically mechanisms for fraud and market manipulations in the penny stock market — and that description is from the U.S. Securities and Exchange Commission (SEC), not a disgruntled investor. How SPACs went from a vehicle used by grifters to one that dominates the IPO market is a story of luck, timing and the ability of investors to adapt to changing market situations.
The SEC eventually adopted additional requirements for SPACs, including filing a traditional registration statement before an IPO. However, other methods of going public and investing remained more attractive, given that the only track record SPACs had was built on fraud. In 2009, only one SPAC found its way to a public exchange. In 2016, we still saw only 13 launched. But then things began to heat up for SPACs. By 2019, 59 SPACs were listed on public exchanges, and by 2020, the IPO world was rocked with 218 SPAC listings.
So, what made 2020 the year of the SPAC? It comes down to a combination of capital looking for a home, market volatility, high stock valuations and low interest rates. A traditional IPO is always expensive, but more so for a small company with a bright future but limited current resources. Any company going that route will want as much assurance as possible that the money spent will be worth it.
“SPACs come and go in favor,” explains Shari Mager, a partner at KPMG. “The market volatility we saw in 2020 has contributed to their current popularity because there is a little more certainty around the returns than with a standard IPO. I expect to see what we’ve seen continue, but there is lot of competition out there now for good targets. This makes speed to market a driver.”
On the SPAC investor side, a world of low interest rates and high valuations on other stocks made SPACs a reasonable place to park money for a while. A SPAC is normally structured so investors can get money out if they don’t like the deal it makes. SPACs also need to find a suitable acquisition within a specified time period. If they are unable to find an appropriate and willing company to buy, the SPAC is dissolved, and investors get their money back. Investors also hope they will be able to get in early on the next Facebook or Google, though DraftKings will do in a pinch.
Well-publicized deals by high-profile investors are also helping fuel SPAC growth. For example, Richard Branson took his Virgin Galactic Holdings public through a $1.5 billion SPAC merger. In July 2020, Bill Ackman’s Pershing Square Tontine Holdings became the largest SPAC on record when it listed on the NYSE and raised $4 billion to be used for the purchase of a high-quality, growth company. The same month, a SPAC run by Michael Klein, formerly of Citigroup, closed the $11 billion acquisition of healthcare service provider MultiPlan, which is the biggest SPAC merger ever.
HOW IT WORKS
SPACs raise money in an IPO, and then place that capital in a trust, which earns interest at market rates, while the sponsor searches for a business or businesses to acquire. SPACs have a limited time to find an appropriate target, usually 18 months to two years, before they need to dissolve and return the capital to their investors. When a SPAC’s managers identify an attractive acquisition target, they present the target business to the investors via proxy materials. The investors then vote on the acquisition. If the investors agree to move forward, a share price is determined before the acquisition. The companies then complete the transaction, and the target becomes a listed stock. Recent examples include sports-betting operator DraftKings Inc., electric truck maker Nikola Corp. and space travel company Virgin Galactic Holdings.
Proponents of SPACs say this method of going public offers opportunities to businesses that would otherwise not be able to access public markets. With a SPAC, the IPO is already done. The selling company only needs to negotiate with one entity: the SPAC that might acquire or merge with it. This makes the process faster and surer. Everyone agrees to the valuation, rather than waiting for the market to determine it, and the selling company can cash out their existing investors.
The selling company’s management often remains in place, while an experienced SPAC management team joins the board to help the acquired company deal with the regulatory requirements of life as a public company.
BUYER BEWARE
Although a SPAC IPO is considered speculative, there is actually little risk to the sponsor and SPAC investors. The same cannot be said about the retail investor who jumps into the stock after the target company is acquired. According to a Goldman Sachs analysis of 58 SPAC deals from January 2018 to early 2020, the average SPAC underperformed the S&P 500 and the Russell 2000 three, six and 12 months after a merger.
Renissance Capital has gone even further in analyzing the results of SPACs. Of 223 SPAC IPOs conducted from the start of 2015 through July 2020, 89 had completed mergers and taken a company public. Of those 89, the common shares have delivered an average loss of 18.8 percent and a median return of –36.1 percent. That compares with the average after-market return from traditional IPOs of 37.2 percent since 2015. As of July 24, 2020, only 26 of the SPACs in that group had positive returns, the study found.
According to New York University’s Michael Ohlrogge and Stanford University’s Michael Klausner, six months after a deal is announced, median returns for SPACs amount to a loss of 12.3 percent. A year after the announcement, most SPACs are down 35 percent. Hundreds of SPACs are currently searching for viable merger partners. This competition could very well make returns even worse for your standard investor as SPACs lower standards to find a willing acquisition.
So, why are SPACs so popular if most of them see stock prices fall after the acquisition event? Because they are very lucrative for the SPAC sponsors, hedge funds and selling company investors, even if the retail investor gets short shrift. By the time the average SPAC enters into a merger agreement, warrants afforded to hedge funds, underwriting fees and the generous sponsor’s promote eat up more than 30 percent of IPO proceeds, according to the Ohlrogge and Klausner study. This financial structure makes a SPAC nearly risk free for the sponsors and selling company investors. The retail investor is not as lucky. These are speculative investments — the newly listed firms are often so young that they haven’t turned a profit yet — so equities investors would probably be wise to view them more as a gamble than an investment.
Some of the most active sponsors are trying to make the structure better for the after-merger investors. Bill Ackerman, for example, has said that his newest SPAC will not include a promote and will, instead, align returns better with stock market performance. Others are looking to tweak other less-than-optimal features around the edges.
“There is a lot of activity right now,” says Priya Cherian Huskins, senior vice president, management liability at Woodruff Sawyer. “But the stress in the system has the capacity to squeeze out people who should not be in this field. There are a lot who will learn and do well, while others fall off. As SPACs mature, they will be a viable path to going public.”
IS THE END TO THE BOOM IN SIGHT?
The 2020 SPAC boom was the result of a perfect storm of factors, including low interest rates, lots of private equity capital, and a high-flying stock market. Remove any of these drivers and SPACs are likely to stumble. However, there is no indication that any of these things will change any time soon, so there is no reason to believe that SPACs will be any less popular in 2021 than they were in 2020. And this would be a good thing for companies looking to go public, as well as for the exchanges.
“What I’ve seen so far augers well for SPACs to continue to grow going forward,” says Mark Baulder, a partner at Wilson Sonsini Goodrich & Rosati. “We’ve had a relative dearth of IPOs in the U.S. public markets going back to the dot-com boom and implementation of Sarbanes-Oxley. It would be a tremendous development if there were more avenues for companies to become public or raise capital.”
While SPACs are likely to remain popular in 2021 and beyond, we will probably see sponsors and investors become more discerning. SPAC managers are building track records and, like all investment classes, success breeds success. It should become easier to research and invest in those managers that have proven they can pick winners. And then, maybe the retail investor will be able to profit off of SPACs the way hedge funds and sponsors have been doing all along.
Sheila Hopkins is a freelance writer in Auburn, Ala.