With $40 Billion of Capital Available, Will SPACs Become a Viable Alternative to the Traditional IPO?
Amid this year’s white-hot IPO market, the SPAC, or special purpose acquisition company, has incinerated previous records for this once-obscure financing vehicle. Thus far, in 2020, 116 SPACs have been funded through initial public offerings, raising $40 billion. SPACs make up the single largest “industry” group in 2020’s crop of IPOs, accounting for 45% of the number of new issues and 44% of total capital raised. More "blank check" companies debuted on NASDAQ and NYSE in August and September than "real" operating companies. The financing vehicle has attracted a host of luminaries, from investment icons like Bill Ackman of Pershing Square and Peter Thiel, baseball savant Billy Beane of “Moneyball,” and former Speaker of the House Paul Ryan.
The enormous amount of investable capital sitting on the balance sheets of these entities, is leading even mature, venture-backed companies to consider if SPACs might provide a more efficient path to achieve public status and raise capital on favorable terms. Many SPACs have tremendous flexibility in the industries and geographic regions where they can complete a business combination, including a number that are focused on China or Southeast Asia. In some cases, the SPAC sponsors may be able to lend prestige and guidance on public company readiness that can help a less experienced management team be successful.
Investors’ willingness to shovel money into SPACs is intriguing, given their subpar returns. Year-to-date, SPACs have returned 5% on average to shareholders compared to a 36% average return for non-SPAC IPOs. Over a more extended period, the results are even more mixed, with a recent study by Renaissance Capital showing that out of the SPACs that have managed to acquire an operating business since 2015 had an average loss of 18.8% and a median loss of 36.1%. Numerous academic studies have shown a consistent pattern of value destruction by SPACs during earlier periods.
So, what accounts for the overwhelming attraction for the SPAC format?
Something for Everyone
In theory, a SPAC provides public market investors access to juicy, privately negotiated deals typically only available to elite investment institutions and wealthy families — they’ve been dubbed a “poor man’s private equity fund.” A group of founders who are reputed financial or industry experts, known as the SPAC sponsors, form an empty shell company with the intent of sourcing and then acquiring or merging with an as yet unknown operating company. The sponsors retain an investment bank to raise tens of millions or even billions of cash that will sit idle for up to two years until the SPAC locks down on its target.
For investors, SPACS appear to offer the ultimate safe bet, as they are required to place at least 90% of the IPO proceeds in an escrow account. The sponsors cannot touch these funds until the SPAC acquires a suitable acquisition or merger candidate. Most SPACs now commit to locking up 100% of the IPO proceeds into trust, plus any accrued interest. At the end of 24 months, if the SPAC sponsors fail to secure a deal — or if the investors don't like the proposed target or terms — they can elect to get their pro-rata share of the trust refunded. To sweeten the deal, investors also receive a warrant to purchase an additional share or fraction of a share as part of the "SPAC unit." The presence of a warrant gives further upside and enables a range of trading strategies funds can use to lock in their profits.
For companies, SPACs can find a fast track to going public and accessing significant amounts of growth capital at arguably more favorable terms than what a private equity firm might offer. SPAC promoters will often argue that they provide a lower cost of capital by avoiding the underwriting discount of an IPO and the frequent underpricing that occurs to ensure an initial trading “pop” and reward institutional clients. SPACs may be happy to gobble up quirky companies that don’t align with the current appetites of the IPO market. A deal can be completed in as little as two to three months, assuming that the target has audited financials, instead of the more typical six months or more for a fully vetted IPO.
For SPAC sponsors, a successful acquisition can lead to meaningful wealth generation from a single transaction with a relatively low capital commitment. Sponsors typically receive "founder shares" equal to 20% of the post-IPO shares outstanding for nominal consideration. In some cases, these are literally "free money," although as the structure has matured, investors now expect founders to have "skin in the game" in the form of warrants or shares purchased through a private placement. This upfront founder investment covers the initial listing expenses, making it possible for 100% of IPO proceeds to remain in the trust.
Investment bankers have learned to love SPACs as they make substantial fees marketing off of essentially a set of founder resumes. While there are some minor differences in deal structure, most SPAC registration statements repeat essentially the same boilerplate; there are no operations to perform due diligence and no history of financial performance to analyze. If the SPAC closes on an acquisition it will generate an ongoing stream of advisory fees for bankers, lawyers, auditors, and other professionals — in short, something for everyone.
A Confluence of Conflicts
In reality, the SPAC's complex structure generates a confluence of conflicts of interests that may be at least partially accountable for the subpar performance of many of these deals.
When SPACs first became popular, the SPAC "unit" usually included one share and one or two in-the-money warrants. Sharp hedge funds realized that they could sell the warrants to book a profit, and then once a target was announced, withhold their vote on the deal unless the promoters agreed to buy out their shares above trust value. Such “greenmail” strategies led to all sorts of convoluted private negotiations, usually to the disadvantage of less-informed retail investors.
In a SPAC IPO, the investment bank will also set aside a portion of the underwriter's discount, pending an acquisition's successful completion. If there is no deal, the trust distributes those escrowed fees back to shareholders, creating a powerful incentive for banks to help SPAC founders make it across the finish line.
The reduced level of scrutiny that a company receives when merging with a SPAC, compared to the multiple rounds of SEC review in a traditional IPO, may also make the format more attractive to companies whose disclosures are less than impeccable. One of the most spectacular recent SPAC success stories was subsequently the subject of a short seller report that led to its CEO resigning and a collapse in its share price.
The mandate of SPAC founders is to find a desirable target for their shareholders, leading to long-term stock appreciation and enabling investors to exercise their warrants. On the other hand, if these sponsors cannot close on an acquisition, their founder shares and warrants become worthless, and their initial investment vaporizes. From a financial perspective, nearly any deal is better than no deal for SPAC sponsors. Indeed, they can realize rich returns (at a favorable capital gains tax treatment) even if the share price declines by 50% or more post-merger.
As these conflicts became evident, the SPAC structure has evolved to increase the probability of a merger or acquisition closing and motivate SPAC founders to land higher quality deals (so SPACs become an actual investment, rather than an arbitrage play).
The Evolution of the SPAC
The pedigree of the modern SPAC dates back to the “blind pools” of the South Sea bubble, in which 18th Century investors subscribed to “an undertaking of great advantage but no-one to know what it is.” The format resurfaced again with the rise of penny-stock “blank check” offerings in the 1980s, which ended with the SEC cracking down on the most prominent brokerage behind these deals and implemented Rule 419 to protect investors against abuses. The modern SPAC was born in 1993, and the format's popularity has waxed and waned over the years, before reaching a fever pitch in 2020.
Some of the most important recent innovations to the SPAC structure include:
Will all these structural changes make the current generation of SPACs more likely generate positive returns for investors
What is certain is that there are now tens of billions of "dry powder" sitting in SPACs, all of which have a definitive end date to find an acceptable way to deploy it. And more SPACs are most definitely on the way. Forty-five new blank check IPOs have filed publicly with the SEC so far just in the month of September.
The End Game for SPACs
When everything from the economy's underlying health to the outcome of the election is up in the air, SPACs have an undeniable appeal. On the one hand, a SPAC is a safe place to stash money with a high probability that you can get it back if you need to. On the other hand, they could end up being a ticket to the future of space travel — anything is possible until the sponsors announce their merger target — the undertaking of great advantage!
Whether they overcome the taint of their past performance will depend entirely on whether they can source high-quality companies prepared for the rigors of the public markets. At least some voices believe that SPACs may be a viable alternative for venture-backed companies to get public at warp speed while leaving less money on the table than through a traditional IPO.
In a widely-read recent blog post, Bill Gurley, of Benchmark venture capital, argued that the plethora of funded SPACs puts companies in a unique position to negotiate favorable terms with sponsors and obtain “a much lower cost of capital versus a standard IPO.” He believes that companies can effectively negotiate their valuation and other deal terms effectively with a single sponsor, rather than waiting for large institutional investors to impose a massive discount through the traditional IPO book-building process.
It remains to be proven if SPACs offer a superior option to IPOs for mature venture-backed companies. To minimize SPAC's redemptions, shareholders still need to believe that the merger terms provide sufficient upside to forego opting for a cash payout. But he is undoubtedly correct that if there were ever a time when negotiating dynamics favored quality companies, it would be now with tens of billions in cash sitting idle and sponsors under the gun to “use or lose” the proceeds they have raised. Globally, hundreds of capital-hungry "unicorn" companies have outgrown the venture funding model and seek ways to access the public capital markets.
2020 is indisputably the year of the SPAC. If those stars align, 2021 may shape up as the year when SPAC investors finally start making some real money.
 In 2011, Jenkinson and Sousa looked at the 58 SPACs that completed mergers between 2003 and 2009 and found an average negative return of 24% in the first six months and 55% in the first year.