In 2020 SPACs, or Special Purpose Acquisition Companies, raised $82 billion, almost as much money as regular IPOs. This year, SPACs have already raised $38 billion and are expected to easily outpace the total raised in 2020.
So, what are SPACs, how do they work and are they worth investing in? In this post we break down the objectives of SPACs, the way they work and whether or not they are worth investing in.
- What is a SPAC?
- What is the objective of a SPAC?
- How SPACs work
- Pros / Cons of SPACs for companies
- Pros / Cons of SPACs for investors
- Examples of recent SPACs
- Risks of investing in SPACs
What is a SPAC?
SPACs, which are also known as blank cheque companies, are publicly listed companies that exist to merge with existing privately owned companies, taking them public in the process. A SPAC is like a cash shell company, but unlike most cash shells, it has no operating history.
When you invest in a SPAC you are providing the lead investor with capital to acquire or merge with another company. However, when the SPAC holds its IPO, there isn’t a specific target company. Typically, a SPAC will be created to make an acquisition in a specific industry, within a prescribed timeframe. The SPAC sponsor will usually be a prominent venture capital, private equity, or hedge fund manager.
What is the objective of a SPAC?
SPACs are best viewed from two perspectives: that of the sponsor or lead investor and that of the target company. From the lead investor or sponsor’s perspective SPACs are like funds that seek to unlock value by taking advantage of opportunities. However, unlike other types of funds, a SPAC only unlocks value in one company.
From the perspective of the target company, merging with a SPAC is an easier, faster, and more certain way to become listed on the stock market. Merging with a SPAC is similar to doing a reverse listing by merging with a listed cash shell.
How SPACs work
The process followed by a SPAC corporation can be divided into three phases: The pre-IPO phase, the IPO, and the acquisition or merger.
The process of creating a SPAC is initiated by a sponsor or lead investor. The first step in the process is to form a management team to manage the SPAC and complete a transaction. Before a SPAC can sell shares and become listed, the same IPO process as any other company needs to be followed. The difference is that the SPAC has no operating history. So, the prospectus will focus on the track record of the management team and the type of opportunity they intend to pursue.
The management team receive founder’s shares which can account for as much as 20% of the shares ultimately issued. This block of shares is known as “the promote” and is the way the lead investors are compensated for managing the SPAC. Lead investors also buy warrants at a discount to cover the costs incurred during the IPO process.
The lead investors first appoint underwriters and file a registration statement with the SEC. The management team then conduct a roadshow to promote the SPAC to institutional investors. If the underwriters are satisfied that there is sufficient support from institutional investors, they will agree to underwrite the offering, and the IPO goes ahead. Retail investors can participate in the public offering or buy shares once they are listed.
When you invest in a SPAC company, you actually receive units which consist of shares and warrants. A warrant is a call option that allows you to buy more shares at a later date. Once the IPO is completed, the cash raised is placed in a trust until a deal is concluded. This means your investment may be tied up for up to two years. The warrants are issued to compensate you for the low returns you will earn until a deal is announced or completed.
Unlike traditional IPOs which are priced according to demand, units in SPACs are typically priced at $10. Investors can also redeem their shares if they aren’t happy with the merger that ultimately occurs, or, if there is no deal in the allotted timeframe. Each unit will typically consist of one share and one warrant or a fraction of a warrant. The warrants will typically have a strike price of $11.50.
Merger or acquisition
Once the IPO is completed the lead investors will begin the search for an acquisition target. For a potential deal to qualify it must operate within the industry originally specified and at least 80% of the IPO proceeds must be spent on the deal. Sponsors typically look for companies that are significantly larger than the capital raised during the IPO. During this period, investors can sell their shares, warrants or both. Investors can also buy shares or warrants in the secondary market. Shares typically remain close to $10 until rumors of a deal begin to circulate.
As soon as a target company is identified and before due diligence is conducted, shareholders are notified of the potential deal. Then, before a merger is actually finalized, shareholders are given the opportunity to vote on the deal. If enough shareholders approve the deal, the details of the merger are finalized and announced. Shareholders can also redeem their shares at this point. They will receive the amount they invested less any costs associated with the process.
For the deal to be completed, additional funding is often required. This capital is often raised from PIPE (Private Investment in Public Equity) deals with institutional investors. Further capital is also raised when investors exercise their warrants. When the merger takes place, the shares begin trading with a new name (typically the name of the target company) with a new ticker symbol. If no deal is agreed within the prescribed timeframe, funds are returned to shareholders – or the deadline can be extended by way of a proxy vote.
Pros / Cons of SPACs for companies
For private companies, SPACs offer an alternative to the IPO route to becoming publicly listed. A traditional IPO can be a long and costly process. Company leaders, who may not have experience dealing with public market investors, must first conduct a roadshow to market the company to investors. Satisfying the requirements of stock exchanges can also be time consuming.
There is also a lot of uncertainty involved in a traditional IPO. A company may spend months getting ready for the IPO, only to see little demand for the stock due to changing market conditions. The SPAC route means a management team only needs to deal with one investor. Typically, the lead investor will have more experience structuring a deal and marketing it to investors. The level of uncertainty is reduced as the process is faster. In addition, there are fewer regulatory hurdles as the IPO has already occurred.
The downside of this route is that the company is likely to end up selling its equity at a lower price than it could by conducting its own initial public offering. However, this assume the IPO would have seen substantial demand.
Pros / Cons of SPACs for investors
The main advantage of SPACs for retail investors is the opportunity to invest earlier in the cycle. Typically, when a company holds a public offering, they allocate most of the shares to institutional investors. In the case of popular IPOs, demand for shares is strong, which increases the IPO price too. On the first day of trading, the shares will trade at even higher levels.
Your growth stocks are unlikely to become multibagger stocks if you initially invest when the stock is overhyped, which is often the case with IPOs. SPACs give investors the opportunity to invest before demand outstrips supply. Another advantage of SPACs is the opportunity to invest in a single company alongside some of the best investors on Wall Street. These investors are often experts at stock picking and at unlocking value in a company.
Finally, SPACs do give you the opportunity to redeem or sell the shares if you don’t like the deal that is announced. This means downside risk is limited if your initial investment was at $10, although you won’t receive the full $10 as some costs are deducted.
There are however a few disadvantages to investing in a SPAC business. Firstly, your investment will be diluted during the process. This dilution can be as high as 50%, depending on the percentage of shares awarded to founders, the amount of additional funding and whether or not you redeem your shares.
Dilution can be reduced by redeeming the shares for $10 (minus some costs) and then exercising the warrants. However, this requires a larger upfront investment as units typically comprise a fraction of a warrant. A SPAC investment also is a bet on the lead investor, rather than on an existing company. This means you cannot do any sort of analysis on the company until a merger is announced.
Examples of recent SPACs
These are examples of SPACs at different stage of the process from IPO to completed merger.
- Social Capital Hedosophia / Virgin Galactic
- Social Capital Hedosophia / SoFi
- Churchill Capital Corp IV
- VectoIQ / Nikola Motors
- Pershing Square Tontine Holdings
Social Capital Hedosophia / Virgin Galactic (NYSE: IPOA/SPCE)
Chamath Palihapitiya‘s Social Capital and London based Hedosophia formed a partnership in 2017 to offer privately owned technology companies an alternative path to traditional IPOs. Six SPACs have been launched so far. Of the six SPACs, three have merged with private companies, one is negotiating a merger, and two are still looking for deals.
The first SPAC led by Chamath Palihapitiya ultimately merged with Virgin Galactic in 2019. The SPAC initially held its IPO in 2017, raising $650 million. Virgin Galactic was founded in 2004 as an integrated aerospace company. It aims to make spaceflights accessible to private individuals and also manufactures aerospace equipment and craft.
In 2018 discussions began between representees of the SPAC and Virgin Galactic. The merger was announced in January 2020, and completed in October, when the ticker changed from IPOA to SPCE. The stock initially traded at $10 but rallied to $37 when the merger was initially announced. It fell back to $9.75 in March 2020 but has since rallied to as high as $60.
Social Capital Hedosophia / SoFi (NYSE: IPOA)
The fifth Social Capital SPAC listed on the New York Stock Exchange in November last year. Investors didn’t have to wait long for a potential merger to be announced. Early in January it was announced that the SPAC intends to merge with fintech company SoFi. The deal is now being finalized.
SoFi is an online platform that provides financial services to the millennial market. The company started out providing loans to students, but now offers insurance, stock trading and banking services. SoFi is a popular platform amongst millennial investors which has resulted in the SPAC itself gaining strong support from that market. The IPO initially raised $700 million, but its market capitalization quickly grew to $2 billion when the deal was announced.
Churchill Capital Corp IV (NYSE: CCIV)
The Churchill Capital Corp IV SPAC has been the top performing SPAC this year on speculation of a pending merger with Lucid Motors. The SPAC listed in September last year with the objective of merging with a company in the electric vehicles industry. The SPAC is one of a several launched by Michael Klein, a former CitiGroup executive.
Lucid Motors, a is a privately owned EV manufacturer founded in 2007. Its first car, the Lucid Air is still in development, but is targeting a range of 517 miles. This is well ahead of the Tesla Model S Long Range, the EV with the longest range currently on the market. The stock price has risen from $10 at the beginning of the year, to over $60. This means the SPAC which raised just over $2 billion now has a market capitalization of $12 billion.
VectoIQ / Nikola Motors (Nasdaq: VTIQ/NKLA)
The deal that took zero emission vehicle manufacturer Nikola Motors public is an example of a SPAC that hasn’t worked out well for investors. VectoIQ Acquisition Corporation listed its first SPAC in June 2018 and eventually announced a merger with Nikola Motors in March 2020. The merged company, named Nikola Corporation began trading on the Nasdaq in June. The share price which had traded close to $10 in January, traded as high as $93 immediately after the merger, but soon began to drop.
There was always some skepticism about the claims the company made about its vehicles and how close they were to production. In September, it emerged that the company had staged a video showing the Nikola One truck supposedly driving under its own power. In fact, the truck was merely rolling down hill, powered by gravity. The apparent fraud was uncovered by well-known short seller firm Hindenburg Research.
The story quickly turned into one of the biggest financial scandals of 2020. The share price fell to about $15 before recovering to around $20. Clearly some investors still see value in the company, but the optimism isn’t close to what it was when the company merged.
Pershing Square Tontine Holdings (NYSE: PSTH)
The largest SPAC to date, is backed by Bill Ackman, a well-known hedge fund manager. The SPAC managed to raise just over $4 billion, when it held its IPO in September. The team is still searching for an acquisitions target but intends to find a company with a value of between $5 and $7 billion. Ackman’s reputation has resulted in strong demand for the SPAC shares and warrants, which are already trading as much as 50% higher than the IPO price.
The details and performance of other SPACs can be tracked on the SPACTRACK website.
Risks of investing in SPACs
SPACs need to be treated on a case-by-case basis. While some SPACs have performed well for investors, performance has on average been poor. Besides the investment warning signs that apply to all speculative investments, you can reduce portfolio risk by considering the following.
- The fact that a SPAC’s lead investor has a good track record does not guarantee they will make a good investment. When a deal is announced, you should do your own research and pay attention to how much your shares will be diluted by additional funding rounds.
- SPACs do not offer the diversification of investment funds, so they should have a relatively small position in the asset allocation mix.
- The share price of SPACs often follows a similar pattern. The price tends to spike when rumors of a deal begin to circulate, when the merger is announced, and when the merger takes place – but drops after each event. Your risk increases dramatically if you invest during these spikes.
- A SPAC typically has a two-year window to complete a deal. It’s worth being extremely cautious of deals announced in the last three months of this period. This is when deals are likely to be rushed, as may have been the case with Nikola Motors. Sponsors lose out when no deal is announced, so they have an incentive to do a deal, even if it’s not a good deal.
Conclusion: Are SPACs worth investing in?
SPACs have given retail investors the opportunity to invest in several companies at attractive prices. But they do come with risks and dilution remains an issue. The good news is that the industry is evolving quickly, and the structure of SPACs is improving. With lots of private companies looking to go public, its likely that SPACs will remain a feature of the investment landscape.