While we have talked about the general froth in the initial public offering (IPO) market, it is time to focus on one of the major drivers – special-purpose acquisition companies (SPACs). SPAC IPOs accounted for over half of all IPOs in 2020 and are already set to make up a majority in quarter one of 2021. This is a cause for worry in the market and, more importantly, for investors who may get caught bearing the real costs of a SPAC. We'll look at the why and how of SPACs, as well as why the odds seem tilted against individual investors realizing a good return.
- The IPO market has been frothy of late, with tech offerings seeing huge jumps in first-day trading.
- Within this IPO market, SPACs are making up a larger share of new offerings. This means that more and more money is hitting the market with a plan to find something to buy.
- SPACs give creators and sponsors structural advantages that later investors don't have, making the decision for retail investors to invest in them even more risky. (And that is saying a lot considering SPACs are essentially a pile of money with no set strategic plan beyond "find something to buy before time runs out.")
How SPACs Work
Special purpose acquisition company is a formal way of referring to what was commonly known as a blank check company. These companies used to form without a business plan for the purpose of buying up or merging with a private company that wasn't currently trading publicly. Blank check companies were strongly associated with the world of penny stocks and pump-and-dump schemes. More recently, however, they have grown immensely in size and press coverage. As the companies staying private have grown larger through more funding rounds, the SPACs seeking them out have similarly grown to make acquiring a unicorn type company plausible.
SPACs are still just a pile of publicly listed cash and a group of people looking to find a private company to buy and take public. They offer an alternative route to the market other than an IPO or direct listing. If they don't find a target within the set time period, SPACs can seek an extension or return their capital to shareholders. Moreover, investors who don't like the proposed deal also have a redemption right to get their money back in advance.
Although it is not required that SPACs have influential figures tied to them, the recent trend is for SPACs to grab a mix of celebrity and known executives to create even more buzz. This is why you are seeing Shaquille O'Neal and Alex Rodriguez helping to usher SPACs into the market. This is also a sign that SPACs are firmly in the mainstream now rather than relegated to shadier corners of the market.
Why a Company Would Merge With a SPAC
Private companies obviously have their reasons for agreeing to merge with a SPAC. SPACs have already done the hard part of the IPO process for potential acquisition targets, raising money and issuing shares. When a company is identified for purchase, SPACs can further leverage their cash by taking on debt or even assuming debt already held by the target. This means that the company can work out a deal privately with the SPAC management team and then see its shares float publicly in very short order. Going public via SPAC is faster than an IPO, results in less public scrutiny of the firm being acquired, and even allows the firm involved to continue talking up the stock, unlike the quiet period around an IPO.
How SPACs Affect Investors
SPACs have a bit of a built-in advantage for their creators. The organizers of the SPAC put up money to tide the SPAC over until it goes public to raise the bulk of its capital. In return for this seed money, the creators usually come out of the IPO with 20% of the equity in the SPAC. This helps the creators supercharge their own returns, even if the performance of the SPAC shares struggles after the merger/acquisition. If the company the SPAC buys does well, the creators do that much better than the public investors.
While most investors understand that the creators of the SPAC have an advantage, there are further nuances that The Wall Street Journal did an excellent job analyzing. Large investors that help sponsor SPAC IPOs are often buying units that contain a share and a right or a warrant. These investors can then redeem the share and keep the warrant to exercise, cutting their downside risk while leaving the door open to large future returns. This puts them at an advantage over an investor intending to buy and hold the SPAC shares, as this latter group also gets hit by dilution through the exercise of warrants and rights.
SPACs and the Makings of a Bubble
We are at a time when even scrutinized and established companies undergoing IPOs in certain sectors (read: technology) are experiencing bubble-like run-ups in first-day trading. SPACs are like a bubble within that bubble, as many of them have targeted tech in the broad sense as their area for acquisition. In this euphoria for electric vehicles, media companies, platforms, and so on, some of these SPACs will turn out to be good investments in the near term for their post-IPO investors (and excellent for creators and sponsors).
Unfortunately, the explosion in the number of SPACs hitting the market means that a lot of dollars are chasing deals of significant size in the same industries. This will inevitably mean that standards will slip and that weaker companies will be brought to market. Eventually, companies going public through SPACs will struggle to ever match the value of cash injected into them, let alone a return on top of that.
The Bottom Line
The celebrity connections, the general IPO madness, and the noted success of a small fraction of the wave of SPACs hitting the market have made them more enticing to investors than they ever have been before. While SPACs can be profitable for the sponsors and useful for the target company looking for a less expensive and restrictive way to go public, the odds are structurally stacked against post-IPO investors without warrants.
These stacked odds will likely get worse as the M&A frenzy on a deadline results in SPACs reaching further down the start-up cycle to pull companies into the public eye long before they are ready for it. Where the bottom of the barrel is and when it will be reached is hard to say, but investors should approach SPACs with the same caution they would if these entities were still dealing primarily in penny stocks.