The markets are flooded with IPOs these days. Still, more often than not, we get to hear that investors are not getting allotted their share applications, especially in most anticipated IPOs.
On the contrary, the lower price bands quoted by underwriters and book runners and the fear of under-subscription for companies raising funds (quite often) do not get the actual listing value.
SPACs, also known as blank cheque companies, come to be a great alternative to IPOs! They have been around for decades but became more popular quite recently. In 2020, they raised a record of 82.1 billion dollars as per Investopedia.
Understanding the Role of SPACs
A SPAC is a blank cheque entity generally formed by investors or sponsors specifically set up to acquire a particular firm or a firm in a particular sector. This entity aims to raise money in an initial public offering (IPO). Initially, it does not have any operations or revenue. After raising the money from the public, the money is kept in an escrow account.
These funds in the account cannot be disbursed except if the SPAC is liquidated to return the money to investors or complete an acquisition. Sometimes, the working capital for SPACs is used from the interest earned.
Source: https://www.nasdaq.com/solutions/spac
All interested investors with faith in the sponsor will invest in the SPAC, and then this SPAC will look for potential companies which want to go public.
Before the creation of a SPAC, a target company is selected. The selected target company is an established private company with a well-known brand in the market. The sponsor will attract investors by introducing this opportunity of growth potential after acquiring the target company at current valuations.
The SPAC offers a lump sum amount to the private company for the share it was willing to offer to the public. Once the deal is done, the SPAC and the private company will merge post which the private company will replace the SPAC in the stock exchange.
Characteristics of SPACs
- The Capital Structure
Retail and institutional investors are usually the sources of capital, and as mentioned earlier, 100% of the money raised in the IPO is held in a trust account. Investors get to own units, in return for the capital, with each unit comprising a share of common stock and a warrant to purchase more stock at a later date.
The units become separable after the IPO into shares of common stock and warrants, which can be traded in the public market.
The founders of the SPAC by paying a nominal consideration for the number of shares that result in a 1/5th (sometimes it may vary a bit) ownership stake in the outstanding shares after the completion of the IPO. These founder shares mainly compensate the management as they are not allowed to receive any salary or commission from the company until an acquisition transaction is completed.
- Management
An experienced management team usually leads the SPACs, composed of three or more members with prior experience in private equity and/or mergers and acquisitions. The management team does not get any salaries, finder’s fees, or other cash compensation before the business combination, nor it participates in a liquidating distribution if it fails to consummate a successful business combination.
There are minimum conflicts of interest within the SPAC structure because all management teams agree to offer qualified prospective target businesses to the SPAC before any other acquisition fund, subject to pre-existing fiduciary duties.
- Governance and Regulation
The company must make full disclosure to shareholders of the target business via an SEC merger proxy statement that includes complete audited financials and terms of the proposed business combination that allows them to decide whether they wish to approve the business combination.
All common shareholders of the SPAC are granted voting rights at a shareholder meeting to approve or reject the proposed business combination.
The trust assets are only released if the voting shareholders approve a business combination, or a business combination is not consummated within the amount of time allowed by a company’s articles of incorporation.
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Advantages of SPACs
With SPACs, there can be a quicker route to IPO and saves a considerable amount of underwriting fees and expenses. The execution is faster than the IPO as a merger usually occurs in 3–6 months on average compared to an IPO that takes 12–18 months. Since SPACs units come with warrants, investors also get the option of buying additional shares if the IPO is a success.
The sponsors are often experienced financial and industrial professionals, making the investments less risky as they have a network of contacts to offer management expertise. The sponsors also have a 20% interest in the SPAC, which leads to a greater alignment of interest between the sponsor and the investors.
Disadvantages of SPACs
Investors are usually betting on the expertise and skill of the CEO or the manager. It may so happen that the manager has not had an excellent track record, and hence the entire investment can become entirely speculative. Also, in contrast to the traditional IPOs, there is comparatively less due diligence which could lead to potential restatements, incorrectly valued businesses, or even lawsuits. If the sponsor is involved in any fraudulent activity, it may happen the entire investment is lost.
There can be scenarios of the capital shortfall if investors’ redemption of shares starts exceeding expectations, leading the SPAC to resort to PIPE (Private Investment In Public Equity) financing to cover the shortfall. In some cases when the target company is not revealed to investors, the sponsor may buy a private company that is not-so-good which may be a threat to destroy the investor’s value.
The SPAC will have to return all the raised money back to the investors if it cannot get a deal within the time frame specified in the prospectus, generally 2-5 years. This leads the sponsor to enter into a deal under pressure which is not so beneficial for investors–just for 1/5th of its share. That can be pretty risky, and hence it’s imperative to have faith in your sponsor and check its backing and brand in the market before investing.
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