Published October 2020
2020 has been a banner year for SPACs, with a record number of companies going public through this method. According to data from SPACInsider, gross proceeds this year have topped $50 billion as of early October, more than the past five years combined. Although there has been concerns about investment risk of SPACs, the trend is expected to stay for the long term.
To briefly explain SPACs (also known as Special Purpose Acquisition Companies), these are business entities that are set up solely for the purpose of acquiring an existing firm. Since this will require vast amounts of money, these shell companies usually raise money via IPOs or have extensive financial backing. After they identify a good business to acquire, a deal is to acquire a target company. After the acquisition, the latter would immediately go public. As such, SPACs could be a quick exit vehicle compared to the traditional IPO.
Based on our study, about 90% of SPAC deal proceeds this year remain unallocated (ie. dry powder). About half of this year’s SPACs have raised over $300 million each. For these large SPACs, they have either acquired a firm (or have an interest) in the following sectors in order of popularity: Technology / Financial Technology, Healthcare / Medical and Media / Entertainment / Gaming. About 46% of large SPAC proceeds were raised by SPACs with an interest in (or have made a) technology/FinTech acquisition.
SPACS in Context
Since SPACs emerge with hundreds of millions in capital without any acquisition target in mind, they are also known as “blank check companies” due to their ability to purchase most private companies.
Although SPACs have been around for a few decades, it has experienced a resurgence in recent years. However, most investors of SPAC mergers found themselves with meager rates of return. According to a Financial Times analysis, most of these investments currently trade below the $10 price at the time of going public. Only a few deals over the past two years, including the DraftKings one, has contributed to sizeable gains.
Rising Popularity of SPACs in Recent Times
Current SPACs are set up with very generous incentive structures. A SPAC founder has lots to gain from a successful acquisition, since they typically receive 20% equity that can be converted into common shares for sale in the public markets. Regardless of whether the acquired company has a strong business or not, the founders still receive their share.
Despite this structure, there are other provisions in place that may have contributed to the growing popularity of SPACs. To protect against scams or poorly made acquisitions, investors can choose to get their money back if they choose not to approve an upcoming acquisition. Similarly, if the SPAC cannot find a desirable company to acquire, investors will still get a refund on their initial principal. Such safeguards result in very low downside for investors but could lead to significant gains in the future.
Other than SPAC founders and investors, companies may also have a lot to gain. In the months preceding the COVID outbreak, several companies chose to postpone their IPO plans due to valuation uncertainties in a relatively heated market. In particular, WeWork‘s IPO fiasco made the public more cautious about companies going public. Unlike IPOs, SPACs will make an agreement with the target company on its valuation. This helps to alleviate market uncertainty as part of the price discovery process, especially in the months preceding the election and amid concerns about the slow recovery of unemployment rates.
There is also the option of direct listing, as Slack did in mid-2019, but there would not be any cash raised — a challenging proposition given that many companies remain cash-strapped. With the economy struggling to recover, SPACs have become an increasingly appealing path for companies that need cash to continue to grow and invest ahead of economic recovery. Regardless, some like Palantir and Asana have chosen this path more recently.
Growing Concern of SPACs as Scrutiny Intensifies
The current economic situation has created strong pressures for companies to take the SPAC path more seriously than before. At the same time, founders and investors have sufficient incentives to participate as well. However, there are some potential obstacles that may raise doubts about this rosy picture.
Firstly, founders’ shares would cause a signification dilution of the market value. Founders typically purchase an initial stake of “founder shares” in the company for a nominal amount before the IPO. These shares generally auto-convert into common shares (say 1-to-1) at the completion of a business combination. The founder stake is often structured to represent approximately 20% ownership interest in the post-IPO company, and could cause significant share dilution.
Secondly, some deals may turn into outright scams. As the SPAC fever continues, it will become easier for first-time SPAC founders to raise capital even without a proper investing record. Shady backdoor deals could lead to gains for some, at the expense of investors.
Thirdly, companies with good business models and are not cash-strapped may still find the traditional IPO route more appealing. Eventually, SPACs may find themselves left with relatively weak businesses to acquire.
Indeed, companies have every right to reject offers from SPAC if they are not interested. In AirBnB‘s case, they rejected an offer as the price was not right. They had initially delayed their planned IPO, but then got approached by billionaire investor Bill Ackman’s SPAC (Pershing Square Tontine Holdings) for a deal. According to online reports, AirBnB CEO Brian Chesky was expecting a public market valuation closer to $30 billion.  Although it was valued at $31 billion from a capital raise in 2017, it has since commanded an implied valuation of $18 billion amid the ongoing pandemic. Given the wide valuation gap, the deal did not proceed and subsequently filed for IPO in August this year.
Long Term Outlook of the SPAC Trend
Despite prevailing concerns, the outlook for SPACs looks promising in the long run. Once the bubble starts to deflate, SPAC founders would find it harder to raise capital. The landscape would become more competitive, with founder remuneration becoming less generous over time. For instance, Pershing Square chose to take the lead by not allocating founders’ shares.
SPAC superstars will continue to attract attention and will be able to raise bigger sums of money each time. On the contrary, SPACs with abysmal track records would struggle to raise funds and will eventually fade away.
Competition will weed out underperforming SPACs, leaving behind high quality SPACs for investors to participate in. Just as crowdfunding has expanded democratization of investment, SPACs will help to advance this cause by allowing retail investors to enjoy the ‘pop’ in price, an exclusive privilege traditionally enjoyed by IPO underwriters. In a world that is becoming more complicated and uncertain, SPACs should be able to establish a niche among companies that desire a state of stability.