Have you come across the term SPAC or Special Purpose Acquisition Company? You may have seen it in the “mergers and acquisition” news section or perhaps in a shareholder newsletter. Think of the latest acquisition news in India: the Bengaluru-based car rental startup Zoomcar will soon be listed on the American stock exchange after being acquired as part of a $456 million SPAC agreement. Yes, SPACs can enable cross-border acquisitions and mergers.
That is just one of the many reasons why SPACs have quickly become the preferred way for businesses to acquire startups and introduce them to the market. It also permits smaller businesses to sidestep the traditional IPO (initial public offering) approach to become a listed company. Yet, most entrepreneurs and business leaders still struggle to understand how SPACs work and when they should be leveraged.
With all eyes on this fairly new concept, let’s start by understanding what Special Purpose Acquisition Companies are, and what they are not.
What Is A Special Purpose Acquisition Company (SPAC)?
A Special Purpose Acquisition Company (SPAC) is a business without any commercial operations that is established for the sole purpose of raising money through an initial public offering (IPO) so that it can acquire or merge with another business. In simpler words, it is a shell company whose only aim is to generate capital that will be used to acquire or merge with a startup or smaller business.
SPACs can also be considered a type of investment vehicle that allows smaller businesses to go public without going through the conventional IPO process. In lieu, a Special Purpose Acquisition Company is set up to raise capital from investors through an Initial Public Offering (IPO), which is then used to acquire the target company. SPACs are typically managed by a group of investors, also known as sponsors, who receive a percentage of the proceeds from the IPO sale. The IPO shareholders also get a return on their investment once the company is listed and its shares increase in value.
Generally, a team of experienced managers or sponsors who form the SPAC invest capital into it. They typically have a 20% interest in the company, commonly known as founder shares. The remaining 80% of the interest is held by public shareholders or institutional investors through the units offered during the IPO of the shares. The distinction here is that while founder shares and public shares often have comparable voting rights, founder shares have the exclusive power to elect the board of directors that governs the SPAC.
A common misconception is that SPAC is just another term for a private equity or venture capital fund. The difference here is that a SPAC has no operations or business plans of its own; it exists just to conduct the IPO and raise capital.
So, what is it that has made SPACs so popular in recent years?
The Increasing Love For SPACs Is Evident
If you do a quick Google search for SPACs, you’ll realize that they are a big deal – literally. Most SPAC deals are worth a few hundred million or even billions of dollars. The Singaporean technology company Grab went public on the Nasdaq in 2022, thanks to a merger with Altimeter Growth for a valuation of $40 billion, making it the biggest SPAC deal to date. In comparison, the largest IPO to date, Saudi Aramco, managed to raise approximately $25.6 billion. Hence, opting for a SPAC approach over an IPO allows acquiring businesses to have more certainty over the capital that can be raised.
The concept of SPAC gained popularity once it became apparent that the coronavirus pandemic would have an impact on supply chains. The economic outlook across the globe changed for the worse, and the financial markets reacted accordingly with the value of stock markets around the world falling. This encouraged many investors to look for new opportunities as opposed to conventional investment vehicles (such as equities and bonds). Thus, the pandemic proved to be a major boost for SPAC investments. Furthermore, SPACs had the support of well-known investment banks such as JPMorgan and Goldman Sachs, which gave them more legitimacy in the eyes of investors.
Moreover, the recent fondness for SPACs stems from the fact that almost anyone can create one; as long as they can persuade shareholders and investors to buy the IPO shares. Before we get into all the reasons that make SPACs so fashionable, let’s look at some numbers.
There was a record 613 SPAC IPOs in 2021, compared to a meagre 59 SPACs that came to market in 2019 – over a tenfold increase in two years. In 2019, SPAC IPOs managed to raise $13.6 billion in the capital. As the interest in SPACs increased, the proceeds raised in 2021 reached $162.5 billion – twelve times as much as in 2019. This was a sure-fire indication that both investors and startups were showing a major preference to raise capital using Special Purpose Acquisition Companies, rather than hosting their own IPOs.
Another key factor is that SPACs have a lower regulatory burden compared to IPOs, leading to faster speed to capital, more transparency and lower fees. For example, SPAC shares almost always have a face value of $10, reducing the need for regulatory bodies to step in to fix a fair price. All these factors culminated in a perfect storm to set the stage for Special Purpose Acquisition Companies to flourish in the past few years.
Yet, there are several other advantages of SPACs that everyone from investors to business leaders need to know.
What Are The Benefits Of Opting For SPACs Over IPOs?
Unsurprisingly, Special Purpose Acquisition Companies saw a stark increase in popularity due to the various benefits they offer over traditional IPOs. Here are a few of them:
- Higher Valuation: SPACs provide a chance for higher valuation as public corporations sell at higher multiples than private ones on the market. Additionally, investors had an incentive to “buy in” during the IPOs because whenever they would redeem their shares, they would not only get their original investment and gains but also an interest payment per share.
- Higher Degree Of Control: Business owners lose some control when they take on private equity. SPACs allow them to maintain a significant stake in the company as there is lower dilution and fixed ownership interest. Moreover, there is control over one’s money when investing in a SPAC. When you invest in the IPO, the invested money is put into a trust account that’s managed separately. When the sponsors of the SPAC choose a company to acquire/merge with, you have the right to get your money back if you are sceptical of the success of the deal.
- All-round Liquidity: SPACs provide security in liquidity, thanks to the capital raised via the IPO. Additionally, SPACs have two years to complete a purchase before they must reimburse the money to their investors. As a result, SPACs need to preserve liquidity from the IPO phase till the acquisition is completed.
- Shorter Time To Listing: SPACs normally take two to three months to complete, while traditional IPOs can take up to two to three years. This is also due to the fact that SPACs are bound by a two-year time limit to complete the acquisition or merger.
- Lower Cost: SPACs often cover the majority of the expenses, saving the company a sizable sum of money compared to standard IPOs, which can be quite expensive to execute. This is also attributed to the fact that SPAC founders often pay a premium on their shares to cover all costs and ensure the merger happens.
- Certainty Of Merger/Acquisition: SPAC deals are identified in advance and the valuation is approved by both parties before moving forward. Investors and the founders of the SPAC can then be confident that the acquisition/merger will take place, and that it will be at a value that everyone is comfortable with. No last-moment revisions or negotiations can be conducted in bad faith.
These factors make SPACs a desirable way for smaller businesses and startups to get publicly listed. Yet, it has not entirely derailed the initial public offering (IPO) approach, which is still considered a viable option. In fact, the number of SPAC IPOs fell drastically from 613 (in 2021) to merely 86 in 2022 as shown in the bar chart above. So, does this signal the start of the end for SPACs?
Was The SPACs Trend A Bubble?
SPACs really took off in 2020, when we saw the first 3-digit SPAC IPO, with 248 Special Purpose Acquisition Companies hosting an IPO. However, several industry insiders predicted that with the expansion in the number of SPACs entering the market, a lot of capital would be spent searching for sizable acquisitions or mergers in the same sectors. Standards will surely deteriorate as a result, and inferior businesses will be listed on the market. Consequently, companies that go public via SPACs won’t be able to match their potential valuation or generate additional gains. Furthermore, SPACs were being endorsed by celebrities and public figures who had a much lower downside than investors if the merger didn’t go through or was done under false pretences.
According to research from the Yale Journal on Regulation done in 2020, among the SPACs included in the study, the average rate of redemption per deal (amount of investors opting out before the acquisition) was 58%. Additionally, they learned that several of the SPACs had raised relatively small amounts of capital and had given investors higher-than-average warrants as an incentive — both signs of lower-quality sponsor teams. As such, it is not surprising to note that in more than a third of the SPACs, over 90% of investors pulled out before the acquisition was completed.
However, the condition has improved post-pandemic, as SPAC sponsors have been offering improved warrants and more transparent investing opportunities. As a result, fewer investors are backing out compared to previous years. The numbers back this trend: between July 2020 and March 2021, 70 SPACs discovered targets for acquisition; the average redemption rate for these 70 SPACs was just 24% or roughly 20% of the total capital invested. In addition, four out of five SPACs saw redemption rates of less than 5%, as stated by Harvard Business Review.
Yet, on the other hand, with 143 SPAC IPOs being withdrawn and 46 SPAC transactions being cancelled, 2022 witnessed the largest number of withdrawn SPAC deals ever. In contrast to the 167 SPAC agreements announced during the first half of 2021, merely 77 SPAC merger and acquisition deals were announced during the first half of 2022, according to research provided by Deal Point Data. Moreover, the median redemption rate has shown a constant uptick since 2016, as shown in the line chart above.
Another key statistic to note is from research done by Goldman Sachs: for SPACs that had finalized an agreement since the start of 2020, the median had outperformed the Russell 3000 index (US market benchmark) from the IPO till the date of the announcement. However, six months after the deal was closed, the median had underperformed the same index by 42 percentage points.
The above stats and current investor sentiment highlight the change in the perception of SPACs. Investors are moving back to traditional investment arenas, as SPACs have failed to deliver expected returns and are too unpredictable in the current market, where mergers and acquisitions may not pan out.
Moreover, SPACs have undoubtedly created a bubble, as their focus has been solely on niche technology startups, especially electric vehicles, crypto and digital media. SPACs are highly unlikely to regain the popularity they had a few years ago, although it remains a quick way to acquire businesses or get listed on the market. In all likelihood, the SPAC trend, which was a bubble, is over.
In The End
A Special Purpose Acquisition Company (SPAC) is a type of investment vehicle that raises capital through an IPO to acquire a private business. It was once critical for business leaders to consider this option, as it was favourable for all parties involved in the transaction. However, an IPO might make more sense in today’s climate, keeping in mind the risks and volatility associated with SPACs.
Additionally, with a majority of SPACs failing to complete acquisitions or mergers this year, it is unlikely to remain a feasible alternative in the years ahead. SPACs did offer a number of advantages over IPOs for startups looking to go public and providing sponsors with the potential for high returns on their investments. However, it is safe to say that the SPAC bubble has burst and the trend will wane soon.
