Demystifying SPACs and their bad reputation
Last year, SPACs — special purpose acquisition companies — experienced an unprecedented boom.
Nearly USD 80 billion was raised by SPACs in 2020, and this year this figure was already exceeded in the first quarter. Significantly more than in any other year (see chart).
In the media, however, the sentiment around SPACs is rather negative. And when I read through the articles, I often have to realize that there is a lot of misinformation circulating.
There, SPACs are often compared to speculative investments like ICOs and cryptocurrencies. Uninformed investors — Dumb Money — would invest in SPACs especially for irrational reasons and FOMO (fear of missing out). I consider this to be unjustified.
As with any other investment class, there are large differences in quality within the category. Of course, there are better and worse SPACs. However, it is important to understand SPACs before dismissing them as speculative investments. Besides, it is time to put away the term Dumb Money anyway. For being dumb, dumb money has had pretty much the same success as its smart cousin.
By now, many people are aware that SPACs are so-called blank check companies that raise money through an IPO to acquire an exciting private company.
SPACs are an alternative to the regular form of going public, an IPO. And this is exactly where the problem lies. You have to understand exactly the status quo — an IPO — before we look at SPACs.
An IPO is an important step for a company. In the course of an IPO, a company raises financing and its shares become tradable on a stock exchange. Its employees can finally convert their hypothetical fortunes into real fortunes.
However, there are many uncertainties and risks associated with an IPO. For example, it is unclear how much interest there is in a particular IPO and what price the shares will fetch in the big wide world.
To reduce this risk, there are investment banks that act as advisors, so-called underwriters. Underwriters are nothing more than intermediaries. They mediate between the company that wants to go public and “the market. The underwriters do not only advise, they even go further and provide a hedge. They guarantee you (the company going public) in certain ways that they will find buyers for your shares. They offer you access to their network and present your company to their clients. This process is called a roadshow. As a result, the bank defines a valuation and a price and commits (!) to sell a number of shares at the agreed price.
In total, there are four types of players in an IPO:
- The company that wants to go public.
- The underwriter, who advises the company on the IPO and performs other important functions and receives an advisory fee of approximately 5% of the IPO value for this.
- The underwriter’s clients, i.e. institutional investors, to whom the underwriter sells the company’s shares before the IPO on favorable terms.
- The remaining investors in the market, who can buy the stock from the moment of the IPO.
Then, on the day of the IPO, the following often happens: The share is often worth a lot more when it becomes tradable. Often the stock goes up as much as 100% right on debut (For example, Snowflake’s stock went up 111%). This means that the buyers of the shares, who bought directly from the advising investment bank, directly generate relatively large profits. One could now claim that these investors have taken a certain risk by investing in a “new” company and that the profit is thus justified.
The problem, however, is that this jump in shares is deliberate. The advising investment bank intentionally prices an IPO lower than possible. That way, it can ensure that there is a jump and that customers (who are part of the bank’s network) are happy. The bank builds a reputation for advising successful IPOs.
In a situation where there is no jump in the share price, the bank also has an ace up its sleeve. The advising bank sells more shares than are issued. The bank, therefore, has a short position on the IPO that it advised. However, to be able to cover this short position, the bank negotiates call options that allow it to buy more shares at the IPO price. So if there is a jump in the share price, the bank exercises the call options and buys shares to cover the short position. If there is no jump and the share price falls at the IPO, the bank can buy the now cheaper shares on the market and thus cover its short position as well. In any case, the bank is fine. It does not take any risks.
The bank, which is hired by a company to do an IPO and for which it is paid, makes additional money by lowering the valuation of the company that pays it. This fact in itself is to be seen critically.
The bank does not only act in the interest of the customer (the company that goes public). The bank acts in its own interests and in the interests of its investors (the buyers of the stock pre-IPO). It acts in its own interest because it prioritizes its own reputation and negotiates terms that prevent negative outcomes. And it acts in the best interests of its customers because it is a club of a few dominant investors who maintain good relationships with each other.
It does not act in the interests of the company, because they do not value the company properly, they undervalue the company (i.e., it theoretically could have raised more money). The underwriter also does not act in the interest of the other investors in the market, who generally pay a much higher price for the shares after the IPO.
Now, these are known facts and this situation is not all bad either. After all, if the bank were to act only in the interests of the company, it would value the company absolutely fairly, but how could it ensure that it could find buyers for this IPO, and all future IPOs? Its clients want a good deal. They want to buy undervalued shares, so the bank has to undervalue the stock to ensure that the IPO business, in general, is maintained. So they also act in the interests of the process.
This process also prevents really bad companies from going public. An IPO process involves a lot of regulatory guidelines. Also, the advising bank is liable with its reputation. It has an interest in not allowing fraudulent or otherwise questionable companies to go public. Think of WeWork, for example. It is only through this community of banks and the fact that all banks adhere to these unwritten rules that the IPO market functions well.
But if you could go public without banks, you could maximize your own benefit as a self-interest-driven company.
And this is exactly the case with SPACs.
A SPAC begins with a well-known investor or entrepreneur raising money from several investors to use it to acquire a company.
He pools the investors’ money in a special vehicle, which he brings public on the stock market, and then usually has two years to find an interesting company and acquire it with the investors’ money. In the meantime, the money is invested in a low-risk way.
If no company can be found within the time limit, the investors get their money back with interest.
If a company is found, the sponsor negotiates the terms of the acquisition directly with the company.
The company’s senior management does not have to go on a roadshow with the underwriter and pitch the company to dozens of investors. He negotiates with exactly one party. If both parties agree, the acquired company automatically becomes a publicly-traded company. The company then receives the money previously raised by the SPAC sponsor as funding.
The investors can decide whether they agree with the acquisition target or want their money back. If they agree, they receive their shares with the option to buy additional shares of the company. For the negotiations and the search, the sponsor receives a relatively large share of the acquired company.
In a traditional IPO, there are uncertainties about the price until the moment of the IPO. In a SPAC, the price is agreed upon once, and at that price the IPO then takes place.
A traditional IPO process takes numerous months, in some cases even years. A roadshow is a time-consuming process for a company’s executives. In comparison, going public with the help of a SPAC can take place within a few weeks.
However, a SPAC also has clear disadvantages. There is often a sponsor who takes a SPAC public. So a SPAC is often linked to the reputation of the sponsor. This can be a well-known investor like Bill Ackman or other successful business people (or celebrities). In a sense, an investment in a SPAC is also always a bet in that person. In return for the work the sponsor has done and for providing their brand, they receive a stake in the company without paying extra. The sponsor’s stake is not paid for by the company going public but is taken into account in the negotiated price.
So going public with the help of a SPAC is not free. Just as with a traditional IPO, other parties benefit first.
The interesting thing is that the sponsor has a great interest in the success of your company. The sponsor is paid in shares, not in IPO fees. If the right person wants your success, it is worth something. So the SPAC sponsor works in your interest, unlike the advisory bank. The banks had some sort of a monopoly on IPOs. They may not have directly deceived their customers, but they still acted strongly in their own interests and in the interests of their investors. Sure, the sponsors also work in their own interest. But their interests are now perfectly aligned with your interests.
As for the risk of a SPAC of not knowing in advance which company will be acquired, this risk is minimized by the fact that you can reclaim your investment amount if you don’t like the acquisition target. If you like the acquisition target, you keep shares in the new “merged” company and you often receive warrants that allow you to buy more shares. So you have a very large upside as an investor with relatively manageable downside risk.
However, SPACs also allow companies that would not have made it to the stock exchange with the help of a traditional IPO to do so. For better or worse. One example of this is Nikola, which turned out to be very questionable after going public with the help of a SPAC. In general, the SPAC process is much less regulated than an IPO (which is every banker’s dream). In an IPO, for example, a company is not even allowed to publish growth forecasts. In principle, a SPAC is not even an IPO, but a merger that results in an IPO. For example, you could claim that Whatsapp went public when it was acquired by Facebook. This is exactly the principle that a SPAC makes use of. This is precisely the principle that a SPAC uses to circumvent regulatory guidelines.
SPACs are thus a competitive product to traditional IPOs. Furthermore, they offer a democratization of IPOs to a certain extent. Of course, they come with costs, but at the same time, they lower the barriers.
If SPACs can hold their own and they don’t attract too much negative attention in the long run (i.e. no more Nikolas), they may indeed become an alternative to traditional IPOs.
Head Operations RFS