Are SPACs a Fad or Here to Stay?

While SPACs may have become popular in the United States from the beginning of 2019 through 2021, 2022 onwards has shown a significant decline in formally announced SPAC deals.

SPACs, or special purpose acquisition companies, are a popular way of taking a private company public while avoiding the long and tedious path of the traditional IPO (initial public offering) process.

Although SPACs have been around since 1980, the ‘SPAC euphoria’ might end. Regarding profits, SPACs track record from 2019 and 2020 shows that sponsors or ‘founders’ of SPACs have done fairly well relative to SPAC public investors, making the investment product somewhat dubious for investors.

Past cases of underperforming company shares like Nikola Corporation or Clover Health Investments after ‘de-SPAC’ mergers have raised skepticism from investors, regulators, and markets alike over the benefits of using the SPAC financial vehicle.

Regarding regulation, SPACs requirements became more demanding in 2021. In December 2021, the SEC proposed new rules that required SPACs to provide additional disclosures to investors, including detailed information on the compensation and conflicts of interest of SPAC sponsors. This considerably narrowed the difference between SPACs and the traditional IPO process on a regulatory level.

Looking through the macro lens, factors such as macroeconomic volatility, higher interest rates from the Federal Reserve, and excessive supply of SPACs have generated more uncertainty and have forced SPACs into a never-ending adaptation process.

Be that as it may, not everything looks gloomy for the future of SPACs. They offer a more dynamic and streamlined infusion of capital for a larger ecosystem of early-stage companies, allowing for a new avenue to opt out of established ways of accessing public capital, such as direct listings or traditional IPOs. They also offer a better investment opportunity with less risk than venture capital or private equity structures.

Even though SPACs may be nothing new and even a fading trend, they are still worth evaluating to determine whether they will favor emerging private companies and start-ups in the near future.

What Are SPACs?

SPACs, also known as blank check companies, are investment vehicles that raise funds through an IPO created for the sole purpose of acquiring or merging with another company to take it public.

SPACs stakeholders are the sponsors, the investors, and the target companies. SPACs are created by the sponsors, who often are well-known in their field or have a solid team of business people who can attract investors.

Sponsors commonly go on a roadshow, similar to traditional IPOs, to find interested investors. They are selling themselves, their team, and their experience, rather than a specific company.

SPACs have a two-year life span (18 to 24 months) and have no operational business whatsoever. If they fail to acquire a target company in two years, the SPAC must be dissolved, and all the raised capital is returned to the original investors with interest.

SPACs Track Record

In recent years, SPACs' creation has witnessed substantial growth. According to Harvard Business Review, in 2019, 59 SPACs were created, with $13 billion invested; in 2020, the number almost tripled to 247 SPACs created with $80 billion, accounting for over 50% of new publicly listed companies in the US. In 2021, 295 were created, with $96 billion invested, making it the biggest year for SPACs yet.

During the last three years, most SPACs have focused on companies disrupting technology, consumer, and energy markets. According to Kroll data, the highest earning sectors from De-SPAC mergers by share returns from 2009 to 2022 were cannabis and crypto, both with 94% returns.

Sponsor's Motivation for Creating a SPAC

In a SPAC, sponsor incentives play a big part in the performance of a merger and post-merger. Some sponsors may hype up a merger just to attract investors and boost the stock price, only to sell their own shares and exit the investment once the merger is completed.

Sponsors receive 20% of the shares of the SPAC as a fee, earning as much as 20% of the raised equity from investors after the merger is completed.

This means that, for example, if a SPAC raises $250 million in capital, and is successful in the merger, the sponsor's ‘founder’ shares, which amount to 20% and are valued at $10 a share, are worth $62.5 million.

These hefty rewards have been questioned over the years. Longer lock-up periods of shares could help to prevent sponsors from selling their shares quickly and can create incentives for thinking in longer terms and acquiring quality targets diligently.

This helps to prevent the ‘return on investment no matter what’ mindset from sponsors and institutional investors, even if the price of the stock performs poorly after the de-SPAC process.

Why Are SPACs Important or Notable?

SPACs can be highly beneficial for a target company that needs flexibility and quick access to public capital markets. They offer a range of advantages compared to the traditional initial public offering (IPO) for taking a company public.

They provide benefits regarding speed, security in valuations, transparency, and redemption options for investors' shares.

Compared to IPOs which may take at least 9 months to a year, SPAC mergers take 3 to 6 months on average.

SPACs also allow investors to redeem their shares from a deal before it is finalized. If the sponsor identifies a target company for acquisition and investors do not like the announced target, they can withdraw from the deal, redeeming their shares for cash plus interest.

Also, if the SPAC hasn't raised enough capital, sponsors can raise additional capital through private investment in public equity (PIPE). PIPE transactions are an important part of the SPAC process because they provide additional funding to support the transaction and help ensure its success.

Another benefit to consider is that in the traditional IPO world, company's pricing depends on market conditions at the time of the listing. With SPACs, private companies can negotiate their price before the merger is completed, not suffering the fluctuations of a volatile market. This means that the private company can agree to a price that reflects its true value and growth prospects.

High Redemption Rates Can Backfire for Business

SPACs may not have to deal with volatile market conditions, but sponsors can't make investors stay on a deal after the target was announced if they are not pleased with it.

Data from HBR shows that from July 2020 through March 2021, the average redemption rate for a SPAC deal was 24%, or up to 20% of total capital invested.

According to Cb Insights, in the first two months of 2022, the average redemption rate amounted to an astonishing 80%, meaning 4 out of 5 shares were redeemed before the deal was completed.

However, this rate is not a shocker in the SPAC world. A 2021 study published in the Yale Journal has shown that in more than a third of the SPACs, over 90% of investors pulled out.

The current rising redemption rate compared to 2020 can be explained by a migration of investors from high-growth risk assets, commonly from the tech sector (a SPAC specialty), to opting for more stable earners and commodities amid an economic slowdown and an attendant bear market.

The Downsides to SPACs

High redemption rates from investors aren't the only downside of choosing the SPAC route. There are other risks to consider in going public with a SPAC merger rather than traditional IPOs.

• For starters, with SPACs, there is a compressed timeline for the private company to prepare to go public. The deadline is 24 months, a much shorter time than an IPO.

• The target company suffers from the sponsor's high fees in the de-SPAC process. SPAC sponsors get 20% of the SPAC shares before the acquisition just for being the founders of the SPAC. This represents a costly loss of equity for the target company.

• Also, target companies may face capital shortages from possible redemption from investors. This is the tricky thing about the redemption option. If initial SPAC investors decide to redeem their shares, cash availability becomes uncertain and may force sponsors to raise PIPE financing, which may not be enough altogether.

• In addition, sponsors might rush on SPACs´ limited time frame and end up with low-quality target companies. A lot of SPACs created face imminent deadlines in 2023. If they fail to acquire a target company, they may face losses from having to return funds with interest. Trying to find any available company with worse financials than typical IPOs will create worse results for investors.

• SPACs also used to have more flexible diligence requirements than the rigorous traditional IPO process, but not anymore. This ‘lighter’ due diligence on regulation has historically resulted in lawsuits against SPACs sponsors and incorrect valuations, making the SEC look closer at SPACs disclosure requirements.
  

SPAC Crackdown From Tighter SEC Regulation

The SEC has increased regulation on SPACs disclosure requirements to avoid fraud and inflation on growth projections of target companies. In response to misleading financial projections, the SEC has proposed a set of new rules that if adopted, could seriously harm the future development of SPACs.

The new regulation has had a ripple effect, making it extremely difficult to find banks to engage in SPAC deals. Due diligence has been raised much higher before a de-SPAC deal can be announced.

However, it's important to note that the SEC is still in the process of gathering feedback on these proposals, and it's possible that the final rules could be different than what has been proposed.

Key Considerations to Maximize SPAC Benefits

1. As potential targets, companies should be highly focused on the specifics of sponsors' deal execution to benefit from it the most, and even through post-merger.
2. Keep a close eye on the expertise and track record of the team of experts, particularly legal advisers, bankers, and IPO readiness advisers. Making sure that they can complete the work in an extremely short time frame is key.
3. Bear in mind that if the time comes, sponsors have to be able to successfully raise PIPE funds and try to ensure the shareholders' approval of the target company.
4. Being that the time frame is limited with SPACs, keeping financial records in compliance with regulatory standards will save everyone time. It will also be considered more leverage in a negotiating position.

The Path Ahead for SPACs

Not all of SPACs will indeed find high performing targets, and some will fail, resulting in lost investments. However, we believe SPACs will remain relevant in the coming years. Surely, SPACs will have a tough time adapting to new regulations and the financial vehicle will suffer around its edges.

As macroeconomic conditions stabilize, we believe sponsors´ incentives will get more transparent, and ‘biased’ economic structures will get spotted more easily, avoiding investors discomfort.

Overall, SPACs are still a great solution for emerging companies that need dynamic, flexible, and yet compliant deals for going public. Like any investment product, as its internal workings are refined over time, certain participants may be able to secure advantageous deals that ultimately benefit all stakeholders involved.