Have SPACs Turned Over a New Leaf?
Pictured above is Jason Robins, the CEO of DraftKings, the sports betting site that was taken public by the Diamond Eagle Acquisition Corporation, a spac. Spac, short for special purpose acquisition company, are investment vehicles that raise money from the public markets and use this capital to acquire private companies to take them public. In other words, a spac is a deconstructed IPO with a very short roadshow. In fact, these investment vehicles have experienced a resurgence and are now extremely popular within US equity capital markets. 1 out of every 5 dollars raised in IPO’s this year have come from spacs. They have raised a record $8.9 billion this year and are estimated to reach $16.5 billion by the end of the year, ahead of last year by around $2.9 billion. However, they have come a long way from being shady investment funds used by dodgy financiers to dump low quality businesses to retail investors.
Before, trading practices within spacs were opaque and were designed to only benefit sponsors. The entire spac structure used to open the possibility of fraud. Spacs would sell 1 common share for $10 with the option to buy an additional share later, typically for $11.50. The spac then had 2 years to find a company to acquire and then present this company to shareholders who would vote on whether or not the company would acquire the target. If they decided not to go ahead with the purchase, initial investors would reclaim the $10, plus interest. However, arbitrage firms would park funds into spacs then threaten to vote down the acquisition proposal unless they were given a ransom payment, undermining the structure of the company. Moreover, there exists a principle-agent problem within the core structure of spacs. Sponsors, those who start and back the acquisition company, are usually given a ‘promote’ of 20% of the shell company for free. This promote is essentially a 20% equity stake in the spac. The stake is supposedly for their efforts in finding a target company. Since the sponsor shares are free, there is a diminished incentive to find a viable target that will add value to the company as they have received a large payment for essentially just trying to find any old acquisition target. Therefore, spacs have traditionally worked for sponsors rather than the ordinary investor.
In many cases, adverse selection can take place within Spacs as companies that go public via a special purpose acquisition company are not usually the ones that planned to go public for a long time but suddenly became a good option due to a sudden and unexpected change in circumstances. This therefore might be a good idea at the time, however true enterprise value is created over time, not suddenly, and therefore many companies that go public via spacs should never really have gone public.
However, they have become more popular in recent times. A reverse merger is the acquisition of a private company by a public company so that the private company can bypass the lengthy process of an IPO. Spacs almost always acquire the target company via a reverse merger. The advantage of a reverse merger is that the private company goes public for cheaper and doesn’t have too undergo the arduous process of an IPO however lawsuits are common due to unhappy investors and reverse stock splits lead to an equity dilution. However, spacs have become more popular due to the current sentiment in equity markets. Many companies feel less pressure using a spac to go public rather than going public via an IPO. For retail investors, it is a chance to buy into ‘fast growing’ businesses that otherwise have remained private. Banks have an incentive to promote spacs given that they earn healthy fees for underwriting and advisory services. They earn 2% of the proceeds when an IPO is finalised and a further 3% when a spac finds a company to buy. This is lower than the typical 7% fee for an IPO however further capital raising initiatives by the spac leads to more fees being collected.
Regardless, players such as Bill Ackman and Moneyball star Billy Beane have entered the spac space. Following success stories such as DraftKings and Nikola, both who boast valuations of more than $10 billion, others are hoping to follow suit. New spacs are coming from venture capital firms looking to find a way to list their own portfolio companies ready for public markets. Spacs are increasingly becoming a financial tool to bridge the public and private markets.
Pershing Square Tontine Holdings founder Bill Ackman. Source: Getty Images Ackman under his spac, Pershing Square Tontine Holdings, has raised $4 billion, the largest equity raising spac to date. His solution has been to abolish the 20% promote and his own hedge fund is buying $1 billion worth of units, aligning the sponsors’ interest with the performance of the spac and hence eliminating the principle-agent problem. However, the success of spacs has been brought into question. An FT report shows that of 145 US vehicles listed between 2015-19, a majority of spacs did find a target but more than 2/3 were trading below their $10 IPO price. For instance, investment giant TPG has 3 spacs, none of which trade above $10.20 per share. Thus, a lot still remains to be seen from the spac space. If the elimination of the principle agent problem does indeed bring more value in the form of better acquisitions and better returns to shareholders, then spacs will prove increasingly popular. Also, their renewed popularity should also be brought into question given that we are at a point in time where IPO’s are harder to conduct than acquisitions due to the COVID-19 pandemic. Regardless, they could become a useful bridge between the private and public market that could see higher access to investment opportunities for retail investors and fresh pools of capital for start-ups with potential.