SPAC has been the hottest investing acronym over the last year and the trend does not seem to be letting up. Special Purpose Acquisitions Company’s, or SPACs, which also go by “blank-check companies,” have been around for decades but recently have become sexier and more lucrative. At the core, SPACs are shell companies that raise capital through an IPO process, similar to how other companies raise public funds. However, unlike established operating companies raising funds to grow their business, SPACs have no underlying business operations. They are raising large sums of money from public investors with the hope of searching for and merging with an already established, private, company which will ultimately be a publicly listed company after the completed merger. Huh? Let’s break this down into investor and company specific views:
What do SPACs mean for public investors?
For public investors like you and I, we have no clue what we are buying. We contribute our capital and cross our fingers that the management team of the SPAC identifies a worthy merger target which performs well as a public company. So, we’re buying a lottery ticket and making a nearly blind gamble. I say nearly blind gamble because there are a few key things to evaluate in a SPAC.
- Management team
- The first and most critical evaluation criteria for a SPAC is the management team. Successful individual investors such as Bill Ackman and Chamath Palihapitiya have recently raised funds through SPAC listings and Softbank has also gotten into the mix. In addition to the operators, it is helpful to look at the advisors on the Board who are backing the SPAC and helping the operators find a private company gem. Boards loaded with current or former CEOs and founders who have a history of running great companies are usually leading indicators for future SPAC success. Note that management is on the clock once funds are raised. The team usually has two years to merge with a target or the funds will be returned to investors.
- Industry
- Just like any other IPO process, a SPAC publicly files a comprehensive S-1 document with the SEC which potential public investors can review ahead of shares trading. Most SPACs will dedicate a piece of the filing to explaining their investment thesis which would include the types of companies they wish to merge with and potentially the target industry. If you want to make a gamble on a strong management team merging with a high growth tech company, it is wise to check if the SPACs investment strategy matches your desired sector.
- Promote
- Without getting too technical (let’s save it for another post), SPACs heavily favor the management team of the SPAC with a large ownership chunk of the merged company reserved to reward the SPAC founders. This is called the “promote” and it is tied to the execution of the merger. Much of the time, this can be upwards of 20% of the merged company which greatly dilutes the other shareholders. Investors have put pressure on the promote and many SPACs are now moving to lower promotes or even zero promotes (although this is rare). So, in addition to evaluating the management team and the SPACs industry preference, a lower promote is certainly a bonus.
What do SPACs mean for the merged company?
The path to IPO is a long one that sucks company time, resources, and money but a SPAC offers a quick path to the public markets for private companies who want to avoid all of this. Through a traditional IPO, a company and its bankers will go on a ‘roadshow’ to market the company and its stock sale ahead of their listing to gage interest in the securities and ultimately land on a price at which it will open on the public markets for retail investors. (Well kind of. If you have been following the enormous pops in first day trading for recent IPOs, these prices can be severely mispriced at least in the public market’s eyes. This can be fodder for a future post.) Preceding this roadshow includes months of drafting the lengthy S-1 document which includes past financial statements of the company, risk factors, sources and uses of IPO proceeds, long management discussion and analysis, and various all other required disclosures showing the guts of the company. And there are many cooks in the kitchen from bankers to lawyers to auditors and other advisors. It is exhausting and sometimes a step mature private companies would like to skip. SPACs give these companies an alternative to being able to tap public funding to fuel future growth.
So, SPACs are a historically unorthodox way for private companies to access the public markets until more recently. Before 2017 there had been less than $10b raised in SPAC offerings in any given year. In 2020, an astounding $83b was raised by 248 SPACs representing huge growth from 2019 when we saw just $13.6b raised over 59 SPACs. Even more surprising is the near $25b raised in the first month of 2020. We’ll save a more detailed discussion on the reasons for the recent SPAC craze, but my personal perspective is that this trend can’t continue at this pace for long and will be forced to cool off because of natural supply and demand factors. If we assume there are currently a large pool of public-ready companies, the large number of SPAC raises recently will quickly shrink the pool of worthy targets to take public. Further, as competition heats up for fewer high quality private companies more bad deals are bound to happen as SPACs run up against their 2-year life. So, I think SPAC fundraising will eventually cool off based on quality supply in the market. To be clear, I am not saying there aren’t a healthy number of private companies out there. The issue will become healthy PUBLIC-READY private companies. Not all companies are ready for the public markets. Corporate governance, systems and controls, investor relations, financial accounting and SEC reporting requirements, and talent and compensation programs are just a few of the numerous factors to evaluate and internal structures to solidify before private companies can sufficiently navigate public company status.
One thing to keep an eye on is increased DOJ scrutiny of acquisitions which may make companies look for other exits and SPACs could help fill some of that void. TBD the opportunity here – depends on how heavily DOJ scrutinizes mergers. (check this article: Crunchbase)
What about the risks?
I don’t think we need to spend much time on the risks. They are pretty obvious. Investors are not investing in an actual company but betting on the management team to find a great company. What that company will be is mystery. But I would like to have readers consider this: Recently we learned WeWork is considering going public through a SPAC merger (article: WeWork_SPAC Talks), and for me it brought up memories of the Company’s botched IPO. Personally, I never bought into the hype and saw the company for what it was. It rents office space. I am unenthused. However, the private funding flowed into the Company (largely from Softbank) creating a lofty valuation ahead of its anticipated public debut. The tables turned when WeWork filed its initial S-1 with the SEC and gave the public its first look under the hood of the Company. To say concerns were raised about the company is certainly and understatement, but long story short, these public disclosures ended the fairy-tale run, demolished WeWork’s valuation, and prevented it from listing. The point is the roadshow process including the public filing of the S-1 is critical for public investors to know what they are getting and it’s a step that we don’t get in the SPAC process. We only get an S-1 from the SPAC itself which, as stated above, only gives us a few intangible criteria on which to evaluate the potential company and the economic value of its shares. Investors should just know the risk but expect some future SEC regulation around SPACs with their current high level of funding. Full disclosure, I have invested in a few SPAC after careful evaluation management team, industry, and promote economics. I don’t mind allocating a small portion of my portfolio to a strong management team in the hopes of getting in early on a strong private company, especially in an overheated market like we currently have.