Credit: The Motley Fool
Introduction
A Special Purpose Acquisition Company is a corporate entity with no commercial operations, formed solely to raise capital and acquire an existing company. Though existing for several years, only recently has it increased rapidly in popularity. Normally, small, capital hungry, companies choose to merge with an existing SPAC instead of the heavily restrictive traditional IPO path. Furthermore, SPACs have been considered to be a cost-efficient way for businesses to go public, avoiding the high fees needed to work with an Investment Bank on an IPO. In this article, I analyze this process, specifically if SPACs help retail investors and the economy as a whole.
How Does It Work?
In the pre-merger stage, a SPAC has no business operations or specific targets for acquisition. The manager first conducts heavy target research to identify the company which suits their expertise best. Once a target is identified, negotiations start to ensure an agreement on the business’s side. If the small business chooses to agree, the shareholders of the SPAC will then proceed to vote on whether to merge with the business.
Everyone, from private equity fund managers to general retail investors, can invest in SPACs. Share prices are listed at $10 and terminate after 2 years if the SPAC cannot acquire a company trying to go public. Normally, SPACs are run by high-profile investors, sponsors, or individuals with substantial expertise in a specific sector. Considered to be a “blank check company,” investors essentially have no idea what company they are investing in when purchasing a SPAC share. More often than not, SPACs are specialized, green and consumer tech being some of the most popular choices, but the growth potential for a particular industry isn’t what drives investors to choose a specific SPAC. Rather, their decision is based on the positive reputation of the SPAC manager and his experience.
SPACs appeal to small businesses because they offer a “backdoor” to the process of going public. Bypassing the normal restrictions of IPOs, mainly the inability to make future projections, SPACs offer an interesting opportunity for new companies who were previously closed off to the public market. Though SPACs sound quite democratizing, many SPAC managers choose companies owned by people they know personally or have had experience with.
Regardless, with the high liquidity and low-interest rates, there has been an enormous rise in the popularity of SPACs–raising roughly $105 billion by June of 2021 alone. However, this “frenzy” may negatively impact investors with extraordinarily high fees.
Good for Investors?
Regardless of who runs the SPAC, it is important, as an investor, to do your homework, reading as much as you can. A SPAC does not need to declare an acquisition for two years, which means that you must be aware of the track record and reputation of the SPAC manager while placing considerable trust in them to execute their job. Furthermore, the sector of the SPAC in which you invest must be one that has growth and disruption potential. Keeping these fundamental values aside, even if you choose to invest, are you likely to receive the return you hope for?
There are three things you must know. #1, hedge funds and Wall Street insiders receive a better deal. #2, your SPAC positions can get tremendously diluted. #3, your SPAC may have a hard time finding a good merger.
#1: When investing early during the IPO phase of the SPAC, investors normally receive a free warrant with each share purchased. These warrants provide investors the ability to buy shares at a pre-arranged price similar to a call option. This is a massive advantage considering that they can both trade once public and have free warrants in their back pocket.
#2: As a retail investor, not only do you not have access to those free warrants, but they may hurt your investment if you choose to trade the SPAC once it is public. If SPAC shares end up trading high once opened to the market after the merger, the hedge fund investors will now exercise their warrants, creating “at least a 100% dilution for the retail investors” who bought in. This issue arises as a result of the original IPO investor’s ability to sell their shares to the SPAC between the merger announcement and finalization.
#3: Of course, there are some instances where SPACs can merge with successful businesses; for example, Virgin Galactic, in the aerospace industry, has been a successful SPAC. However, many SPACs may pursue private company targets in industries where there are few viable prospects that can break out in the public market. Furthermore, the sponsor doesn’t receive compensation for how well the company does, but how much capital is raised for the SPAC. This can create conflict because SPAC managers would rather get a deal done as soon as possible than waiting for the right company.
Good for the Economy?
In 2020, Traditional IPOs raised $67 billion, while SPACs raised $73 billion. It has become increasingly clear that traditional IPOs may be inefficient for businesses to raise capital compared to SPACs. In the past, with “less than a third” of them from 2015-2020 having positive returns, SPACs have performed poorly. However, from a capital markets perspective, the aim isn’t to increase wealth among investors, but rather raise money for companies to grow. Therefore, SPACs shouldn’t just be considered a “fad,” but rather a sensible alternative: “providing companies a quicker and cheaper way to go public than the traditional IPO.” IPOs simply don’t work for companies that lack considerable stake in a booming industry because investment banks aren’t ready to “underwrite them or to raise money at a reasonable valuation.” Plus, with its long arduous process, businesses who end up taking the IPO route aren’t finding adequate returns because their listing price is well below their valuation causing a significant spike on the first day: great for investors, bad for companies (don’t mind the sizable fee from the investment bank).
SPACs have revolutionized this process by using the billions of dollars raised to invest in companies, leading to more competition and companies selling themselves for higher prices. However, the SPAC boom could entail that a ton of money is invested into risky companies that are overhyped; and of course, bubbles aren’t sustainable because investors will avoid funding pricy acquisitions. But, for the economy as a whole, SPACs should be considered beneficial. This bubble can drive technological innovation, having made it far more common than normal to invest in high-risk ventures. One example is the EV industry, where companies like Lucid Motors, with limited sales and production capabilities of its cars, are provided capital through a SPAC.
Conclusion
With this information in mind, SPACs, due to the numerous risks, may not be the sweetest investment for retail investors. However, for the economy as a whole, SPACs have truly revolutionized the process of going public by making it considerably faster, easier to raise more capital, and avoid spending resources on marketing. As bystanders, what we can do is wait and see whether this expanding SPAC bubble will burst or leave lasting positive effects in the capital markets.
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