Specified Purpose Acquisition Companies (SPACs) are a special type of public companies currently available to investors in financial markets. In the United States, the Security and Exchange Commission classifies SPAC as a blank check company. The sole purpose of SPACs is to use the proceeds to finance future acquisition.
A SPAC is basically the reverse of a traditional IPO. A SPAC goes public first—usually with a highly regarded executive team able to raise money from large institutional investors—with the intent to acquire a private company to put in its shell within about 24 months.
You can think of it like: an IPO is basically a company looking for money, while a SPAC is money looking for a company.
SPAC IPO has different stages and its own advantages, and for that reason, SPACs have become a lot more popular with investors as SPAC IPOs over the past 2-3 years have accounted for as much as 25-40% of US IPO volumes. You must have heard of some of the top SPAC IPOs of 2020: DraftKings (NASDAQ:DKNG), Virgin Galactic (NYSE:SPCE), Nikola Corporation (NASDAQ:NKLA), and more.
# Before the IPO of a SPAC
Founders, also called Sponsors, have changed a lot over the past 5 years. Before 2009, many founders/sponsors were individuals or small teams with questionable reputations and motives. Since 2013-2014 the quality of sponsors has gone up. Now they are mostly Private Equity firms with significant sourcing and execution capabilities or former executives with successful experience.
Those Sponsors either use their own capital or raise outside capital to fund what we call “at-risk-capital”. This capital will be used to pay all the expenses the SPAC will spend prior to acquiring a target, including legal fees, underwriting fees, staff expenses, etc. This is important because, in prior periods, all those fees were paid by the proceeds of the IPO. In exchange, the sponsors will receive a mix of so-called “founders shares” and “founders warrants”.
If the SPAC doesn’t successfully close an acquisition, this “at-risk capital” will be lost. If the SPAC successfully closes an acquisition, the founders’ shares and warrants will stay in place. This creates a strong incentive for sponsors to focus their time and resources on the SPAC to find an acquisition.
Few important things to know:
- Before the IPO, sponsors are not allowed to contact potential targets. They can only do preliminary work, like collect public information on a list of potential targets.
- They will only file confidentially with the SEC and flip to a public filing if they think, after this “test the waters” phase, that their chances to successfully IPO are close to 100%
- The best underwriters, namely DB (Eric Hackel), CS, GS and Citi will select the best sponsors they want to work with or even proactively approach PEs or successful executives to start a SPAC. The rest of the sponsors/SPACs will have to settle for second and third-tier SPAC underwriters.
- The best sponsors are the ones who have had successfully SPACs in the past, like; Gores, TPG, Capitol and etc.
# SPAC IPO Stages
Once a confidential filing flips to a public filing, the Sponsor will usually wait for the typical 2-week period to launch a roadshow. SPAC roadshows are usually a lot shorter than normal IPOs. This is because there is no price discovery involved and non-binding orders have already been collected during the “testing-the-water” phase.
The terms have become standardized:
- At the IPO, investors receive a UNIT priced at $10.
- 1-3 months after the IPO, investors are allowed to separate one unit into one common share and one, 1/2, 1/3, or 1/4 of a warrant, depending on the terms offered by the SPAC. Most reputable SPACs will be able to raise capital by only offering 1/3 or 1/4 of a warrant. Less reputable SPACs will have no choice but to offer a full or 1/2 a warrant.
- SPACs typically have 2 years to announce an acquisition. Less reputable SPACs sometimes have to reduce that time to 18 months.
- Warrants are call options on common shares with an $11.50 strike. They expire worthless if the SPAC ends up not doing a deal. If the SPAC closes an acquisition, warrants expire 5 years after closing.
- 100% of the proceeds from the IPO are deposited in a trust account that earns interest (because they are usually invested in short-dated US Treasuries).
- Common equity holders hold 2 SEPARATE rights if the SPAC announces an acquisition: (i) they can vote in favor or against a transaction; (ii) they can elect to redeem all or part of their shares at the value of the trust divided by the number of shares (ie $10 + interests collected since the IPO). It is important to understand 2 things:
o A shareholder who might also own warrants can vote in favor of acquisition but at the same time can elect to redeem, to keep its warrants alive.
o The deal vote is based on a majority but not the redemption election. That means that even if the majority of shareholders decided not to redeem, the minority of shareholders who decided to redeem will still get their $10 back + interest.
Most SPAC IPO investors are hedge funds. The retail investors will also end up owning 10-20% of the shares. It is very rare to see US pension funds / long onlies participate because (i) SPACs are not parts of any indices; (ii) sometimes their mandates do not allow them to own shares in the so-called empty-shell companies.
# Between the IPO and the announcement of an acquisition
The Sponsor approaches potential targets. Most reputable SPACs have a long list of 100-200 potential targets. When they do more research or contact bankers/companies, they find out that 20-30 of them are actionable (i.e open to a sale). They then manage to enter into substantial discussion with 5-10 of them.
On average, a SPAC will announce an acquisition 15-18 months after IPO.
Before announcing the acquisition, the most reputable SPACs will try to raise a PIPE. They typically wall cross some of their top existing shareholders but more importantly will wall cross new investors like pension / long-only funds. This PIPE will be added to the IPO proceeds to be injected into the target. In many cases as well, the PIPE will allow offsetting potential redemptions.
Investors who commit to a PIPE will only get registered shares after the closing of the acquisition, with typically no lock-up involved.
It often happens that the most reputable SPACs will wall cross investors on multiple acquisitions during the life of the SPAC. If investors give negative feedback, the sponsor will just move on to the next target without ever publicizing its failed attempt.
# Between the announcement of a deal and closing
SPACs announce an acquisition before the market open, release an 8K with a press release and a slide presentation. Because the SPAC is already a public company, it is allowed to include financial projections for the private company it is looking to acquire in the presentation.
Immediately after this announcement, the SPAC starts a roadshow, meeting investors but also sell-side analysts who might be interested to cover the company.
- 1.5-2 months after the announcement, the SPAC files a proxy and sets up dates for the votes.
- 2-3 months after the announcement, the vote in favor or against the deal and the redemption election happen.
If the vote is positive and the redemption level is acceptable to the SPAC and the target (there is always a minimum cash level defined in the merger agreement), closing usually occurs a few days after the announcement. If the votes collected and redemption elections do not come back satisfactory, the SPAC and target can take their time, renegotiate, and delay the votes. However, if the process bumps against the expiry of the SPAC, they will have to offer a vote and redemption election to the shareholders to get an extension (usually 3-6 months).
Note that between the redemption election date and the potential closing, common shares of the SPAC can be bought in the open market but do not bear the right to be redeemed anymore, usually creating some weakness or volatility.
# After closing an acquisition
The common equity and warrants change tickers and start trading “regular way” as securities tied to a normal operating company.
Unlike an IPO, there is no obligation for the underwriters of the SPAC to initiate the new company 3 weeks after the effective date. Initiations from the underwriters and other banks, in theory, can happen any time after closing but are typically done between 3 weeks and 2 years after closing. Usually, it is typical to get initiations anytime between the closing of the transaction and the first time the company will report Q earnings.
Long-only and passive funds can now freely buy the common shares as they are now shares of a regular, operating company that might be eligible to index inclusion
# Different trading strategies at play
There are different types of trading strategies from hedge funds you should be aware of:
o Unit arbitrage: there can be price discrepancies between the units on one side and the stocks and warrants on the other. Hedge Funds can long the units (which, as mentioned above, are 1 common share and a fraction of a warrant) + short stocks and warrants if units are undervalued, or long stocks and warrants + short units if the units are overvalued.
o Common share arbitrage: If the common stock trades at a discount to the trust value per share.
o Volatility trade (NOT AN ARBITRAGE): some HFs hold on or buy warrants and short the stock if they think that the volatility implied in the warrant is too low/cheap.
Note that those strategies are mainly constrained by the potential lack of liquidity in the shares and warrants and the lack of borrow availability in the shares, warrants, or units
- This standardization of terms and the higher quality of sponsors have made SPACs a lot more popular with investors. SPAC IPOs over the past 2-3 years have accounted for as much as 25-40% of US IPO volumes.
- SPACs are an attractive way for some private companies to go public, instead of the more traditional IPO route. IPO investors are usually focused on growth companies who have debt or are even cash-rich. They also shy away from companies that need to have some of their investors cash out. The SPAC route allows the companies to delever or raise capital, cash out some of their shareholders, and to take more time to explain their story. This last point is important because now that companies can file confidentially for an IPO and only flip to a public filing for 2 weeks, the regular IPO route only offers 4 weeks to investors to do the work. The SPAC route give investors multiple months to understand the business
- SPACs can offer the wrong type of incentives for the sponsors to do any deal. Usually, given the founders’ shares/warrants structure, the sponsors’ cost basis is anywhere between $4-8 so the incentive to do a deal, even if the regular stock breaks the $10 level after closing can be high. However, a sponsor that doesn’t create value post-closing might never be able to raise a new SPAC ever again.
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