SPACs: The possible benefits and potential pitfalls
Going public is a highly regulated process that can take years to complete. Instead of doing it in a traditional way, private companies are increasingly turning to SPACs (Special Purpose Acquisition Company) to march around the SEC's administrative strain and access the public market in a fast-laned process.
As a shell company—but a publicly-traded one—a SPAC's sole purpose is to raise capital that must be used to invest in an operating business at a later date. As they have no commercial operations, SPACs are able to list faster than a traditional IPO due to the lesser scrutiny required by SEC. Another consideration is the SPAC price is also fixed at $10.00 from the offering, vs market conditions driving the capital raise/IPO price. Later they merge with private companies to acquire their business operations. As a result, the private company becomes publicly traded.
As SPACs appears poised to become an alternative listing route, here we take a deep dive into the benefits and potential pitfalls of this structure through the lens of three different key stakeholders in the process.
Benefits of SPACs for key stakeholders
For sponsors—usually formal hedge fund managers, private equity managers, tankers, or chief executives of fortune 500 companies— the SPAC structure offers easier access to capital and considerable upside potential with 20% founders' equity at nominal cost.
and also have the redemption protection, whereby they can redeem their share and get the original $10.00 back if they don’t like the merger deal. The public investor can vote yes for the transaction to go through, redeem their share for the money back, and keep the warrant in case the deal is really successful. Previously, they couldn't fully benefit from the IPO market as they didn't have the opportunity to invest before the IPO. Since the IPO prices are already pretty rich, private equity and VC firms were reaping most benefits. But with SPACs, public market investors— including retail— can invest in early-stage companies that offer good growth potential.
For the acquired company, SPACs can bring many benefits, including a faster listing process, valuation certainty, strategic partnership and lower marketing costs. Through SPACs, companies can negotiate the deal directly with sponsors, getting more valuation certainty. They can also have more autonomy to select the sponsors, choosing ones that can act as strategic partners able to support the growth of the business post-merger. In contrast, traditional IPOs require time-consuming and expensive roadshows. Also, companies are not allowed to give projections and forecasts, while operating companies merging with SPACs can make projections for the next two to three years.
What are the potential pitfalls?
Certain risks inherent to the SPAC structure are common for all stakeholders, for sponsors, investors and acquired companies alike.
For example, there is a certain degree of criticism around SPACs because of the lacking transparency and the considerable potential for fraud or allegations. Conflicts of interest are the main red flags between the sponsor and potentially the target companies, especially with private equity involved. They can, essentially, exit one of their portfolio companies through a SPAC. This risk very much depends on how forward projections are being made. Because of this, management has to be very careful in getting the valuation justified with the projections they have in mind.
For sponsors, there is the challenge of time constraint. In the SPAC structure, cash capital is held in a trust account which will retain the proceeds for two years. The SPAC has to clinch the deal and merge with an operating business within the time limit. If it fails to deliver within two years, the money from the trust account will have to be returned to all investors. Also, there is the issue of quality and supply of target companies. With fierce competition for targets, this means an increased risk of overpaying for acquisitions.
For public investors, risks to be aware of include the quality of sponsors and their alignment of interests, as well as potential equity dilution. Sponsors are critical as success often depends on the sponsor's reputation. Also, investors should be aware that those who buy post-IPO and hold shares through the SPAC merger have no downside protection once SPACs have completed a merger and become an operating company. Performance of SPACs post-merger can be disappointing.
Finally, there are some potential pitfalls for acquired companies too. For example, SPACs provide a listing. There is usually cash that rolls over from the trust account into the operating company. Sometimes, it is used to pay the founders of the target company their exit price, but most of the time, cash stays in the company to provide for the growth plan of the new company. This is why there is usually a minimum cash requirement in the merger deal.
Next, there is the question of the public company readiness for all the regulatory and public scrutiny post-merger. Also, even if the merger has been approved by the majority of the shareholders, those who vote against can still redeem from the trust account. Finally, it often happens that the target company has to restate its projections because certain assumptions have failed to materialise, such as information affecting the timeline for launching new products.
Although SPACs have been around for decades, their popularity has surged in the US over the recent years, and lately, they have been spreading into other markets such as South East Asia. Now we are on the verge of another milestone for this deal structure as SPACs are about to enter European markets—from December 6th, they can also be listed and traded on the SIX Swiss Exchange.
For SPACs to succeed, certain elements appear critical. First, sponsor quality and expertise are often pivotal, but so is the leadership team of the target company. Also, the ability of the company to scale and offer more products in the future, as well as its current and future revenue growth and profitability, are essential for success. Finally, good governance is critical for building investors' trust to avoid becoming seen as the equivalent of claw machines in an arcade.