Special Purpose Acquisition Companies (SPACs)
A special purpose acquisition company (aka blank check company, shell company) is an investment company created for the sole purpose of acquiring an interest in another company with the hope of making a profit from the acquisition. The companies can be acquired through a merger, stock exchange, asset acquisition, reorganization, or business combination. Some current SPACs include Liberty Acquisition Holdings (LIA.U), GLG Partners (GLG), and Services Acquisition Corporation. (Services Acquisition Corporation merged with Jamba Juice in 2006, and changed its name to Jamba, Inc. JMBA.) The money for the acquisition is obtained through an initial public offering (IPO), also called a blank check offering, before knowing which company will be acquired or even what type of business it will be — hence, the synonym, blank check company. The money received from investors is held in a trust until a target company is found, after which the shareholders can approve the deal or receive a refund of their investment held in the trust. SPACs are marketed as a way for the average investor to invest in private equity.
Most SPACs are Delaware corporations, but some are formed in the Cayman Islands , and occasionally the British Virgin Islands or the Marshall Islands. Stock Exchange listing requirements require that the majority of board members be independent. SPAC directors are selected by the sponsor of the IPO. Thereafter, additional directors are appointed by the SPAC Board of Directors. Directors are publicly elected after the deSPAC transaction, when the successor company created after the merger is listed. Some SPACs stipulate that only founder shares can vote for directors until the deSPAC transaction.
How a SPAC Works
SPACs are like blind pool limited partnerships, where the limited partners invest without knowing specifically what the general partner will do with the invested funds. Because there is no business to evaluate, such companies must be evaluated by the experience and success of the principals, who invest their own money, find the potential acquisitions, and run the business if an acquisition is made. The acquisition must be made within 18 to 24 months; otherwise, the SPAC must be liquidated, and the shareholders' money, which is held in an escrow account that earns interest, must be returned to them, minus the costs of looking for a company to acquire. If a suitable acquisition is found, the SPAC must seek shareholder approval for the acquisition.
A sponsor, often a financial institution, creates a SPAC, listing it on the stock market to raise money from public investors. The objective is to find a private company, to acquire it to take it public, which is sometimes known as a reverse merger. Usually, the sponsor has greater interest in specific sectors, usually related to the sponsor’s expertise. The SPAC's investors will own part of the acquired company in proportion to the part of their ownership in the SPAC. After a target is found, the SPAC sponsor announces the deal, followed by a deSPAC process where current investors are convinced to hold their shares while seeking new investors. The acquired company then becomes a public company.
After the acquisition target is identified, the de-SPAC process gives shareholders the right to choose either to stay with the deal or redeem their SPAC common stock for a pro rata share of the funds in the trust. If the deal is approved, then the privately held target company becomes a publicly listed operating company. The de-SPAC transaction refers specifically to the listing of the successor company.
The sponsor is usually a new limited liability company formed expressly to sponsor the SPAC. The sponsor signs a letter of intent, then seeks private investments to initiate funding, a process sometimes known as private investments in public equity, or PIPEs. The sponsors go on a roadshow to meet with investors, to explain the objectives and investment opportunity of their new company, so that they can get subscriptions for a certain number of shares. Many of these initial investors have no interest in holding an ownership stake in the acquired company; rather, they hope to flip the shares for a profit after the sponsor announces a target or an acquisition, much like early investors flip their shares after an IPO. The PIPEs do help to indicate the value of the SPAC shares by showing the initial prices for the shares, what sophisticated investors were willing to pay. Executives of potential target companies will negotiate with the sponsors and PIPE investors of the SPAC to determine the acquisition price of the company. Eventually, the PIPE is closed, then the SPAC merger is announced. When the merger is complete, the ticker symbol for the SPAC becomes the ticker symbol for the new company.
Part of the roadshow includes talking to analysts who may cover the company, since they may significantly influence the stock price of the new company. Furthermore, it helps to generate additional interest in the SPAC, hopefully to generate and oversubscription of the shares. However, if the shares are undersubscribed, then sponsors may be forced to add additional capital during the PIPE or the de-SPAC process.
Most SPACs are set to complete a merger or liquidate within 24 months of the IPO closing, but stock exchange rules do permit a period as long as 3 years. Many SPACs allow an automatic extension of the period to acquire a target if a definitive agreement or letter of intent is signed within the specified period or if additional capital is contributed to the trust account by the sponsor. Most SPAC acquisitions require shareholder approval, but since at least 20% of the SPAC's outstanding shares are held by the founders who will obviously vote in favor of the transaction, only slightly more than 30% of the public shares can provide a majority to approve the transaction. If the DeSPAC transaction does not occur, then the public shareholders get their money back and the public warrants, along with the founder warrants and shares, expire worthless. Shareholders can redeem their shares to get their money back, even if they voted for the acquisition. If too many shareholders redeem their shares, then the company may be delisted, since stock exchange rules require a minimum number of investors as part of their listing requirements. About 15% of SPACs that went public from January 2010 to May 2018 did not reach a deal. However, with so many SPAC IPOs just in the 1st 3 months of 2021, the percentage not reaching a deal is likely to increase dramatically.
SPACs avoid identifying any potential target before the IPO because SEC rules would require that they disclose information about the target. Indeed, the SPAC prospectus must state that the SPAC did not consider any specific target business at the IPO and will refuse to consider any businesses that approach it for a possible combination.
SPACs usually include an industry or geographic focus for the target acquisition, but they are not restricted to that focus. Stock exchange rules stipulate that one or more target businesses or assets have a aggregate fair market value equal to at least 80% of the assets held in the trust account when the agreement for the DeSPAC transaction is signed. However, SPACs generally seek businesses at least 2 to 3 times larger than the SPAC to minimize the dilution of public shares by founder shares. The SPAC prospectus usually stipulates that the SPAC must own or acquire 50% or more of the outstanding voting securities of the target so that it is not required to register as an investment company under the Investment Company Act of 1940.
The steps for a successful completion of the SPAC process include:
- May take 2 months or longer
- Incorporate the SPAC
- Prepare SEC Form S–1, IPO Investment Prospectus, which is the initial form to file to offer securities to the general public, providing a description of the company’s properties and business, description of the securities being offered, information about the managers of the company and about financial statements certified by independent accountants
- Respond to SEC comments, typically over a 6-week period or longer
- Set underwriting agreement
- Set pricing
- Set up a trust account to receive the funds of investors that will be used to fund the acquisition or to redeem public shares of the SPAC if the SPAC process fails
- SEC rules require that a SPAC keep 90% of its IPO gross proceeds in an escrow account until the acquisition of the target company, which must take place within 36 months. If the acquisition cannot be completed within that time, then the SPAC must file for an extension or return the funds to its investors.
- The acquired company should have an aggregate fair market value of at least 80% of the amount held in escrow within 36 months.
- Promote the SPAC through a road show.
- May take up to 19 months
- File periodic SEC filings
- Find target business
- Conduct due diligence
- Negotiate acquisition
- Arrange PIPE or debt financing
- Prepare tender offer document
- Sign agreements for acquisition and financing
- May take 3 to 5 months or more
- Announce acquisition
- File proxy and tender offer documents
- Obtain shareholder approval, renegotiate transaction, or search for a new target
- File SEC Form Super 8-K, CURRENT REPORT within 4 business days of the de-SPAC transaction to report key financial and business information about the acquisition target. The Super 8-K requires at least 3 years of audited financial statements of the target business.
- The combined SPAC and private company must meet the listing requirements for a stock exchange, usually NASDAQ or the New York Stock Exchange.
Sponsors sign a lockup agreement requiring the sponsors to hold the stock at least 1 year after the closing of the de-SPAC process, but the lockup period may be shortened to 180 days if the stock trades above a fixed price for 20 days in a 30-day period, 150 days after the de-SPAC process.
SPACs may have forward purchase agreements with affiliates of the sponsor or institutional investors, committing them to provide more funds if necessary to complete the de-SPAC transaction.
Trust funds are used to purchase government securities to earn interest while the funds are being held until the completion of the merger. However, the trust document usually permits the SPAC to withdraw interest to pay franchise and income taxes and may also permit a limited withdrawal of interest for working capital.
For a company that was to go public, merging with a SPAC has advantages over the traditional IPO. It is faster. The company can avoid going on a roadshow to convince investors to buy into the company, since it only needs to negotiate with the SPAC sponsor, and it can avoid some of the legal requirements of an IPO. One thing the company may do is publish detailed multiyear financial forecasts while companies in an IPO can only publish historic finances. Being able to make financial projections instead of relying on financial history allows the SPAC to sell more shares at higher prices. There is also greater leeway to paint a rosier picture for the company without running afoul of security laws prohibiting potentially misleading statements. Furthermore, if the SPAC sponsor and the company cannot agree to the price for the company, then it is easier to back out without suffering the embarrassment of backing out of an IPO. More than 40% of 2020’s IPOs by volume have been SPACs, raising $31.6 billion, exceeding double all of last year’s $12.4 billion. SPACs have increased enormously in 2020, continuing into 2021:
As of 2021, there are 3 ETFs primarily focused on SPACs:
- Defiance NextGen SPAC IPO ETF (SPAK), the 1st ETF based on SPACs, started October 1, 2020, is an index tracking fund investing in both US listed SPACs and SPAC merged companies. Companies are selected based on market capitalization and liquidity and the weighting of the index is based on market capitalization, rebalanced annually. Expense ratio: 1.0%.
- Morgan Creek – Exos SPAC Originated ETF (SPXZ) is also actively managed, investing in pre- and post-merger SPACs, started on January 26, 2021, but the investments have equal weighting rather than being based on market capitalization, thus providing more diversification. Expense ratio: 1%.
- SPAC and New Issue ETF (SPCX), started December 16, 2020, is an actively managed fund investing only in premerger SPACs, dropping SPACs after they merge, and is managed by Tuttle Tactical Management. Expense ratio: 0.95%.
It will be interesting to see if active management does better than a passive index. While active management does not seem to boost most other funds, at least in the long term, it may make a big difference with SPACs. So far, as PCX is up almost 10%, much better than the SPAC index, but SPXZ is down more than the index, down 15.6% compared to 10.84% for SPAK. Short interest on all 3 ETFs is high, indicating that many investors expect SPACs to decline.
SPACs as an Investment
The ownership interest in SPACs is usually sold as a unit consisting of one share of common stock and a fraction of a warrant to purchase additional common stock. Investors can trade the units, shares, and warrants separately.
Investors who earn the most profit in the SPAC are the sponsors and the PIPE investors, who are typically large institutions, such as hedge funds. Sponsors may purchase 20% of the SPAC's stock cheaply, typically for about $25,000. SPAC sponsors receive what are called founder shares that convert into public shares during the de-SPAC transaction. Sponsors also typically receive warrants to buy additional shares. This compensation for founders is often called the promote. They also receive warrants, allowing them to buy additional shares in the company for an exceptionally low price. This is why many celebrities are getting in on SPACs, since they can use their followers to draw interest and sell shares in the SPAC, allowing them to exit their investment at a nice profit.
Most SPACs go public for about $10 a share, trading around that price until an acquisition is announced. The potential profit on SPAC investments is limited, partly because much of the investment and profits go to the sponsors and PIPE investors of the SPAC. Moreover, the sponsor’s warrants for additional shares dilutes the outstanding number of shares held by the public, thus diluting the value of each share. Of 18 companies going public as a SPAC merger in the year before March 2021, 11 were trading for less than $10 per share.
The principals who create the SPAC, unlike the shareholders, do not get their money back, which may cause them to choose any target, even if it has little potential for profit. If the principals do buy something, then they can sell their shares in 6 months to a year.
Many blank check companies were created in the 1990's, but most of these were fraudulent, and subsequently went bankrupt. Because some of the recent private equity deals have yielded good returns, there has been greater interest in SPACs recently. In 2019, 30 SPACs were created, rising to 66 in 2020, with many more already being created in 2021. Many of the major banks are also considering creating SPACs for the investing public.
Some industry research reports show that shares of SPACs that completed de-SPAC transactions between 2015 and July 2020 have delivered an average loss of 18.8%, compared with the average returns of 37.2% of traditional IPOs for the same period.
A major risk to most SPACs is litigation. Since the SPAC process is complex and the law is stringent, SPACs are easy targets for litigation, which may drain the SPAC of enough funds to complete its transition to a merged company. Forward purchase agreements with PIPE investors or other institutional investors help to mitigate this risk. A major risk is that the SPACs founders may be highly motivated to acquire a target regardless of its potential for profit because, otherwise, they will lose most of their investment. Litigation is especially likely if the shares are trading for less than $10 per share. Other potential sources of litigation include the lack of transparency or the lack of due diligence in the DeSPAC negotiations and undisclosed relationships among the sponsors, management, consultants, and PIPE investors especially if they are being offered a job in the public company.
SPACs may not be Good Investments for Retail Investors
At the end of March 2021, the SEC has started looking into SPACs, which have rapidly proliferated from 2020 to the 1st quarter of 2021. SPACs often benefit sponsors and PIPE investors at the expense of retail investors. In the 1st quarter of 2021, 8 companies that have combined with SPACs have been sued by investors, alleging that the sponsors are reaping huge paydays after the SPAC combined with its target but without full disclosure of due diligence that the SPAC performed prior to merging with the company. Indeed, SPAC sponsors and PIPE investors may profit handsomely even if the acquired company is performing poorly and is not likely to do better later. Indeed, if sponsors and early investors do not think highly of the prospects of their acquisition, then they may be more likely to try to generate interest in the company by exaggerating its prospects and hiding disadvantages with the hope of selling their shares to retail customers who will certainly not have the same insight into the merged company’s prospects. After all, 1 of the advantages of SPACs is that sponsors can advertise future financial projections, which can help increase interest in those who believe the projections. This can make the selling of a SPAC merger much like a pump-and-dump scheme, allowing early investors to sell at a profit to retail investors. Even without good prospects, sponsors are highly motivated to find an acquisition within 2 years of the SPAC’s formation, because, otherwise, the sponsors must return investors’ money.
Furthermore, as ETFs are created that invest specifically in SPACs, the benefit to sponsors and PIPE investors may become even greater, since ETFs are more likely to draw retail investors who are not aware of the disadvantages and potential fraud in SPACs. Another increased risk with SPACs is that insider trading is easier, making it easier for investors with inside knowledge to dump the investment while the stock price is high. Investment success will be best by evaluating the management team behind the SPAC, their track record, and their valuations.
The main problem with SPACs as an investment is that the sponsors get paid if they just complete the de-SPAC transaction, even if the acquisition target is not a good one. Usually, the sponsor's promote is not based on performance goals. However, some SPACs are doing things differently. Pershing Square Tontine Holdings is basing the sponsor's promote on performance goals, by paying them with warrants instead of founder shares, exercisable at 20% above the IPO price.