Special Purpose Acquisition Companies: How They Work and Why They Matter

 

In recent years, special purpose acquisition companies (SPACs) have taken the financial world by storm, offering a unique path to going public. These "blank check" companies have become a popular alternative to traditional initial public offerings (IPOs), attracting both investors and private companies looking to enter the public market. SPACs have gained attention for their ability to streamline the process of taking a company public, often with greater speed and flexibility than conventional methods.

The rise of SPACs has sparked debates about their advantages and potential risks. These investment vehicles involve key players such as sponsors, investors, and target companies, each playing a crucial role in the SPAC lifecycle. From the initial formation and IPO to the business combination and beyond, SPACs navigate a complex landscape of regulatory requirements, financial reporting, and investor relations. As the popularity of SPACs continues to grow, it's essential to understand how they work, their impact on the market, and what the future may hold for this innovative approach to public offerings.

The Rise of SPACs

Historical Context

Special Purpose Acquisition Companies (SPACs) have a longer history than many might realize. The concept was initially introduced by GKN Securities in 1993, with David Nussbaum, the firm's chairman and CEO at the time, often credited as the creator of this investment vehicle . Between 1993 and 1994, GKN launched 13 SPACs, with 12 successfully acquiring a company . However, subsequent legal troubles faced by the firm delayed the widespread adoption of SPACs by other market participants .

For many years, SPACs remained a niche investment vehicle in capital markets. They were historically used by smaller companies that had difficulty raising capital on the open market via traditional IPOs . The SPAC landscape began to change in 2005 when the total capital raised by SPAC IPOs first surpassed USD 1.00 billion . This figure increased to USD 12.10 billion in 2007 before decreasing substantially after the Global Financial Crisis in 2008 .

Recent Trends

The SPAC market experienced a resurgence beginning in 2013, with 10 SPAC IPOs representing USD 1.40 billion in proceeds . This was followed by relatively slow but consistent growth until an explosion in popularity in 2020 . The year 2020 marked a turning point for SPACs, with the number of SPAC IPOs and total capital raised increasing by 420% and 513%, respectively, compared to 2019 . In fact, there were more SPAC IPOs in 2020 than in the previous 12 years combined .

This momentum continued into 2021, with SPACs reaching an all-time high. In that year, 613 SPACs raised a staggering USD 162.50 billion . At their peak, SPACs accounted for more than 50% of new publicly listed U.S. companies . However, the SPAC bubble seemingly burst in 2022, with only 67 SPACs raising a mere USD 11.60 billion .

Reasons for Popularity

Several factors contributed to the surge in SPAC popularity:

1. Market Volatility: The market instability following the COVID-19 pandemic led companies to postpone traditional IPOs and opt for SPACs, which offer more price certainty .
2. Speed and Efficiency: A SPAC acquisition can be completed in mere months, while registering an IPO with the SEC can take up to half a year alone .
3. Flexibility and Customization: SPACs are highly customizable and can address a variety of combination types, making them an attractive alternative to late-round funding options .
4. Credibility of Sponsors: Established hedge funds, private equity and venture firms, and senior operating executives entered the SPAC market, bringing credibility and expertise to the industry .
5. Access to Capital: SPACs provided an infusion of capital to a broader universe of start-ups and other companies, fueling innovation and growth .
6. Potential for High Returns: Some SPACs have delivered significant returns, such as DraftKings (687% return), Betterware (585%), and Iridium (570%) .

Despite the recent decline in SPAC activity, experts believe that SPACs are here to stay as an alternative financing option, particularly for more speculative VC-type investments . However, regulatory changes and investor skepticism are likely to reshape the SPAC landscape, leading to a more balanced and scrutinized market in the future.

Key Players in a SPAC

Special Purpose Acquisition Companies (SPACs) involve several key players, each with distinct roles and responsibilities in the process of taking a company public. These players include sponsors, underwriters, investors, and target companies.

Sponsors

Sponsors are the driving force behind SPACs. They are typically experienced business executives, companies, or private investors who provide the initial capital and expertise to form and manage the SPAC . Sponsors receive approximately 20% of the SPAC's equity, known as founder shares, for a nominal investment . This structure allows sponsors to profit significantly even if the merged company's stock price declines .

Sponsors can be categorized into three groups:

1. Experienced business executives with project ideas but lacking funds
2. Companies seeking to raise substantial capital for projects
3. Private investors or PE investment funds looking for potential gains

Sponsors play a crucial role in identifying and acquiring a suitable target company within the specified timeframe, usually 18-24 months . Their reputation and expertise often attract investors and help negotiate the business combination.

Underwriters

Underwriters play a vital role in the SPAC process, particularly during the initial public offering (IPO) stage. They typically receive a percentage of the offering price, known as the "underwriting discount" . Underwriters' responsibilities include:

1. Facilitating the SPAC IPO process
2. Providing due diligence and evaluation of disclosures
3. Potentially participating in the de-SPAC transaction

Recent regulatory proposals suggest expanding the definition of "distribution" for SPAC IPO underwriters, which could increase their liability in de-SPAC transactions . This change aims to encourage greater due diligence and more accurate disclosures throughout the SPAC lifecycle.

Investors

SPAC investors can be divided into two main categories:

1. Public investors: These are typically institutional investors who purchase common stock or ordinary shares during the SPAC's IPO .
2. Private investors: Often involved in private placements, such as Private Investment in Public Equity (PIPE) transactions, which have become increasingly common in recent SPAC deals .

A key feature of SPACs is that investors who purchase shares during the IPO have redemption rights . This means they can elect to receive their pro rata portion of the trust account, including interest, upon the business combination, regardless of whether they vote for or against it .

Target Companies

Target companies are private operating companies that SPACs seek to acquire or merge with, effectively taking them public. The search for a suitable target is similar to a typical M&A transaction, involving accelerated financial, legal, and tax due diligence .

Key aspects of target companies in SPAC transactions include:

1. They must have an aggregate fair market value of at least 80% of the assets held in the SPAC's trust account .
2. Historically, SPACs focused on positive EBITDA companies, but recent trends have seen pre-revenue "story-stock" companies entering the market .
3. The target company succeeds to the SPAC's public filing status, effectively becoming a public company upon completion of the merger .

The SPAC structure offers target companies a potentially faster and more flexible path to going public compared to traditional IPOs. However, they must be prepared for the accelerated timeline and increased scrutiny that comes with public company status .

SPAC Capital Structure

Special Purpose Acquisition Companies (SPACs) have a unique capital structure designed to facilitate their purpose of raising capital and acquiring a target company. This structure typically consists of three main components: units, common stock, and warrants.

Units

SPACs typically offer investors units during their initial public offering (IPO). These units are structured with a par value of USD 10.00 per share and consist of two main components :

1. Shares of common stock
2. Warrants or fractions of warrants

The SPAC unit trades for some time after the IPO, after which the common stock and warrants may begin trading separately on an exchange with their own unique trading symbols . This structure allows investors to participate in the SPAC's potential growth while also providing additional incentives through warrants.

Common Stock

Common stock represents ownership in the SPAC and typically makes up about 80% of the interest held by public shareholders . These shares have voting rights similar to those of founder shares, with the exception that founder shares usually have the sole right to elect SPAC directors .

The funds raised through the sale of common stock are placed in an interest-bearing trust account. This account cannot be disbursed except to complete an acquisition or return funds to investors if the SPAC fails to complete a deal within the specified timeframe, usually two years .

Warrants

Warrants are a crucial component of the SPAC capital structure, offering investors additional potential for returns. A warrant is a contract that gives the holder the right to purchase a certain number of additional shares of common stock from the company in the future at a predetermined price .

Key features of SPAC warrants include:

1. Exercise Price: Typically set at USD 11.50 per share .
2. Exercise Period: Warrants usually cannot be exercised until after the business combination or at least 12 months after the SPAC's IPO .
3. Types: There are two main types of warrants - public warrants and private placement warrants .

Public warrants are issued alongside SPAC shares during the IPO, while private placement warrants are offered to SPAC sponsors or founders before the IPO . The terms of warrants can vary significantly across different SPACs, including the number of shares that can be purchased, the exercise price, and the circumstances under which the SPAC can redeem the warrants .

It's important to note that warrant holders typically don't have voting rights, and only whole warrants are exercisable . The value of warrants is influenced by factors such as the current share price, volatility, and time to maturity .

Understanding the SPAC capital structure is crucial for investors. The combination of units, common stock, and warrants provides a unique investment opportunity, but it also comes with complexities and risks. Investors should carefully review the terms of each SPAC offering, particularly the warrant terms, to make informed investment decisions.

The SPAC Lifecycle

Formation

The journey of a Special Purpose Acquisition Company (SPAC) begins with its formation. A group of experienced investors or industry professionals, known as sponsors, create the SPAC as a shell company with no operations . These sponsors typically invest a nominal amount of capital, which translates into approximately 20% interest in the SPAC, commonly referred to as founder shares . The remaining 80% interest is held by public shareholders through units offered in the initial public offering (IPO) .

IPO

The next stage in the SPAC lifecycle involves going public through an IPO. During this process, the SPAC raises capital from investors, with the funds typically held in a trust account . Each unit offered in the IPO consists of a share of common stock and a fraction of a warrant (e.g., ½ or ⅓ of a warrant) . The average SPAC IPO size has significantly increased over the years, rising from USD 36.00 million in 2009 to USD 324.00 million in 2021 .

Target Search

Once the SPAC has completed its IPO, it enters the target search phase. The SPAC's management team has a specific timeframe, typically 18-24 months, to identify and complete a merger with a target company . During this period, the SPAC researches potential targets, reaches out to companies, and may work with investment banks and advisors . SPACs generally look to combine with a target company that is 2-3 times the size of the amount of capital in the trust account .

De-SPAC Transaction

The final stage of the SPAC lifecycle is the de-SPAC transaction, which involves the merger between the SPAC and the target company. This process typically includes the following steps:

1. Negotiation: Once a suitable target is identified, the SPAC's management team enters into negotiations to determine the terms of the merger .
2. Announcement: When a merger agreement is signed, the deal is announced publicly, and investors are notified .
3. SEC Filing: The business must file an S-4 proxy financial statement with the Securities and Exchange Commission (SEC), containing audited financial statements, managerial discussions, and other required information .
4. Shareholder Approval: SPAC shareholders must approve the deal, typically requiring at least 20% shareholder approval .
5. Completion: Upon shareholder approval, the merger is completed, and the target company becomes a publicly traded entity through the SPAC .

The de-SPAC process can be completed in as little as three to five months, which is substantially shorter than a typical traditional IPO timeline . However, the entire process, from formation to completion, can take anywhere from eight to ten weeks if everything moves quickly, or several months if there are delays or additional SEC comments .

It's worth noting that SPACs often rely on private investment in public equity (PIPE) to generate additional capital before the business combination . This provides more certainty to stakeholders and allows investors to buy shares in the company at the time of the merger .

Advantages of SPACs

Special Purpose Acquisition Companies (SPACs) offer unique advantages to various stakeholders involved in the process of taking a company public. These benefits have contributed to the growing popularity of SPACs as an alternative to traditional Initial Public Offerings (IPOs).

For Sponsors

SPAC sponsors stand to gain significantly from this investment vehicle. They typically receive approximately 20% of the SPAC's equity, known as founder shares, for a minimal initial investment . This structure allows sponsors to potentially earn hundreds of millions of dollars for an upfront stake as low as USD 25,000 . The substantial potential returns serve as a strong incentive for sponsors to complete a deal, even if it may not be in the best interest of other investors .

Sponsors can be categorized into three groups:

1. Experienced business executives with project ideas but lacking funds
2. Companies seeking to raise substantial capital for projects
3. Private investors or PE investment funds looking for potential gains

For sponsors, SPACs offer a faster and more cost-effective way to raise funds compared to traditional IPOs. While a traditional IPO may take at least 18 months to organize and could cost 10% or more of the planned IPO proceeds, a SPAC usually requires only three to five months until the IPO is ready, with remarkably lower costs .

For Investors

SPAC investors, particularly those who participate in the IPO stage, enjoy several advantages:

1. Money-back guarantee: Investors in a SPAC IPO have the option to redeem their shares for what they paid plus interest, essentially providing a risk-free investment .
2. Warrants: In addition to shares, investors receive warrants, which can be valuable if the SPAC is successful. These warrants act as a risk-free bet on the SPAC's success .
3. Potential for larger stakes: Investors involved in a SPAC from the outset may have the opportunity to own a bigger stake in the ultimate merged company compared to what they might achieve through a traditional IPO .
4. Attractive payoff profile: The combination of redemption rights and warrants makes SPACs particularly appealing to institutional investors, especially hedge funds. In fact, across 47 SPACs that merged between January 2019 and June 2020, redemptions amounted to 73% of IPO proceeds in the median case .

For Target Companies

Private companies looking to go public find several advantages in merging with a SPAC:Faster execution: A SPAC merger typically takes 3-6 months, significantly shorter than the 12-18 months required for a traditional IPO .

1. Upfront price discovery: Unlike in an IPO where the initial price depends on market conditions at the time of listing, companies merging with a SPAC can negotiate the pricing before the transaction closes. This is particularly advantageous in volatile markets .
2. Additional capital: SPAC sponsors often raise debt or PIPE (private investment in public equity) funding in addition to their original capital. This can provide the combined company with funds for growth, even if some SPAC investors redeem their shares .
3. Reduced market volatility concerns: The agreed-upon valuation between the target company and the SPAC can help mitigate some market volatility risks associated with traditional IPOs .
4. Ability to use forward-looking statements: Unlike in traditional IPOs, private companies can use forward-looking statements when marketing themselves to a SPAC. This is particularly appealing for fast-growing companies .
5. Access to expertise: SPAC sponsors are often experienced financial and industrial professionals who can offer management expertise or take on roles on the board of the combined company .
6. Reduced regulatory burden: The regulatory demands on a private company in a SPAC merger are generally less onerous and costly than in a traditional IPO .

These advantages have contributed to the rise of SPACs as an attractive alternative for companies seeking to go public, investors looking for unique investment opportunities, and sponsors aiming to capitalize on their expertise and network.

Challenges and Risks

Dilution

One of the primary challenges faced by Special Purpose Acquisition Companies (SPACs) is the significant dilution of shareholder value. This dilution occurs through various mechanisms inherent in the SPAC structure. The sponsor's "promote," typically consisting of shares equal to 20% of post-IPO equity, serves as a substantial source of dilution . Additionally, to attract IPO investors, SPACs offer attractive returns for holding cash, further diluting share value .

The extent of dilution can be staggering. For SPACs that merged between January 2019 and June 2020, the median dilution amounted to 50.4% of cash delivered in a merger . This means that a SPAC with median dilution delivering USD 1000.00 in cash from selling 100 shares would have the equivalent of roughly 150 shares outstanding .

Redemptions exacerbate this dilution. When shareholders redeem their shares, it reduces both cash and shares, but disproportionately affects the cash-to-share ratio. The mean and median redemption rates for SPACs that merged between January 2019 and June 2020 were 58% and 73%, respectively . This high redemption rate environment poses challenges for SPACs aiming to complete business combinations, as less cash remains in the trust account to satisfy minimum cash conditions for acquisitions .

Time Constraints

SPACs operate under strict time constraints, typically having 18-24 months to identify and complete a merger with a target company . This limited timeframe can create a "merge-or-lose" dilemma for sponsors, potentially leading to conflicts of interest . The pressure to complete a deal within the specified period may result in hasty decisions or suboptimal target selections.

The time constraints also affect the due diligence process. As SPACs face increased scrutiny, they need to be prepared for longer transaction execution timeframes and greater costs to complete transactions . This extended timeline can strain resources and potentially impact the quality of deals.

Regulatory Scrutiny

The SPAC market has faced intensifying regulatory scrutiny, particularly from the U.S. Securities and Exchange Commission (SEC). In March 2022, the SEC proposed new rules and amendments that would significantly impact SPAC operations . These proposed rules include:

1. New disclosure requirements regarding sponsor economics, potential conflicts of interest, dilution to shareholders, and projections.
2. Requirements for fairness opinions.
3. Elimination of safe harbor protections for forward-looking statements .

The increased regulatory attention has already begun to impact market practices. Market participants in de-SPAC transactions have started undertaking enhanced due diligence processes and requiring deliverables that generally mirror those in traditional IPOs, including negative assurance letters from counsel and comfort letters from auditors .

The challenges and risks associated with SPACs have led to a slowdown in SPAC activity. Factors contributing to this decline include disappointing performance by newly de-SPACed companies, rising inflation, macroeconomic uncertainty, and the aforementioned increased regulatory scrutiny . As a result, SPAC participants must navigate a more complex landscape, balancing the potential benefits of this investment vehicle with its inherent risks and challenges.

The Future of SPACs

Market Outlook

The Special Purpose Acquisition Company (SPAC) market has experienced significant fluctuations in recent years. In 2023, the SPAC market witnessed a 64% decline in Initial Public Offerings (IPOs) compared to 2022, accompanied by a record number of liquidations . The average gross IPO proceeds decreased from approximately USD 159.00 million in 2022 to USD 125.00 million in 2023, while liquidations increased from 145 to 197 . These trends indicate a cooling off period for the SPAC market after its explosive growth in previous years.

As of December 2023, 127 SPACs were actively searching for targets . However, the market faces challenges, including disappointing performance by newly de-SPAC'd companies, increased regulatory scrutiny, an uncertain economic outlook, and rising interest rates . These factors have contributed to a slowdown in SPAC activity and increased investor caution.

Looking ahead, the SPAC market faces both opportunities and challenges. While 140 de-SPAC transactions were announced but not yet completed as of December 31, 2023, representing over USD 27.00 billion in IPO proceeds , the market also faces pressure from looming expiration dates. In the first quarter of 2024 alone, 77 SPACs searching for targets, representing approximately USD 18.00 billion cash in trust, are obligated to complete mergers .

Potential Regulatory Changes

The regulatory landscape for SPACs is evolving, with significant changes on the horizon. On January 24, 2024, the Securities and Exchange Commission (SEC) adopted new rules and amendments to enhance disclosures and provide additional investor protection in SPAC IPOs and subsequent business combination transactions . These changes aim to address concerns about the adequacy of disclosure and the responsible use of projections in SPAC transactions.

Key aspects of the new rules include:

1. Additional disclosure requirements regarding SPAC sponsor compensation, conflicts of interest, dilution, and target company information .
2. Making the target company a co-registrant with the SPAC in certain situations, increasing responsibility for disclosures .
3. Treating business combination transactions involving reporting shell companies, including SPACs, as sales of securities to shareholders .
4. Aligning the regulatory treatment of projections in de-SPAC transactions with traditional IPOs under the Private Securities Litigation Reform Act of 1995 (PSLRA) .
5. Mandating disclosure of all material bases and assumptions underlying projections .

These regulatory changes are set to take effect on July 1, 2024, and will significantly impact the SPAC landscape . The new rules aim to increase transparency and investor protection, potentially leading to a more stable and regulated SPAC market in the future.

Evolution of Structures

As the SPAC market matures, there is an ongoing evolution in SPAC structures and practices. Sponsors are increasingly using alternative promote structures to align incentives and distinguish themselves, making their SPACs more attractive to IPO investors and potential target companies . One approach involves subjecting a portion of the founder shares to an 'earn-out' construct, where these shares vest only if certain post-closing trading price targets are achieved .

The importance of complementary Private Investment in Public Equity (PIPE) financings has also grown, especially for larger de-SPAC transactions . PIPE financings offer several benefits, including the ability to raise funds without the parallel sponsor promote . This evolution in financing structures may continue as SPACs adapt to changing market conditions and investor preferences.

Looking ahead, SPACs may need to focus on transparency and innovative structures to maintain their appeal as an alternative to traditional IPOs. The flexibility of de-SPAC transactions, including the ability for price discovery and negotiation within an acquisition agreement, may continue to attract target companies seeking liquidity . However, the success of future SPACs will likely depend on their ability to navigate the evolving regulatory landscape and deliver value to both investors and target companies.

Conclusion

To wrap up, Special Purpose Acquisition Companies have emerged as a significant force in the financial world, offering a unique path to going public. Their rise to prominence has had a profound impact on the landscape of public offerings, providing advantages such as speed, flexibility, and potential for high returns. However, SPACs also face challenges, including dilution, time constraints, and increased regulatory scrutiny, which have led to a recent slowdown in SPAC activity.

Looking ahead, the future of SPACs remains uncertain but full of potential. As the market evolves, we're likely to see changes in SPAC structures and practices to address current challenges and adapt to new regulations. While the SPAC boom may have cooled, these investment vehicles are likely to remain a part of the financial toolkit, offering an alternative route to public markets for companies seeking liquidity. The ongoing evolution of SPACs will be crucial to watch as it continues to shape the landscape of public offerings.

FAQs About Special Purpose Acquisition Companies (SPACs)

1. What is a SPAC?

A Special Purpose Acquisition Company (SPAC) is a blank check company created for the sole purpose of raising capital through an initial public offering (IPO) to acquire or merge with an existing private company, allowing that company to go public without going through the traditional IPO process.

2. How do SPACs work?

SPACs raise funds through an IPO, and the proceeds are placed in a trust account. The SPAC's management team then has a set timeframe (typically 18-24 months) to identify a target company for acquisition. Once a target is identified, the SPAC merges with it, and the private company becomes publicly traded.

3. What are the advantages of SPACs?

Speed and Efficiency: SPAC mergers can be completed much faster than traditional IPOs, often within a few months.

Price Certainty: Companies can negotiate valuations before a merger, reducing market volatility concerns.

Access to Capital: SPACs can provide additional funding through PIPE (Private Investment in Public Equity) transactions.

Less Regulatory Burden: The regulatory requirements for SPAC mergers can be less demanding than those for traditional IPOs.

4. What are the risks associated with SPACs?

Dilution: The issuance of founder shares and warrants can significantly dilute existing shareholder value.

Time Constraints: SPACs have limited time to find a target, which can lead to rushed decisions.

Regulatory Scrutiny: Increasing attention from regulators, such as the SEC, can affect SPAC operations and disclosures.

5. Who are the key players in a SPAC?

Sponsors: Individuals or firms that create and manage the SPAC, typically receiving a significant equity stake for a nominal investment.

Underwriters: Financial institutions that facilitate the SPAC IPO, ensuring regulatory compliance and investor interest.

Investors: Public and private investors who provide capital during the IPO and can redeem their shares under certain conditions.

Target Companies: Private firms that the SPAC seeks to acquire or merge with, benefiting from a quicker path to becoming publicly traded.

6. How do investors benefit from investing in a SPAC?

Investors can benefit from:

Redemption Rights: The option to redeem shares for their initial investment plus interest if they do not approve of the proposed merger.

Warrants: Opportunities to acquire additional shares at a predetermined price, potentially increasing returns.

Risk Mitigation: SPACs can offer a relatively lower-risk investment option compared to traditional IPOs due to the money-back guarantee during the IPO stage.

7. What is the future outlook for SPACs?

While the SPAC market has experienced a slowdown due to regulatory scrutiny and disappointing performance of previous de-SPACed companies, they are expected to remain a viable route for companies looking to go public. Regulatory changes and evolving market conditions may lead to more stable and transparent SPAC operations in the future.

8. What regulatory changes are expected for SPACs?

New rules proposed by the SEC aim to enhance disclosure requirements, address potential conflicts of interest, and regulate the treatment of projections in SPAC transactions. These changes are expected to take effect in July 2024, impacting how SPACs operate moving forward.

9. How can companies benefit from merging with a SPAC?

By merging with a SPAC, private companies can enjoy a faster route to public markets, negotiate upfront valuations, access additional capital, and benefit from the expertise of experienced sponsors, all while facing potentially fewer regulatory hurdles compared to traditional IPOs.

10. Are SPACs likely to disappear?

While SPAC activity has decreased recently, they are not likely to disappear. SPACs may evolve and adapt to new regulatory environments and market conditions, continuing to offer an alternative path for companies seeking public market access.