A new way for a company to go public has been taking off—special purpose acquisition companies (SPACs). While they have a structure that’s been around for a couple decades, SPACs have never previously had a year like 2020. As of mid-October, over 135 SPACs had raised an average of US$387 million each, and there were 155 SPACs shopping for deals (having raised funds, but not yet announcing an acquisition), with some US$43 billion in capital available to be deployed. By way of comparison, just 59 SPACs raised money in 2019 and 46 in 2018.
What is a SPAC? These entities, sometimes known as blank check companies, are formed by financial sponsors and seasoned industry executives to raise money in an initial public offering (IPO) before they have any assets or business. The money raised in the IPO is then held in trust while the SPAC seeks out an M&A opportunity. SPACs typically have about two years to get a deal done, otherwise they are required to return the IPO proceeds to the investors.
From the sponsor side, the economics of a successful SPAC are compelling—a modest investment of at-risk capital results in the sponsor owning 20 percent of the SPAC after its IPO, plus warrants to increase that ownership share. From the target company perspective, SPACs are an alternative route to going public, a workaround to the traditional IPO. And what’s in it for public investors? The opportunity to invest in an IPO alongside notable private equity sponsors in companies with growth potential, while enjoying downside protection until the initial acquisition and immediate access to liquidity through the markets.
Powering the SPAC boom
SPACs may not be having such an extraordinary year if the common path to a market listing—the IPO—were working optimally for companies that want to tap the public markets. However, there’s a growing sense that regulatory friction is making the IPO path too long, difficult, and unpredictable.
A company going public in an IPO faces the risk that, while preparing regulatory filings and searching for the right underwriter, the entire process can be derailed. A stock market selloff, a business misstep, or some other setback may mean that the amount of money to be raised suddenly shrinks or the possibility of completing the IPO vanishes entirely.
The market volatility caused earlier this year by the COVID-19 pandemic underscored the market risks for a company contemplating an IPO. The ability to get an offering done all but disappeared for a time—and although the IPO markets have partially rebounded, SPAC activity has surged.
Investor interest, meanwhile, is being driven by the involvement of some of the biggest names in the financial industry. Private equity leaders, such as TPG, Apollo, and Blackstone, have all sponsored SPACs. Hedge fund star Bill Ackman recently raised US$4 billion for his Pershing Square Tontine Holdings, the largest SPAC yet created. Large banks, such as Goldman Sachs to Citibank, are serving as underwriters. These players have the capital, the know-how, and the network to pull off grand scale acquisitions, and that helps give investors the confidence to pour in money.
With so many SPACs getting funded, a key question is whether there are a sufficient number of acquisition targets. An attractive target for a SPAC needs to be public company ready—meaning it can produce the financial filings regulators require and it is prepared for the scrutiny that comes as a public company. So far, SPAC sponsors have been finding worthy targets. But will that continue with so many SPACs now on the acquisition hunt?
The equity waiting to be deployed by SPACs is significant. If this increased capital creates excessive competition for attractive companies to purchase attractive targets, the deals that get done may be more risky—or SPAC sponsors may push into new sectors or geographies. The PE industry has faced capacity issues for many years, and the dry powder that PE firms have within their traditional buyout funds still dwarfs what SPACs have raised.
One way SPAC sponsors have been able to expand the pool of potential targets has been to move into hypergrowth industries, sometimes buying less mature acquisition targets. “SPACtivity” has really taken off in some niche industries, such as professional sports, entertainment, space, and electric and autonomous vehicles.
The success or failure of these riskier companies as publicly traded entities may influence the overall direction of SPAC activity. Nikola, which is developing heavy trucks powered by batteries and hydrogen fuel cells, has been on a wild ride since its SPAC merger in June, to cite one prominent example. The shares soared initially after the SPAC transaction, but they fell back to earth amid controversy over the company’s progress in getting products ready for market.
What to watch for
Another way SPAC sponsors may find more desirable acquisition targets is to look overseas. There are a number of international companies that would like access to greater liquidity for themselves and their stockholders by tapping U.S. public markets through a SPAC merger. It bears watching to see whether more SPACs come to market to pursue transactions with international companies, as this could be an indication of how long the SPAC boom may last.
Monitoring economic terms and structures may also be helpful in assessing the longevity of the SPAC trend. Much as there is regulatory friction that tempers interest in a standard IPO, there is economic friction in the SPAC model. In most SPACs, sponsors receive 20 percent of the equity in the post-IPO company—a feature known as the sponsor promote—and purchase warrants that allow them to increase that ownership level. The sponsors put only a modest amount of capital at risk in exchange for equity that can ultimately be worth hundreds of millions of dollars.
Sponsor promote economics have been remarkably consistent to date—with a few notable exceptions such as the SPAC that Ackman created. His Pershing Square Tontine Holdings does not have the 20 percent sponsor promote. Instead, the sponsors only hold warrants, and those warrants have a strike price at a 20 percent premium rather than the typical 15 percent premium. Elsewhere, sponsors are forfeiting increasingly larger amounts of their sponsor promote ownership through negotiations with acquisition targets.
It will be interesting to watch how sponsor compensation evolves as SPAC competition increases. And new regulatory pressure may be on the horizon. Just last month, the chairman of the Securities and Exchange Commission, Jay Clayton, said that he’s “particularly focused on” the incentives and compensation that SPAC sponsors receive. With increased competition already changing the game, this increased regulatory scrutiny could provide another angle on the future of SPAC activity.
Authored by Mark Kurtenbach, and Christopher Weigand