SPACs: What They Are and How They Work
By Nazire Göksu, Nurten İlgi Naim, Semiha Bilge Önoğlu
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“SPACs have made it possible for many businesses to increase their funds, more than they could have using other methods, facilitating innovation across a variety of industries. The profit potential for sponsors, suitable risk-adjusted revenue for investors, and a relatively alluring capital raising procedure for targets are all benefits that successful SPACs provide.”
Special Purpose Acquisition Companies (SPACs) have become a popular investment method in recent years even though they existed in various forms for decades. They have now become a preferable way to take companies public. Also known as “blank check companies”, SPACs offer an alternative to traditional IPOs, they allow investors to contribute money towards a fund, which is then used to acquire an unspecified business to be identified after the IPO. SPACs are companies without commercial operations. These companies are publicly traded corporations with the purpose of effecting a merger with a privately held company and enabling the company to go public. SPACs raise capital from public-equity investors and shorten the traditional IPO process along with offering better terms than a traditional IPO.
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SPACs have become increasingly popular in recent years due to their potential for high returns, but also because they offer an alternative path to going public. Companies can bypass the traditional IPO process, which can be time-consuming and expensive, by merging with a SPAC. In fact, in 2020, SPACs raised over $80 billion in the capital, up from $13.6 billion in 2019, according to data from SPAC Insider.
How do SPACs work?
SPACs are generally formed by expert investors or sponsors in a particular business sector or industry. SPACs raise funds in an IPO which is usually based on a geography and sector. Even if SPAC founders have an acquisition target, these targets are not identified in order to avoid disclosures during the IPO process. Following the IPO, the proceeds are placed in an interest-bearing trust account. This trust account cannot be dispensed except to complete an acquisition, or it will return the funds to investors if the SPAC is liquidated. The interest earned from the trusts can sometimes serve as the SPAC’s working capital. SPACs have to merge with a company and close a deal in a specific time frame, which usually ranges between 18 and 24 months. If a SPAC fails to merge with a company in the given time frame, then it liquidates and the funds are returned to investors, the public shareholders. On the other hand, once the target company is identified and announced, the public shareholders of the SPAC may vote against this transaction and redeem their shares. If additional funds are required for completing a merger, the SPAC may issue additional shares such as a PIPE (private investment in public equity) deal.
When private companies are considering going public, they can choose the traditional IPO method or the SPAC route. Both routes will enable private companies to become public however there are significant differences between the two which should be considered. While a SPAC is a non-operational public company aiming to merge with a private business, in an IPO a private company raises money in the public market. In the case of a private company that is planning an IPO, preparation for an increase in public investigation, filing paperwork and financial disclosures are needed. Such companies typically prefer hiring an investment bank for consulting on the IPO and helping set an initial price for the offering. One of the reasons IPOs are losing popularity over SPACs is that IPOs are much more costly; both timewise and money-wise. The hired investment bank takes a percentage (ranging between 3.5% and 7% according to recent study) of the gross IPO proceeds in fees, while a SPAC deal costs much less, especially on financial consulting and legal fees. Furthermore, a SPAC merger only takes 3–6 months while the IPO usually takes 12–18 months on average. The detailed process to fulfill the requirements of a public entity and the ongoing negotiation process of the share price valuation extends the time required for the IPO process. Despite the advantages of the SPACs by means of time and money, traditional IPOs still remain a viable option and as much preferred as SPACs due to the latter’s own risks and question marks.
Advantages of SPAC’s
SPACs are also an opportunity for individuals to invest in promising private companies. After an acquisition, SPAC stocks are listed on major exchanges, enabling investors to add SPACs to investment portfolios through their online brokerage accounts. Another method to invest in SPACs is through an exchange traded fund (ETF). With the proper due diligence, buying shares of a SPAC before the announcement of the target company may allow investors to participate in significant growth opportunities. The proper research on the SPAC funds should be completed before investing.
SPACs also have other advantages apart from offering a method for private companies to go public and being a tool of investment for individual investors. SPACs help owners of the “target companies” to negotiate a premium price when selling to a SPAC as the time is limited to commence a deal. Merging with or being acquired by a SPAC which is sponsored by financiers and executives allows the target company with better market visibility. SPACs have become a preferable option than traditional IPOs in times of market uncertainty. However, there are some disadvantages and risks that should be considered. Returns from SPACs may not always meet the offered expectations during its promotion stage. Approximately 70% of SPACs that had their IPOs in 2021 were trading below their $10 offer price. Also, the number of lawsuits being filed against SPACs by shareholders are rising proportionally to their increasing popularity. The sudden increase in the popularity of SPACs have led to new accounting regulations and an “Investor Alert” issued by the Securities and Exchange Commission. The increased regulatory oversight and less-than-expected performance in early 2022 caused a slight decrease in the popularity of SPACs.
SPACs’ popularity as a potential liquidity option continues to grow for companies. SPACs have shown a great improvement in recent years and became a much more preferred investment method since the 1990s. The shorter timeline of SPACs than traditional IPOs hold great importance in this state of affairs. Even though not all SPACs are destined to succeed, just like any other method of raising capital, SPACs offer great potential for significant benefit. However, both the advantages and risks should be well understood before committing to an investment in such companies in order to benefit from these investments. Potential investors should be aware of the newest regulations and changes since the process is evolving in a fast pace.
Risks of SPACs
There are still downside risks for SPAC investors; like with all investment strategies, investors should be aware of the range of potential risks associated with choosing the SPAC route, including market fluctuations and the potential risk to end up investing in a failing business without any secure business strategy. Although all investments carry some risks, SPACs do give investors the ability to withdraw and receive their money back before continuing with the acquisition. One of the main risks is that SPACs are essentially a bet on the sponsors’ ability to identify a suitable target company. If the sponsors are unable to identify a suitable target company, the SPAC will fail, and investors will lose their investment. Additionally, SPACs are often structured in a way that benefits the sponsors at the expense of the investors. For example, sponsors may receive large fees for identifying a target company, regardless of whether the merger is successful or not.
CNBC’s Yun Li stated that “Faced with intense competition, deadline pressure, and a volatile market, some SPACs had to settle for less ideal targets, and in some cases, throw their entire blueprint out the window,”. The Securities and Exchange Commission (SEC) stated in April 2021 that they were taking into consideration new rules that would alter how SPACs disclose data on financial statements to investors. That month, the pace of issuances decreased by over 90%. Even if the boom of SPAC IPOs in 2021 has been halted by more government control and surveillance over SPAC operations, in the long run, this makes SPACs a more reliable, attractive, and better-arranged investment mechanism for public investors.
SPAC’s and Family Offices
SPACs can be perceived as asset management firms or family offices. However, a family office is a private company that offers wealth management services for high-net-worth families. These companies aim to maintain and increase their wealth by offering advice on investment strategies, tax planning, and estate planning. Family offices are long-term businesses based on mutual trust and dedication. From financial to lifestyle management, family offices provide various services based on truthful communication internally. Family offices were established as single-family offices at first focusing on one specific wealthy family but as the demand increased for these businesses, family offices started to operate as multi-family offices which render services to various families. Some family offices may choose to invest in SPACs as a business plan, but family offices are private organizations providing financial management for a particular family whereas SPACs are firms with shares that may be bought by anybody on a stock exchange.
The idea of family offices backing SPACs became more familiar as SPACs boomed in the last couple of years. Since family offices are more flexible with their investments and their capital, they could be an effective source of capital and network for SPACs. Moreover, family offices are interested in investing in SPACs because of the arbitrage opportunity. The public exchange of SPACs has also decreased. This has led to numerous SPAC shares trading below the regularly established trust value of $10 and the accrued interest. Because SPAC investors have the option to redeem their shares for their fair trust value when there is no agreement or if they decide not to stay engaged in the deal, this has generated an arbitrage opportunity for investors, particularly family offices.
