What Are Special Purpose Acquisition Companies (SPACS): Are They High Risk?

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Billed as one of the most bizarre years, one thing stood out in 2020: Special Purpose Acquisition Companies SPACs. Better known as shell companies, SPACs took the market by storm as the need to raise capital inched a notch higher among private companies.

While private companies have always had ample access to capital from venture capitalists, the situation changed significantly in 2020 due to the pandemic. With COVID-19 injecting uncertainty, private companies have had to seek new ways of raising capital fast to navigate the challenging macro environment.

What Are SPACs?

SPAC’s or special purpose acquisition companies operate as alternatives to traditional Initial Public Offering. They are shell companies that hedge funds and fund managers use to take private companies public without going through the traditional IPO process.

While SPAC’s have been in operation for decades, the phenomenon appears to have gained momentum in recent months owing to the COVID-19 pandemic creating uncertainty in the IPO market. Likewise, SPAC’s have emerged as attractive offerings that allow companies to go public without contending with the traditional IPO process’s volatility.

Similarly, SPAC’s have continued to attract strong interest and demand from investors partly because of their ability to guarantee high reward investments at relatively low risk. Immediate data indicates that as much as $56 billion poured into SPAC listings in the first ten months of 2020.

How SPAC’s Work

Experienced business executives form special purpose acquisition companies. Such managers are relied upon to attract investors and raise sufficient capital to acquire a company with tremendous potential in generating long-term shareholder value.

Given that SPAC’s are merely shell companies for raising capital, the founders act as the selling point for sourcing funds from investors. In a bid to lure investors, the founders provide starting capital that allows them to align their interest with investors.

SPAC’s are formed with the sole purpose of raising investment capital through an IPO. In most cases, such business structures allow investors to contribute money, which is used to acquire one or more businesses identified after the IPO.

Any amount raised through IPO by SPAC is often held in trust until a predetermined period elapses or acquisition is made. If an acquisition is made, the investment vehicles must return the funds to the investors upon deducting all the bank and broker fees.

Issuing the IPO

SPAC’s management team contracts investment banks to handle the IPO process. The SPAC management team agrees with the investment bank on a fee to be charged for the service, normally less than 10% of the IPO proceeds.

In preparation for the IPO, a prospectus must be issued, which focuses on the SPAC’s sponsors and less on the company, given its lack of history and revenue reports. In return, the investment banks are tasked with the responsibility of selling securities during the IPO at a unit price that represents one or more shares of common stock.

All proceeds collected during the IPO are held in a trust account until an acquisition target is identified.

Acquiring Target Company

Once a special purpose company raises funds through an IPO, the management team has 18-24 months to identify a target company and complete its acquisition. However, the acquisition period may vary depending on the company and industry.

There are usually no restrictions on the type of company that a SPAC can acquire. In most cases, the management affirms the industry in which they wish to carry out an acquisition. When the management finds an acquisition target, they negotiate the acquisition focusing on price and valuation.

After deciding the acquisition terms, the sponsors must propose the acquisition target to shareholders for approval. Shareholders are accorded the opportunity to approve or reject the acquisition. Even if shareholders approve an acquisition, some shareholders can still redeem their shares if they do not like the acquisition target.

It is important to note that capital raised through SPAC’s often covers 25-35% of the purchase price. In most cases, sponsors ask existing institutional investors such as hedge funds to chip in the additional capital to complete the acquisition.

With sufficient funds in place, SPAC can now take the target company public. Even though SPAC is a public entity approved by the SCE, the target entity must independently obtain its approval from regulators.

The target company does not face fewer regulatory requirements, as is the case in the normal IPO process when going public. Instead, its process of going public is only shortened, and once approved by the regulator, the SPAC ticker changes to reflect the name of the acquired company.

Once an acquisition is complete, SPAC managers profit from their company’s stake, usually 20%. Investors, on the other hand, receive equity interest according to their capital contribution. The management team must not collect any salaries when running the SPAC until the deal is complete.

The people or companies that launch SPAC s often stand to make millions regardless of how the acquisition pans out.

Investing in SPACs

Special purpose acquisition companies provide a direct listing pathway, whereby a private company goes public by acquiring a listed company. While SPAC’s provide a path for investing in companies without contending with the rigorous IPO process, they should be approached with caution.

In most cases, SPAC’s lack of previous operations or financial data that investors can use to gauge their long-term prospects. Their track record and long-term prospects often times depends on the management team’s reputation.

The fact that most SPAC management team is led by highly reputable names such as Chamath Palihapitiya and Bill Ackman often times adds a layer of credibility.

Why Special Purpose Acquisition Companies?

Most private companies prefer the special purpose acquisition company’s process of going public as opposed to the traditional IPO for a number of reasons. Stability, speed, and strategic partnerships are some of the reasons why companies are turning to SPACs.

A SPAC process will always appeal as it avoids the price uncertainty that comes about with the traditional IPO process. While a traditional IPO process can take a year to finish, the SPAC merger process is much faster, lasting between 3 to 4 months. The strategic partnerships that target companies ink with SPAC sponsors continue to entice most private companies.

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