A SPAC Odyssey 2021 | The ORO Letter #5
What's Next For SPACs?
SPACS were in a frenzy last year and at the start of this year.
Virgin Orbit and Boxed are among the current big names looking to go public with SPACs. Even celebrities like Serena Williams, Shaquille O’Neal, and Alex Rodriguez have jumped on the bandwagon.
But fervour has cooled since the start of the year as fears of inflation and hype have taken hold. A regulatory crackdown on SPAC warrants in the US has also played a part. Regardless, SPACs are here to stay and will continue to evolve. They play a unique role in capital markets. So what’s a SPAC, and what happens when it meets a security token?
The Recent Frenzy
Q1 2021 saw 304 SPAC listings worldwide, with $98.4 billion raised. As is often the case with hypes, SPACs were hot and made even hotter by celebrity and media buzz, with everyone from Jim Cramer to the SEC chiming in with their opinions.
The frenzy has settled down in Q2. So far this quarter, there have only been 50 SPACs listed for $10.9 billion.
What Is a SPAC?
SPACs allow a group of investors to pool money together in order to find and acquire a company and then take it public. For the target companies, SPACs can offer an easier path to an IPO.
SPAC stands for Special Purpose Acquisition Company. It’s a company that raises money through an IPO with the sole purpose of acquiring or merging with an existing company, except that the target company is generally not identified at the time of the IPO — this simplifies the IPO process because fewer disclosures are needed. It is also why SPACs are called “blank check” or shell companies. Although the target company is not known, a SPAC will nominate the industry or geographic region they are interested in.
SPACs were created by David Nussbaum and David Miller in 1993 as a way for private companies to gain better access to everyday investors.
Originally, the reputation of SPACs was far from great. But like that rough diamond of a boyfriend that gets a job and becomes a father, they have matured over time. Goldman Sachs now offers SPACs, and the NYSE began listing them in 2017. But you should still be careful that you don’t marry an incorrigible scoundrel! Not all sponsors are created equal.
Today, SPACs or SPAC-like creations can be found not only in the US, but also in Europe, and emerging markets from India to Hong Kong are looking for a piece of the pie.
How Does It Work?
A SPAC is formed by sponsors; a group of initial investors and a management team. Given that money is raised with no specific target company, sponsors need to have strong investment track records or a high public profile to attract other investors. This is where well-known fund managers, private equity funds, institutional investors, and even celebrities are useful.
After obtaining regulatory approval for their SPAC’s IPO, sponsors will go on a roadshow to drum up interest. They will also engage with institutional investors to help find investors and underwrite the IPO. Debt can also be issued.
Sponsors take “founders’ shares” from the IPO, usually around a 20% stake in the SPAC. Only founders’ shares can elect SPAC directors.
The other 80% are given to the remaining investors in the form of units made up of a share and warrants. A warrant is a contract that allows the holder to buy a set amount of common stock in the final company at a set price. It is a little something extra to pique the interest of potential investors.
By convention, SPAC units are typically priced at $10 or €10 per unit. A SPAC’s price changes little until a target company is acquired — up until that point, a SPAC has no underlying business that can be valued.
After the IPO, the funds are placed in a trust account (escrow) minus certain fees and expenses. Interest from the trust account is sometimes put towards the SPAC’s operations or can also be used to pay taxes. The principal can only be for acquisition and redemptions.
Blank checks don’t last forever, and SPACs are no different. Sponsors set a deadline of around 18 to 24 months to find and acquire a target company.
If a company is not found before the deadline, the SPAC is liquidated and the funds in the trust account will be returned pro-rata to the shareholders.
If a company is found, SPAC shareholders vote on the proposed acquisition. If approved, SPAC shareholders swap their SPAC shares for shares in the acquired company. They also have the option of cashing out their SPAC shares plus interest accrued if they do not want shares in the acquired company.
SPACs acquire a target company through a merger, also called a reverse merger or de-SPACing. The target company is merged with and into the SPAC or a subsidiary of the SPAC. The shareholders of the target company typically receive cash and shares in the newly merged entity.
SPACs often need extra money to acquire a target, so they typically issue new shares to institutional investors, which are called Private Investment in Public Equity deals (PIPE). Such deals are often controversial because of the favourable terms given to institutional investors.
When a company is acquired, the SPAC lists on a stock exchange.
Advantages
Sponsors benefit from the flexibility of a SPAC. They can raise capital off their reputations and then invest in areas they are experts or interested in. They also tend to get a nice premium with their founders’ shares.
SPAC investors benefit from being able to invest in an attractive target company at an early stage. They also benefit from the expertise and connections of the sponsors.
SPACs also provide investors with some assurance because of their standardized framework and established track record. Their structure and operation are a known quantity.
The target company benefits because a de-SPACing is faster and less onerous than a traditional IPO. A traditional IPO takes around six months and faces a higher degree of disclosure and scrutiny. A de-SPACing can be completed in a few months, without a prospectus or roadshow.
A de-SPACing is also less exposed to market volatility, which can lead to big swings in the potential listing price of an IPO.
Disadvantages
Many of the disadvantages lay with regular investors.
Sponsors still wield enormous power. In the early days, investors had to pray and hope that the sponsors would deliver. While regulations and time have matured SPACs, they remain riskier than investing directly into a known stock. The SPAC process can also take away from the relationship between a company and its initial shareholders. The shareholders were delivered rather than engaged with. As the EU shareholders right directive says:
“Shares of listed companies are often held through complex chains of intermediaries which render the exercise of shareholder rights more difficult and may act as an obstacle to shareholder engagement.”
Liquidity is an issue for investors. They face the opportunity cost of locking their money up with a SPAC for up to two years. In a low-interest-rate environment, this cost is lower than otherwise, but a lot can happen in two years, and SPAC investors may have to forego many other investment opportunities.
Many, including former Goldman Sachs CEO Lloyd Blankfein, argue that SPACs are less transparent and rigorous than a traditional IPO. As mentioned above, this is a bonus for the target company — but a disadvantage to investors.
There is evidence that sponsors tend to overpay for target companies. They can be more worried about completing a deal before the deadline than getting the best possible deal.
Sponsors often give too favorable a deal to institutional investors at the PIPE stage. Investors know it is coming but just don’t know how bad it will be.
Some New Twists
Hedge fund guru Bill Ackman’s created a giant SPAC last year when he raised $4 billion for “Pershing Square Tontine Holdings” (PSTH).
He has also shown a few new twists on the normal SPAC playbook. Normally, a SPAC will acquire a single company. They can acquire multiple companies but this quickly gets complicated.
In early June, PSTH announced a complex three-part transaction. PSTH bought a 10% stake in Universal Music Group — hello Taylor Swift! It also created a new vehicle called a Special Purpose Acquisition Rights Company (SPARC) and kept the remaining funds in the original SPAC.
At this stage, Ackman’s SPAC may reflect the enormous amount of capital he raised rather than a new evolution in SPACs, but time will tell.
SPAC 3.0: The Next Generation
One area that does promise to revolutionize SPACs is security tokens. Welcome to the world of Tokenized SPACs, or ToSPACs.
As in the case of traditional IPOs, security tokens can offer SPACs increased transparency and reduced costs.
All the details and conditions of a SPAC can be stored on a blockchain and programmed onto a token. No sponsor or third party service provider is needed to interpret or enforce conditions. It is completely transparent. This can help eliminate unwanted future surprises for investors.
The greater transparency and cost efficiency also has the potential to unlock more innovative approaches to a wider range of investors and target companies.
Just like smaller companies are increasingly interested in STOs, will we see the growth in mini SPACs that acquire smaller companies?
This future may be coming soon. We believe that existing STO-friendly frameworks in Luxembourg could also be used for ToSPACS. All we need is that first pioneer.
Final Thoughts
As security tokens continue to prove their worth in the security space, it is no surprise that their many advantages will be extended to other areas in finance. The SPAC frenzy may have cooled since the start of the year, but security tokens promise an even more dynamic future for SPACs.