What You Should Know About Special Purpose Acquisition Companies (SPACs)?

It’s very likely that in the past few months you have seen a headline about SPACs, but what exactly is a SPAC?

SPAC stands for special purpose acquisition company. Special purpose acquisition companies have historically been known as blank check companies.

Special purpose acquisition companies have no commercial operations and are formed essentially as shell companies just to raise capital through an initial public offering (IPO) with the purpose of acquiring another company.

The SPAC craze has taken over Wall Street in recent months, with many companies opting to go public this way. As mentioned, after they go public, they look for other private companies to buy.

This process makes those private companies public without requiring that they go through the traditional initial public offering process involving roadshows to gain investor support and attention from the media. The total number of SPAC deals completed in 2020 increased by 400% as compared to the previous year and in 2021 they are increasing at an even faster rate.

Special Purpose Acquisition Companies (SPACs) By The Numbers

Historically, special purpose acquisition companies (SPACs) have been seen as bad for investors, but good for sponsors in terms of their returns. In just the month of January of this year, special purpose acquisition companies raised around $26 billion which is almost one-third of the $83 billion they raised in all of 2020.

This year it seems like everyone is involved in sponsoring or setting up special purpose acquisition companies, including celebrities like former NBA star Shaquille O'Neal. Some people, though, are not convinced that the exponential growth is here to stay.

Are SPACs A Bubble?

Some people have started to sound the alarm, saying that SPACs are a bubble that is likely to burst soon. Even David Solomon, Chief Executive of Goldman Sachs, which serves as an underwriter on several SPACs deals, stated that the boom in special purpose acquisition companies, and the money they have been raising, is not sustainable.

News Media And Regulations

News media representations of special purpose acquisition companies are often negative and there is regular concern expressed among financial experts that there needs to be more regulation with regard to SPACs.

A 2020 study found that most SPACs share prices fall after the merger. There have been a number of successful special purpose acquisition companies though, like sports betting firm DraftKings.

The rules and regulations that do exist for SPACs generally require that they identify the firms that they could possibly merge with within 24 months after their IPO or the IPO funds need to be returned to investors. This is often not as simple of a task as it seems initially. There are a few hundred SPACs that need to complete this process this year if they want to avoid returning the funds they raised.

The Future Of SPACs And Other Thoughts

Special Purpose Acquisition Companies are unlikely to disappear anytime soon, especially considering their current popularity. If set up by skilled individuals with the intention of acquiring a specific company in a specific industry, SPACs can be a great way to be able to be ready for the right opportunity. In essence, if a SPAC is already aware of the private company that they wish to acquire, the SPAC system can be useful.

The problem arises when speculation drives the value of the SPAC up past the future opportunity for appreciation through acquisition. The incentives can get misaligned between the SPAC sponsor and SPAC investors as the SPAC promoter’s profits come not only from appreciation after a company is acquired, but also indirectly from the SPAC investors’ initial investments. There are a number of other misalignment concerns that have been raised.

The Pros And Cons Of SPACs And Traditional IPOs

Like the other options for taking a company public, SPACs have pros and cons. The traditional IPO process is also not a great process.

In the traditional IPO process, there are high fees, it takes a long time and requires a lot of effort, there are many steps, and the investment bankers often underprice the IPO because their incentives are misaligned with the companies that are going public.

Pros of SPACs

  • Time: Unlike the average 2-3 year process of a traditional IPO from start to finish, SPACs only take 3-4 months.

  • Additional Profit Opportunities: SPACs have the potential to be good for large investors like banks because there are additional profit opportunities available after the target company has been identified. Investors can purchase additional shares at a discount.

  • Costs & Conflict of Interest: They avoid some of the costs and conflicts of interest inherent in traditional IPOs

Source: CBInsights

Cons of SPACs

  • Risk: They can have a lot of risk for retail investors.

  • Time Constraints: There are time constraints in the SPAC process.

  • Misaligned Incentives: The team responsible for creating the SPAC and taking it public (the sponsor) can make a great deal of money even if the acquired company doesn’t do well after it has gone public, so misalignments with investors can be significant.

Special Purpose Acquisition Companies And The SEC

The SEC has recently opened an inquiry into SPACs and sent letters to Wall Street banks looking for information on their SPACs dealings. They are specifically looking for information on how underwriters are managing the risks involved in SPACs.

Supposedly the letters were sent from the SEC’s enforcement division, signaling that they may be a precursor to a formal investigation. It is suspected that the SEC wanted information on SPAC deal fees, volumes, and what controls banks have in place to police the deals internally. According to one source, they also asked questions regarding compliance, reporting, and internal controls.

Another Option For Going Public

Now that you know what SPACs are as well as some pros and cons of SPACs and traditional IPOs, you should understand the third option for going public: a direct listing.

Direct listings have been gaining in popularity recently as well. Recent changes to the regulations for direct listings have made them an even more popular way to go public. In a direct listing, no new shares are created and only existing shares are sold. Also, there are no underwriters involved in a direct listing.

After the recent changes were made to the regulations for direct listings, well-known venture capitalist Bill Gurley said on CNBC:

“I can’t imagine, in my mind, when you can do a primary offering through a direct listing, why any board or CEO or founder would choose to go through this archaic process that has resulted in massive one-day wealth transfers straight from founders, employees and investors to the buy side.”

Choosing the way to take a company public depends on a variety of factors, as well as weighing the pros and cons of each option. So, if you were going to take a company public, which do you think you would choose; a SPAC, traditional IPO, or direct listing? Which do you think is best for you as an investor?

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