2/23/2021: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Special Purpose Acquisition Vehicles (SPACs), lately have become a popular way for private companies to go public. Also known as “blank-check” companies, SPACs enable sponsors to raise capital through an IPO for an undisclosed and often unknown acquisition. Once an acquired unlisted company is announced, the SPAC raises more capital in the public market to complete the acquisition. Over the last 12 months, SPACs have raised $120 billion, according to Bloomberg. In fact, SPACs have already surpassed $70 billion in 2021. Virgin Galactic, DraftKings and Nikola Motor all were acquired by a blank-check companies.
A group of investors, including the SPAC sponsor, float a shell company to bring it public and raise a pot of cash. Once public, the sponsor hunts for a private target firm and offers to merge with it, raising a second round of financing from smaller investors. In the end, the target company’s shareholders own slightly more than half of the combined entity with the SPAC sponsor and shareholders owning slightly less than half.
The SPAC boom is motivated by several factors. First, it’s an easier and often cheaper way for private firms to go public. A private company going public via a SPAC has a few advantages over a traditional IPO. Private companies can go public on a faster timeline and there’s more certainty around a company’s valuation and equity capital raised. Cost is also a factor. Investment bankers often charge between five and seven per cent of the transaction value in traditional IPOs. Moreover, bankers are often accused of setting IPO prices artificially low to pass undervalued securities to their clients at the expense of founders and early backers. Another factor motivating the SPAC trend is that sponsors receive “promoter” shares, which equate to about eight per cent of the post-merger equity. That’s sizable enough to make a good return even if the merged firm’s shares sink after going public. Additionally, early backers – often hedge funds, private equity firms and other sophisticated investors – receive warrants as an added incentive to their investment which they can execute once a deal is announced. Beside the benefit of an equity kicker, early SPAC investors can redeem their original investment once the deal is announced, essentially playing with house money. While the feature was intended to protect shareholders, it provides early investors with an attractive investment payoff, giving them a “free look” at the proposed transaction. While SPAC sponsors aren’t required to acquire a target firm, if after two years they don’t make an acquisition, they must return all invested capital to shareholders and pay the interim operating expenses. That disincentive creates a ticking two-year shot clock that could push sponsors to acquire anything, regardless of the investment opportunity.
While SPAC growth is making headlines now, these instruments have been around for a few decades. Like any new offering, early investors garner more benefits than latecomers. Being an early investor brings the potential for big payoffs. SPACs are structured to deliver favorable terms that guarantee a modest, yet predictable, payoff no matter what happens. Early investors have little downside, given their ability to redeem their original investment at cost. Yet they are also granted warrants in the target company, enabling them to participate in the upside. Later investors don’t receive those benefits.
Considered poor man’s private equity because acquisition targets are selected from a universe of private companies, SPACs in general are not as safe, nor as rewarding, as directly investing in private companies. SPAC sponsors vary in expertise and the incentives offered to early investors are stacked against those who invest later. Warrants, when exercised, can dilute later shareholders’ interests. Moreover, since sponsors don’t owe a fiduciary duty to the investors in the takeover target, as they would in a traditional IPO, they can make optimistic projections and grand claims when pitching an announced deal to investors that traditional IPO companies are restricted from doing.
According to a Wall Street Journal report from last August, of the completed mergers since the start of 2015, SPACs delivered an average loss of 18.8 per cent, compared to a 37.2 per cent gain for conventional IPOs over the same period. Professors Michael Klausner of Stanford University and Michael Ohlrogge of New York University claim in their recent paper, “A Sober Look at SPACs”, that SPACs deliver far worse returns than traditional IPOs. Companies that went public through SPACs fell in value by an average of three per cent after three months, 12 per cent after six months and by more than one-third a year later. They lagged the universe of companies who come to market via traditional IPO. The quality of the sponsor was a critical ingredient in a SPAC’s success. SPACs with high-quality sponsors consistently outperformed non-high quality in the marketplace, according to their research. The IPOX SPAC Index, which tracks the performance of a broad universe of special purpose acquisition companies, paints a more optimistic picture. This index has performed in line with the Russell 2000 Index of small companies since the beginning of Q4/20, albeit with slightly higher volatility.
Our bottom line is that SPACs are great investments for investors who partner with quality sponsors. The experience and gravitas of the individual operating the SPAC is undoubtedly the biggest factor in determining SPAC success. The second most important factor is timing. Get in on the ground floor. Early investors reap substantially higher benefits than those who pile into the SPAC once the target company is announced. Successful SPAC investing follows the old Wall Street adage “it’s not what you know, but who you know” – this is truly what makes the difference. We at Cresset are on the lookout for compelling SPAC investment opportunities to partner with great sponsors.
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