Explainer: What’s a SPAC and Why Do They Matter in the Financial Industry?
On a Whatsapp group, I was discussing with some people how the former darling of the US technology community, WeWork, is looking to go public through the SPAC vehicle. In 2019, it was valued to go public at $47bn before revelations of the dealings of its founder Adam Neumann became public and all went on pause. Now, it’s going through public through a SPAC at just $9bn.
The discussion was going well until someone asked us to backtrack and explain what a SPAC means. The concept of a SPAC is interesting and you never know if you will find it useful now or in the future after reading my explanation.
What is a SPAC
SPAC stands for Special Purpose Acquisitions Company. This company is a blank company. It has no existing business. No employees. No products. Sells nothing. No commercial operations. So what does it do? It is basically a shell company set up for the sole purpose of taking money from the public through an IPO. The money taken from investors is then used to purchase an existing company with operations public.
For instance, on Jan 1, 2019, a SPAC called Social Capital Hedosophia Holdings was founded. In October 2019, it merged with and took to the public Richard Branson’s Virgin Galactic, a space company developing commercial spacecrafts aiming to provide spaceflights to humans.
Why Do Companies Have to Merge with SPACs instead of Going Public Directly?
Good question. The simple answer is that it takes a lot of time for a traditional IPO to happen. It is also expensive. To take a company public through the traditional means, a company needs what is called an underwriter (which takes as much as 7% of the total proceeds from the gross IPO process). This company helps to conduct extensive research on how much should be raised, the amount of shares to be offered to the public, the investment bank to use, etc. After then, tons of regulatory paperwork are filed to get approval from the regulatory authority (SEC). Then the company goes on a roadshow to pitch their investment to the public. During this process, the price of the shares is set. As simple as this sounds, it could take as much as 24 months for this process to be completed; 6–12 months of planning and 6–9 months for the actual IPO process. It takes as long for good reason: an existing business looking to take the public’s funds should provide as much transparency as possible to the public before they invest.
But with a SPAC arrangement, the process is much shorter. The SPAC process allows a company to bypass the lengthy and more expensive procedures they would have taken if they went through the traditional process.
Because a SPAC does not have an existing business, it does not have any financial disclosures like balance sheets, cash-flow statements, income statements, etc. to make. Thus, in just 2 months, it can get a SEC clearance for an IPO. SEC however says that a SPAC only has 24 months to merge with an existing company. But a lot of SPACs already have companies they want to invest in. Once they have decided on a company, in as little as 5–6 months they can take a private company public.
A SPAC Boom…
Because of the ease of raising funds from the public, the SPAC business is booming. Though it was created by David Nussbaum in 1993, a time when blank check companies were prohibited in the US, it did not capture the attention of investors until 2003. But since last year, partly due to the uncertainty brought about by the pandemic, it is becoming the default channel through which companies solicit funds from the public. From January to March 2021, SPACS raised about $100 billion. The entire amount that was raised through SPACs last year was $83 billion. The 2020 figure was more than six times bigger than in 2019.
SPACs still lined up for 2021 include Bill Gates-backed portable ultrasound start-up Butterfly Network and DNA-testing startup 23andMe. Companies like BuzzFeed and Vice Media are also looking in this direction.
SPAC advocates have said that underwriters price IPO too low. They allow say that selling a SPAC can add up to 20% to the sale price compared to a typical equity deal.
Is SPAC good for the Investor?
Because of the wonders of technology, anyone from anywhere including in Nigeria can invest in SPACs. There are several apps that allow investments from Nigeria to other markets. And one unique feature of SPACs over the typical investment deals is that you can take your money back. Unlike when you invest in an IPO where your funds are put in a trust account to be managed separately, in a SPAC arrangement your funds are locked to be put in a merged or acquired company. When that company is chosen, investors have the right to take their funds back if they are uncertain about the direction the new company will go. If you think the SPAC you get involved in is going in a wrong direction, you can pull your funds. This is not possible in a traditional IPO.
Still the US SEC has asked the public to be careful of SPACs. Because of the ease of creating SPACs, SEC has warned investors not to base their investing decisions solely on whether a celebrity or star athlete has endorsed the product. A good example is the SPAC acquiring WeWork listing the basketballer Shaquille O’Neal as an adviser.
Another advantage of a SPAC is that when you buy into a SPAC, you almost always pay a set price of $10/share and get options to buy more shares in the future at a low price. That can be a bargain. Still, it’s a leap of faith. You are buying shares in a shell company and hedging a bet that it will merge with a desirable private firm in the future, thus boosting the share price.
It doesn’t always turn out well. Nikola Motors Co. for instance has given SPACs a bad name. It merged with a SPAC in 2020 and then had its shares spike to $66/share. Not long after, there were allegations of fraud including that it staged a video of its hydrogen fuel-cell truck driving. Critics have said that incidents of frauds like this would have been caught by regulators had the company gone through the traditional IPO. Subsequently, the stock tanked to $14.
It will take some time to know how SPACs have fared against companies that have gone the traditional IPO route. In the end though, the retail investor would have to take responsibility for whichever one they invest in.