February 2, 2022
Special Purpose Acquisition Companies have been on the rise in the last few years. Despite experiencing some waning in popularity lately, it seems that these vehicles are here to stay. But do they offer a viable path to exit for venture-backed companies?
Special Purpose Acquisition Companies, or SPACs, have taken the world by storm in the last few years, particularly in the U.S. and especially since 2020, contributing to the explosions of IPOs in the most unprecedented year in financial markets. Last year, these shell companies, which are created with the objective of going public and then subsequently merging with an existing operating private company, accounted for more than 50% of new publicly listed U.S. companies, according to NASDAQ data. In 2007, the last peak of SPAC IPO volumes, they represented around 14% of the new listings. The popularity of these vehicles is explained by many factors, notably highly valued sponsor teams, a unique investment structure that allows target companies to list without facing the uncertainties of a traditional IPO – an important factor during the pandemic – with a lower cost. This has led to astonishing figures: in 2020 there were globally 248 new SPACs listings for a record $83.4 billion in proceeds, from only 59 listings in the previous year, according to the SPAC-tracking company SPACinsider. While only 21 SPAC-related mergers were consummated in 2018 and 22 in 2019, this ballooned to 115 completed or announced SPAC mergers in 2020, according to EY. The first quarter of 2021 was also dominated by special purpose acquisition company IPOs, with 294 new SPACs pricing IPOs for $95.7 billion in proceeds, 21 mergers completed and another 116 announced. Then, EY notes, “Traditional IPOs stepped back into the spotlight in Q2 helped by a number of factors including ample liquidity in the financial systems and strong global equity market performance among others.” Still, these peculiar vehicles continue to make headlines: DWAC jumped 800% after announcing that it would acquire Trump Media & Technology Group, which plans to launch a social media platform with the former U.S. president.
Anatomy of a SPAC
A SPAC is a shell company, which IPOs to become publicly-traded on an exchange, without any business operations, with the sole purpose of then acquiring a private company (known as a de-SPAC transaction), generally to occur within two years (otherwise the proceeds must be returned to investors), thereby serving to take the target company public. This unique investment structure offers the target company some advantages, i.e. avoiding the typical uncertainties and regulatory burdens of an IPO, and benefiting from a much shorter process timeline. But there are also interesting advantages for investors: when a sponsor group takes a company in a SPAC, they do not offer shares, but units, typically including shares and warrants, and sometimes certain rights, mitigating the risk if the team selects a poor target. While SPACs have been gaining massive attention for the past two years, the concept has been around since the ’90s. Originally, referred to as “blank check companies,” looked at unfavourably and with suspicion, and structured by virtually unknown niche underwriters, the path to mainstream legitimacy dawned with the commencement of SPAC IPOs underwritten by bulge bracket investment banks, beginning with Deutsche Bank’s lead of a SPAC IPO in 2005, as other major banks soon followed suit.
And in the past few years, prominent investors (spanning PE, VC and hedge funds) and industry executives have entered the fray and formed SPACs, which has fueled the recent boom. Notable sponsors include renowned hedge fund manager Bill Ackman, former Credit Suisse CEO Tidjane Thiam, and former Vice Chairman of Citi Michael Klein. But the SPAC frenzy has also been charming people outside the financial community: many celebrities have even gotten into the game, including athletes Shaquille O’Neal, Steph Curry and Serena Williams, musicians Jay-Z and Ciara, among others.
The three stakeholders in a SPAC transaction: sponsors, investors, and the target company
SPACs are formed and promoted by “sponsors,” typically a group of individuals with a notable track record of investing in or serving as industry executives in particular sectors, who then seek to source and complete an acquisition of a private company once the IPO of the SPAC is completed, receiving 20% of the common equity of the SPAC as founders shares (typically referred to as the “promote”), for performing this role. Such economics are highly attractive for the sponsors, and are achieved at the outset, regardless of the quality of the ultimate target or its performance as a publicly-listed company. Among the top SPACs under the spotlight in this regard, specialised media mention Bill Ackman’s Pershing Square Tontine Capital; Michael Klein’s Churchill Capital; KKR Acquisition Holdings I Corp, guided by CEO Glenn Murphy; Niccolò de Masi’s dMYM; 7GC & Co Holdings, a partnership between 7GC, a VC fund, and serial SPAC issuer Hennessy Capital Investment; Peter Thiel’s Bridgetown Holdings, Robert Nardelli’s Accelerate Acquisition; and many others. From the standpoint of the target company, a SPAC serves to fast-track a company’s timeline to go public, and in comparison with a traditional IPO the related process is less costly, provides valuation clarity at the beginning of the process (rather than towards the end), receives less regulatory scrutiny (since the SPAC is already listed), can generate higher valuations, and serves as an alternative source of growth capital. Also less established companies can list through this alternative path, although more attractive, notable sponsor groups are garnering the attention of more attractive private companies as potential targets. However, the companies which are going public through a SPAC must be prepared for the responsibilities associated with being a publicly-listed company given the accelerated timeline and their potentially limited capabilities. Further, investors in the private companies, including founders, must also factor in the dilution associated with the promote equity for sponsors. For ordinary investors, SPACs represent access to startups and a VC/PE-like alternative investment class which they traditionally may not have had access to, with the opportunity to redeem their shares if they are not supportive of the eventual target company, while still earning interest and the ability to hold onto the warrant component. This scheme also represents an exit opportunity for the investors of VC-backed companies. Taking a look at investors’ statements, in recent times Menlo Ventures exited the pet care company Rover when the startup went public on the NASDAQ via the SPAC merger with Nebula Caravel Acquisition. Tusk Ventures exited the smart lock company Latch, which merged with TS Innovation Acquisitions Corp. Bill Gates’ Breakthrough Energy Ventures exited Quantumscape, which was purchased by SPAC Kensington Capital Acquisition.
The SPAC market has been losing steam
According to FactSet data, during the first quarter of 2021, “SPACs made up 68.5% of all IPOs, . Then the bonanza started slowing down; the second quarter saw almost a 90% decline in issuance from the first three months, for a number of reasons, including a harder regulatory stance on the investment scheme, investors pausing to digest the glut of SPACs and disappointing share price performances,” said EY in a report. On the regulatory front, the Securities and Exchange Commission issued new guidelines for accounting practices, challenging the accounting for the warrants, and is also considering rules relating to restricting the safe harbour protections for forward-looking statements granted to SPACs in their merger filings. If that safe harbour is removed, companies could be held liable if they are unable to meet their financial guidance issues during the M&A process.
The SEC is currently investigating a number of other SPAC deals, including Clover Health and Draftkings. Several electric vehicles companies, such as Lordstown Motors and Nikola also fell under regulatory scrutiny. On top of that, there was a worrying increase of class actions: shareholder lawsuits against post-merger SPACs rose to 15 through the first half of 2021, CNBC says. According to the strategist team at Goldman Sachs led by David Kostin, SPACs have been simply delivering modest returns lately. In the third quarter, “An average of six SPAC IPOs have raised $1.2 billion in total capital each week,” the Goldman strategists wrote in a report. A better result than the one reached by the four SPAC IPOs completed in the second quarter, but much less than the results in the first quarter. “Lower real rates appear to have provided a renewed tailwind to SPAC issuance,” but the regulatory and legal worries “continue to cloud the issuance outlook.”
On top of that, the boom in SPAC issuance has created a hypertrophic market, with more and more players looking for less and less suitable acquisition candidates.
SPACs are here to stay
Despite losing steam, SPACs are here to stay. While the lion’s share of the market for SPAC listings so far was in the U.S., even for European companies, the most recent dynamics are showing a promising growth in the Old Continent. A Freshfields report published in September observes that “the SPAC market in Europe has continued to grow, with nearly 30 SPACs listed so far in 2021. Euronext Amsterdam has been taking the lead with over 40% of the European SPAC listings, along with three on the Frankfurt Stock Exchange. In London, the Financial Conduct Authority has published its final policy statement in relation to the SPAC regime, which came into force on 10 August and looks set to encourage SPAC listings in London, with several in preparation and more being discussed”. For Venture Capital investors, SPACs remain an interesting alternative to exit an investment. It is essential to be selective, as recently stated by Bill Gates, but there is evidence of several advantages in exiting through a SPAC merger: more flexibility, as it allows negotiating with sponsors for a customised exit, and less exposure to public scrutiny than ordinary IPOs. Valuations are usually higher, and less impacted by market timing and volatility, which represent a bigger risk in traditional listings.
The negative factors impacting recent SPAC performance might work as a wake-up call for the sector in adjusting to more transparent and investor-friendly practices. Some SPAC sponsors are already offering more investor-friendly terms, such as Bill Ackman’s SPAC, utilising a structure without management fees and incentive fees. Other players are tying lock-up periods of sponsor shares to higher stock price thresholds, better aligning incentives. Sponsor fees in some instances are already starting to come down, with greater incentive-based upside tied to business performance, rather than upfront equity ownership. Alignment of long-term shared incentives seems critical: well-negotiated valuations for acquisition targets, and longer-term incentive horizon for sponsors, would allow sponsors, investors and the target companies to all win together, and for higher-quality target companies to be chosen.
In this context, some SPACs probably end up failing, others may not find targets before having to return proceeds to investors. There might be a Schumpeterian creative destruction, leading to a stronger market.
While the future of the SPAC phenomenon, and its longer-term impact on financial markets, and PE/VC is as yet unclear, one of the likely scenarios is ultimately fewer but better SPAC deals, driven by better-aligned incentives for SPAC sponsors, higher-quality sponsors and targets, combined with heightened regulatory oversight.