SPACs – What’s the hype? | Poshaan Daryanani
In the previous article, titled Introduction to IPOs, we explained how IPOs work. But did you know that apart from IPOs, there is another way for companies to go public? In fact, Special Purpose Acquisition Companies (SPACs) have increasingly become the chosen method of going public.
Major companies that have merged with SPACs include electric car manufacturer Fisker, Richard Branson’s space tourism company Virgin Galactic, and online casino company Golden Nugget Online Gaming. Apart from the fact that it is difficult to conduct IPO roadshows amidst the Covid-19 pandemic, the recent hype surrounding SPACs can also be attributed to a low-interest rate environment which has resulted in a lot of liquidity.
Given that this trend is expected to continue where SPACs listings in the U.S. continue to outpace traditional IPOs, it is worthwhile to explore how they work and crucially, why SPACs are one of the hottest trends on Wall Street at the moment.
How does a SPAC work?
Photo Credits: Nasdaq
SPAC is Wall Street jargon for a publicly traded investment vehicle that holds nothing but cash. Also known as blank-check companies, SPACs exist to buy private companies and effectively take them public while avoiding the pitfalls of a traditional initial public offering (IPO). Typically, SPACs are founded by a small group of individuals or an entity affiliated with an asset manager such as Blackstone, TPG, or Goldman Sachs.
When the SPAC IPOs at $10 per share, the cash raised is put into a trust while the management of the SPAC searches for acquisition targets. Generally, management has two years to find a target. If no acquisition is made in the allotted time, the trust is unwound, and money is returned to investors. If a SPAC identifies an acquisition target and a deal is complete, the SPAC will cease to exist, and the combined company will trade under a new ticker.
Why SPACs are the new IPO
Ever wondered why popular companies such as EV truck start-up Nikola, sports-betting firm DraftKings and rare-earth minerals producer MP Materials Corp. all went public through SPACs? In our humble opinion, there are 3 main reasons why they joined the growing wave of companies that prefer SPACs, even though IPOs are the cheaper alternative.
1. Lower Risk Profile
Compared to an IPO, a SPAC poses a lower risk for the company: You sign a deal with one person (the SPAC sponsor) for a fixed amount of money (cash in the SPAC trust). With an IPO, however, there is greater unpredictability as the amount of money you raise is highly dependent on whether the mass public will buy your stock. Essentially, you announce the deal before negotiating the price and you hope that your marketing raises sufficient demand for your shares. Therefore, there is a shift toward one-on-one deals rather than one-to-many capital raises as companies value certainty and with SPACs, the outcome (amount of capital raised) is known before the company goes public.
2. Faster Capital-Raising Process
Another compelling explanation for the SPAC boom is that a typical SPAC timeline is much shorter than for traditional IPOs. This is indeed one of the reasons that influenced Grab’s decision to go public via a SPAC. Instead of choosing an IPO and spending 12 to 18 months building investor confidence by proving their business model, Grab decided to merge with Altimeter Growth Corp and went public in less than 5 months. This merger with Altimeter enabled Grab to bypass much of the IPO process as the shell company had already done the legwork of raising capital via its own IPO.
Additionally, some companies may want to take advantage of this shorter fundraising process for tactical reasons. For instance, MP Materials decided to merge with Fortress Value Acquisition, a SPAC, to ride on the increasing demand for EVs and accordingly, the demand for rare earth metals. Currently positioned as the only low-cost producer of rare earth oxides outside of China, it is an opportune time for them to raise capital right now. Hence, it makes more sense for companies like MP Materials to take advantage of a time-sensitive economic shift or a well-hyped trend and choose SPACs as the faster alternative to fundraise.
3. Lack of Scrutiny
Lastly, companies that are not established will prefer SPACs as a way of raising capital as the standards for SPACs are lower. In comparison, the high standards of an IPO mean that only established companies will likely be able to meet the stringent requirements set out by the SEC (Securities and Exchange Commission). Essentially, if Nikola had planned a normal IPO instead of merging with a SPAC, it would have to schedule it for some time after it had a working product rather than mere renderings of prototypes. In fact, many of the promising businesses, especially those in the electric-vehicle industry that merged with SPACs, did not have coherent financial forecasts or even revenues yet. In such situations, going public via SPACs is the only option as these companies need the money from blank-cheque companies to fund their capital-intensive factories and technology development.
Evidently, for a myriad of reasons, there is a fresh wave of interest in this unusual investment vehicle, but do they live up to the hype? Stay tuned for our next article, where we analyse whether SPACs should be a part of your investment portfolio!
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