SPACs – A More Efficient Way to IPO

SPAC – Key Points

IPOs of blank check companies or SPACs have been surging since last couple of years. In 2019, 59 special purpose acquisition companies raised $13.6 billion via IPO with the intent to acquire promising private companies in a set time period – typically 24 months. In the seven COVID infected months in 2020, out of roughly 100 IPOs, nearly 64 have been SPACs raising over $22 billion. The high level of uncertainty and volatility in the equity markets is quite likely the catalyst. Against this backdrop, SPACs, as a way of going public, has found ready acceptance among the entire startup ecosystem including the VCs and PEs, private companies, and investment banks. Additionally, SPACs have allowed retail public investors to invest in the high growth private companies. It essentially makes the entire IPO process more streamlined with key advantages including (1) abbreviated time to market, (2) transparent and upfront pricing, (3) hand-holding by vastly experienced managers, (4) SPAC and the sponsor stand to benefit from the success of the target company, and (5) downside protection for the investors.

Tailwind for SPACs

Increasingly companies have been exploring alternative ways to go public – reverse merger, direct listing, and now the surge in SPACs.  IPOs in comparison, despite its history and all its glamour have proved to be one the most long drawn and expensive way to go public.

The biggest advantage of SPACs is the abbreviated time to IPO. From 6 months to close to a year for a traditional IPO, whereas the time for a target private company to get listed via a SAPC is 3 to 4 months as much of the leg work involved in an IPO has already been done by the SPAC.  Primarily, this comes from far less scrutiny of financials by SEC as well as analysts at investment banks. WeWork possibly would have been publicly trading had it let itself get acquired by a SPAC.

Secondly, SPAC merges with the company its taking public. Accordingly, the deal is essentially an M&A transaction with the price negotiated between the target, the sponsor, and PIPE investors. It’s a hard negotiation based on target company’s valuation and market standing but the pricing is transparent and upfront while the entire pricing mechanism in traditional IPOs are quite arbitrary and highly subjective.

Additionally, compared to a PE deal, merging with a SPAC can add up to 20% to the sale price as SPAC sponsors interests get tied with that of the company they are acquiring. Sponsors would be more inclined to create value by acquiring the company at a fair price and then working with it to increase its value. Furthermore, first time entrepreneurs stand to benefit from the vastly experienced managers who have often led giant MNCs for years such as David Cote – CEO of Honeywell International from 2002 until 2017. Chamath Palihapitiya, for instance, became Chairperson of Virgin Galactic and is guiding the company with his experience.

Furthermore, de-SPAC transactions are not dependent upon market demand. For a SPAC the demand for an acquisition is already there with funds in the trust and accordingly tend to do well in uncertain and volatile markets as evident in the first half of 2020. In IPOs, however, market timing can make or break the IPO.

Figure 1: SPAC Lifecycle

Source: Gunderson Dettmer

 “There are trade-offs to every approach to the market. We’ve seen a lot of IPOs with arguably inefficient pricing and some huge [opening day] pops. That has piqued a lot more operating companies’ interest in exploring whether combining with a SPAC is a better route for them.” – John Tuttle, Vice Chairman and Chief Commercial Officer, NYSE

While in IPOs the banks are in a consulting role for the private company, in a SPAC a sponsor, typically a VC or a seasoned executive, work towards a common end with the company as both become one entity post the merger. Additionally, sponsors also hold stock options or warrants in the target and stand to benefit if the company does well. This ensures that the SPAC sponsors try their best to find the right company for merger and post-merger work with them to ensure higher returns on their investment. Furthermore, to better align interest SPAC sponsors have typically one year lock-up period and also push holders of target companies to have a similar lockup.

Arguably, SPACs have their well disguised fee structure, including 20% sponsor promote. However, that is on the original SPAC raise whereas de-SPAC transaction adds more equity leverage in the form of PIPE investments. PIPE to SPAC funds are typically in 3:1 or 4:1 ratio which could lead to $300 million SPAC generating a $900 million to $1.2 billion total transaction size. This effectively lowers the fees to 5% to 6% which is slightly lower than the up to 7% IPO fee. Recently, with bigger sized deals, many SPACs have done with the sponsor promote to make SPACs more lucrative for start-ups. Pershing Square Tontine Holdings, Bill Ackman’s SPAC, does not have a 20% sponsor promote.

Accordingly, private companies seem to be favoring SPACs as a less onerous, quicker, and more economical way to go public. Nikola for instance announced in the first week of March and went public on June 4, 2020.

“Once we had locked in the PIPE investors and looked at the market volatility and COVID concerns in late February, it became clear to us at that point that having certainty, a strong valuation, and the ability to get the transaction done by June was very attractive compared to the IPO path” – Kim Brady, Nikola CFO.

Figure 2: SPACs – Key Advantages

Note: (1) From LOI to closing (2) From initial prospectus drafting to close of IPO

Source: Bridge Point Capital

SPACs also provide retail investors far greater access to the capital markets than IPOs, which are more skewed toward institutional investors. With SPACs retail investors are able to get in early in promising private companies, which enhances the potential for higher returns while shielding them from the high risk associated with investing in private companies.

SPACs have come up as an attractive option for conservative investors with upside potential. For investors, SPAC usually offers higher returns than treasury bills while according the convenience and flexibility of redeeming the funds if the target is not to their liking. In IPOs whereas the investors don’t have the luxury of opting out at the last moment. No midway, it’s either in or out for investors.  

While, they may not seem very attractive when the equity market is performing well, however, in times of high volatility and market crashes such as the current crises, SPACs have emerged as a viable option. More importantly, with safety and relatively higher yields than other conservative investment options, SPACs also offer the possibility of higher returns quite comparable to traditional IPO market. If the company does well, investors also have the option of redeeming the warrants in lieu of stocks.

Figure 3: Traditional IPO vs. SPAC IPO Performance

Note: Annually from 2014 to 1H2020

Source: Bloomberg Law, as of July 7, 2020

On the downside, if the SPAC fails to identify a target, or the target is not appealing, or the deals fails to materialize, investors who have paid premiums could face substantial loss.

SPACs – Creating Demand

A major and crucial advantage a SPAC has is that it is demand independent. It is a complete reversal of the traditional IPO and acquisition process that starts with a private company seeking to go public or getting acquired. While, in both an IPO and an M&A a firm approaches an investment bank, in a SPAC a sponsor with a seasoned management executive creates demand with a SPAC IPO and with the demand locked in a trust, they search for a target to complete the process with an acquisition deal. With direct and active involvement of investment banks, PEs, and VCs in first getting public investor nod with IPO and then seeking private companies in the relevant sector, SPACs are expected to surge higher. Credit Suisse, for instance has underwritten three SPACs led by Chamath Palihapitiya. Chinh Chu, a senior Blackstone Director, has combined with Neuberger Berman to launch four SPACs including two in 2020. Goldman Sachs has been launching its own SPACs with $700 million raised in its second SPAC in June 2020.

With COVID crises and economic downturn private company valuations have come down. As they look to raise funds to ride out the crises, SPACs with greater certainty of proceeds at an early stage appeal to many private companies.

“You can also sit down with potential owners of your stock, give them a multiyear forecast, and talk about how you want to build the company over the next five to 10 years. And the founder gets enormous flexibility in designing their board, lockups, and more. All of these things will create an enormous market for SPACs as the primary vehicle that tech companies [should] use to go public.” —Chamath Palihapitiya

The appeal of cash with the temptation of going public guided by an experienced management team and a sponsor whose interest aligns with target performance will be a huge boost for the startup ecosystem in the U.S. and accordingly, SPAC’s going forward will take an increasing share of the IPO market.