SPACs Are Hot, But What Are They?

Despite the pandemic, 2020 has been an exceptional year for initial public offerings (IPOs). Thus far, 471 IPOs have been launched – more than double the amount listed in 2019 [1]. However, IPOs are not the only way for companies to go public. The use of a Special Purpose Acquisition Company (SPAC), otherwise known as a blank cheque company, has resurged in popularity, becoming a cornerstone in the 2020 M&A and IPO markets. Thus far in 2020, 243 SPAC IPOs were listed, comprising 1 of every 5 dollars raised in IPOs, with Goldman Sachs reporting that SPACs could drive up to $300 billion in M&A activity over the next two years [2, 3, 4]. It is clear that SPACs are once again becoming important, but what are they? This article will walk through how SPACs function, their history, and some notable examples from their monstrous 2020 season.

SPAC Fundamentals

At their core, SPACs function as shell corporations whose sole purpose is to acquire a target company and take them public without going through the traditional IPO process. To do this, a SPAC must first go through its own IPO process, before later acquiring the target company and taking it public. During the SPAC’s IPO, investors buy common shares with warrants (the right) to buy more, but the acquisition target has often not been specified by that point. To account for this ambiguity, SPACs set a liquidation window, which gives them a set period of time to acquire or merge with a target company or they will dissolve, with the IPO trust funds being returned to shareholders.

Although SPACs often do not specify their acquisition targets during their IPO, they also lack free reign to acquire any company. In their registration with the SEC under Form S-1, SPACs often provide prospective industries to target in addition to their financial information; however, some SPACs do not set prospective criteria. Additionally, The target company’s fair value at acquisition must be greater than or equal to 80% of the SPAC’s net assets. Shareholders also have voting rights to approve or deny the acquisition of the target company once specified. These checks ensure that SPACs cannot raise large amounts of capital while only spending a small fraction of the funds, retaining the rest and cheating shareholders out of returns.

Once a SPAC has undergone its IPO, it must identify a target company before the end of its liquidation window. Once a target has been identified and a prospective acquisition agreement is constructed, the SPAC must disclose the audited financials of the target firm and the terms of the merger to shareholders. If the SPAC’s shareholders approve the merger, the process is very similar to a reverse merger. Essentially, the SPAC, which is already public, buys a controlling stake in the private company, taking the new operating company public without the lengthy IPO process.

SPACs vs IPOs

As discussed, SPACs bypass the lengthy IPO process for private companies. Many investors also favor SPACs because they avoid some of the key pitfalls of IPOs: share underpricing and high bank fees. Many owners complain that underwriters (the banks which guide companies through their IPOs) leave money on the table by setting the initial share price lower than where it could be to guarantee investor demand. Consequently, owners often raise less money through IPOs than they could have otherwise. By contrast, listing on public markets  through SPACs gives companies more control over the initial share price since they are completing a merger contract with the SPAC, not attempting to attract many institutional investors. As an interesting aside, oftentimes share prices skyrocket following IPO debuts – with an average one day rise of 20% in 2020 [5]. These “pops” are often caused by underwriting banks underpricing the newly public company’s shares to guarantee investor interest. Underwriters will often do this because most IPO contracts stipulate that if the bank cannot attract enough institutional investors, they must buy the remaining unsold shares.

A Brief History of SPACs

SPACs are not new by any means. The first SPAC was created in 1993 by David Nussbaum. At the time, blank cheque companies were prohibited in the United States and SPACs functioned as an exception to listing them [6]. Initially, SPACs focused on helping smaller, less developed companies go public with the promise of outsized returns for their sponsors. Unsurprisingly, many of these firms delivered poor returns or failed outright, damaging their reputation in investors’ eyes and keeping SPACs in obscurity for years.

However, in the early 2000s, SPACs made their first resurgence due to a lack of public investment opportunities––the number of public companies continues to decrease while money in public markets increases, creating an imbalance in supply and demand. Additionally, private equity funds began seeing SPACs as an alternative investment to generate exit opportunities with relatively attractive risk portfolios. Furthermore, SPACs’ risk declined when the SEC revamped regulation to mandate fixed share prices and monitor voting and redemption rights [7].

In 2014, SPACs surged again, starting an upwards trend in gross M&A activity year-over-year. Activity ballooned in 2020 to $81.24 billion in activity, compared to $13.6 billion in 2019––a 497% increase [8].

Providing Context to the Principles

One of the more prominent SPAC mergers of the year occurred when the SPAC Diamond Eagle brought sports betting site DraftKings into the public market. Diamond Eagle’s first step was going public on May 10, 2019, where it raised $400 million to later acquire DraftKings [9]. In April 2020, Diamond Eagle finalized a deal to acquire both DraftKings and betting platform SBTech to create a vertically integrated gambling and betting ecosystem [10]. The deal in which Diamond Eagle paid $2.7 billion in cash and stock received approval from the SPAC’s shareholders, allowing the merger to go through.

After completion of the merger, DraftKings became a publicly listed company under DKNG and incorporated in Nevada. Additionally, during the process, the new company attracted $380 million in PIPE investments––PIPE stands for private investments in public equity, which is the allocation of a public company’s shares to private investors, not through a public offering in an exchange [11]. The newly public DraftKings consisted of 75% DraftKings investors, 13% SPAC investors, and 12% PIPE investors [12].

Looking to the Future

Although SPACs will not replace the traditional IPO process, they are becoming a staple of M&A and IPO activity. As they become more enticing to investors and owners alike, it is crucial to understand how they work. However, only time will tell if the returns support the sudden resurgence of this historically rocky floatation method.