William John Market Report 09-06-21
William John Market Report 09-06-21Category: Reports
Are Special Purpose Acquisition Companies (“SPACs”) the future for the transition from private to public?
SPACs fall under the umbrella term of “blank check” companies. A blank check company is a public company that uses the capital raised from its own initial public offering (IPO) to acquire an unidentified business without a predetermined business plan or strategy. Hence, investors that purchase company shares during the IPO are investing blind, coining the term “blank check”. A SPAC is a type of blank check company that raises money from its IPO and deposits the capital into an interest-bearing trust-account or an ‘escrow’ account. Then, the management of the SPAC must find a target and agree an acquisition for it within 24 months or must return the deposited capital, plus earned interest, to investors. Before examining their future, however, it is important to dissect their past.
The blank check company has existed for decades and has a nasty past. Prior to the Securities Enforcement Remedies and Penny Stock Reform Act 1990 (“PRSA”), they were often used by broker-dealer operations to acquire companies that would struggle in their own IPO to raise sufficient capital, normally “penny stock” companies. With no regulation on penny stocks prior to 1990 and the vague “blank check” nature of the acquiring company, many such operations defrauded unsuspecting investors during the 1980’s using cold calling sales tactics and market manipulation.
This caused regulatory bodies to intervene with the PRSA in 1990, causing the blank check company to disappear off the map almost entirely. In fact, according to Derek Heyman’s paper in the Entrepreneurial Business Law Journal, there were approximately 2,700 blank check offerings during the fiscal years 1987-1990. In the early 1990’s (post regulation) there were fewer than 15. The dismal past of blank check companies though, has been a positive crucial contributor to the regulatorily robust SPAC, created by a very talented group of lawyers in 1992 and modelled on the PRSA. It should be noted that the SPAC have undergone a dormant period from its development up until the mid-2000’s. The reasons for this are two-fold.
Firstly, the traditional IPO during the 1990’s (Dotcom era) and early 2000’s was a sufficient model to raise capital from the public. Investors had a risk appetite for companies going public without a necessarily robust audited track record. Secondly, economic conditions (especially prior to 9/11) were favourable and therefore investors trusted public listings without underlying market volatility negatively affecting their companies opening prices. However, during the mid-2000’s, SPACs began to pick up pace. Observing SPAC and US IPO activity since 2003:
As noted from the graph, SPAC IPOs climbed in popularity through the mid-2000’s, declined through the financial crisis 2007-09, remained dormant again through the 2010’s and have aggressively picked up pace since 2019. A generalised observation to be made is that when total IPOs are climbing and the economy is in a recessionary cycle, SPAC IPOs surge in popularity.
There are a few principal reasons why SPACs exist, and more importantly, why they surge in popularity during these circumstances. The first one is that the target company of a SPAC does not have to go through an IPO of its own, which is timely and costly. Therefore, when market conditions do not favour a private company to go public, a better direction to take is to merge with a SPAC, which has absorbed “going public” costs through its own IPO. Furthermore, merging with a SPAC allows the target to directly negotiate its valuation with the sponsors of the SPAC. Whereas traditional IPOs are open to market speculation and whose stock price can thrive or wither contingent on market sentiment – a big risk if markets are highly volatile. Finally, SPAC mergers offer huge incentives for their sponsors. Typically, they will receive a 20% equity stake in the finalised merged company. However, regardless of the equity arrangement between sponsor and SPAC, the investor has the option to redeem their SPAC shares for the purchase value + escrow interest if a suitable deal cannot be found, or swap their shares for the shares of the merged company which effectively acts as a put option and insures the investor of a return either way. This is a significant de-risking opportunity of capital relative to an investor in a typical IPO.
There are, of course, some risks attached to SPACs. A common one highlighted by reputable names in the world of finance, including ex Goldman Sachs Chief Executive Lloyd Blankfein, is the adverse selection problem of information asymmetry. Adverse selection refers to a market situation whereby buyers and sellers have different information. Crucially, participants that have key information might participate selectively in transactions at the expense of other parties who do not have the same information. In other words, because of the time constraint nature of SPACs, many critics are concerned SPAC management maybe concerned with negotiating the “quickest” deal rather than the best, which could cause management to overpay for the target company to agree a deal in time. The problem of “pressurised overpayment” is likely to be a lingering question about the effectiveness of SPAC opportunities for many years to come.
So, are SPACs the future to take companies public? There are some clear incentives for sponsors and the target company itself. In fact, it is almost certain that when companies are looking to go public, but a typical IPO is not warranted in unfavourable economic conditions, SPACs are a viable and cheaper alternative. The prominent question will be, with over 400 SPACs floating on public exchanges in 2021 so far, can the manager of a SPAC find the suitable deal and agree a “fair valuation” for the target? If it cannot, investors can walk away with their escrow interest, but the credibility of SPACs may dissolve over time without a flurry of successful mergers in the next 24 months.
Any opinions expressed in these documents are those of William John and are provided for information only. E&OE.
1 Heyman, D. “From Blank Check to SPAC: The Regulator’s Response to the Market, and the Market’s response to the regulation”, Entrepreneurial Business Law Journal, Vol. 2:1 p532