by Dr Sunwoo Hwang, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance
2020 has been the year of special purpose acquisition companies or SPACs. A SPAC is a blank check shell company designed to take private companies public without going through the traditional initial public offering (IPO) process. 2020 saw 230 SPAC IPOs and $77 billion raised in the United States alone at the time of this writing on 13 December 2020. The 230 SPAC IPOs account for 54 per cent of the total IPOs and 45 per cent of the total IPO proceeds (source: SPAC Analytics). Both their number and the amount of capital raised hit a record high and greater than those of the total annual US IPOs since 2014. However, SPACs have received little attention in the academic literature, presumably because they were almost invisible in the IPO market years ago. Capital raised by SPACs made up less than seven per cent of the total IPO proceeds before 2015, except during the financial crisis. But, in 2020, a SPAC has become the main gateway to public markets, outnumbering traditional IPOs and raising 45 per cent of the IPO proceeds. SPACs appear to deserve more attention and research by financial economists.
The very first question to ask is why a SPAC exists. On the demand side of the SPAC product market, the SPAC offers several benefits to capital-starving private firms. First, it offers a faster timeline. If a company chooses a SPAC over a traditional IPO, it takes three to four months rather than two to three years. It also involves greater certainty regarding a firm’s valuation and the amount of capital raised. A company negotiates only with a SPAC, instead of myriad investors, and receives the IPO proceeds already raised upon the merger approval of SPAC shareholders. Third, a SPAC route is popular amongst young private firms or mature private firms such as unicorns , which suffer a valuation disadvantage compared to mid-aged (i.e., six-ten years old) private firms that public investors prefer. On the flip side, a SPAC is more expensive than a traditional IPO, which charges seven per cent to pay an underwriter. A target company leaves equity for sponsors, which is 20 per cent pre-merger and diluted by a exchange ratio to one to five per cent post-merger, and 5.5 per cent for underwriters.
On the supply side, SPAC sponsors obtain easier access to capital as a SPAC faces fewer regulatory obstacles than traditional IPOs. The SPAC IPO process is relatively simple and easier than, say, raising new venture capital funds. Furthermore, SPAC sponsors enjoy significant upside, receiving 20 per cent of SPAC shares post IPO, yet low risk, investing in late-stage private firms. The SPAC has additional appeals to private equity (PE) sponsors. SPACs can serve as co-investment vehicles, allowing PE sponsors to do side-by-side transactions with less leverage and more equity, and provide greater liquidity certainty than private portfolio firms in which PE firms have illiquid interests.
In the capital market where SPAC sponsors stand on the demand side, SPACs entice investors based on the following merits. Institutional investors invest in initial SPAC, which offers common shares and warrants combined as units, and use warrants to purchase additional shares following successful mergers, with little downside. Initial investors receive their money back if a SPAC fails to find a target or if they do not like a selected target. Also, retail investors can invest in PE type transactions. These benefits are not without costs, however. Because a SPAC has a limited lifespan of two years, sponsors may rush to merge with any (potentially low quality) firm approaching the deadline. In so doing, sponsors may overvalue the target to pass the minimum transaction amount threshold.
The natural next question is why SPACs have become stunningly popular in recent years. One obvious possibility is the pandemic has increased uncertainty. In uncertain times, private firms in need of financing may fear they cannot raise additional rounds of capital from private investors. Even so, they may not go for traditional IPOs, which take years and raise an uncertain amount of capital. But the uncertainty is unlikely to explain the whole story as the trend precedes the pandemic. The SPACs’ representation of IPOs monotonically increased from 12 per cent in 2015 to 28 per cent in 2019, making each year a record year since the financial crisis (source: SPAC Analytics). There is little evidence of a significant surge in economic uncertainty and stock market volatility, measured by the CBOE Volatility Index, during the five years.
The other possibility that may also explain the pre-COVID-19 trend is the sophistication of the SPAC market, where an increasing fraction of sponsors and investors have sectoral focus and expertise. A recent example is Chardan Healthcare Acquisition Corp., which closed a merger with BiomX in December 2019. Sponsored by health-care-focused investment bank Chardan, several high-profile biotech investors anchored the deal. Also, an investment bank, Jefferies, finds that an increasing number of SPAC sponsors are industry executives.
In addition, numerous open questions are in order. First, structural complexity may create perverse incentives for different players involved, other than the aforementioned one caused by the limited lifespan. Second, in the case of PE sponsors, limited partners may concern about general partners get distracted and worse potentially usurp deal opportunities in favor of SPACs. Third, the discrepancy between control and cash flow rights may engender corporate governance problems. In a typical pre-merger SPAC, sponsors own 20 per cent cash flow rights and 100 per cent voting rights through their class B common shares, which are only issued to sponsors and entitled to vote pre-merger. A majority independent board of directors elected solely by sponsors may not be majority independent.
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