SPACs in 2021: Bane or a Boon?

 In the early 2000s there was a boom of BPOs in India. It was driven by foreign companies who outsourced the non-technical mundane task of sticking to a phone, to a foreign land where labour was cheap, and a huge demand for work among young people looking to make a quick buck existed.

Why this analogy in the start of this article? Well, it’ll help you understand the SPACs just a little better. Imagine someone famous asking you to invest in a company. Chances are, you will want to know more before investing. What if we tell you, there is no company, at least not yet. Will you still invest your money? This is a pitch similar to the ones given by the owners of SPACs, or Special Purpose Acquisition Companies, which is arguably the hottest asset class in the U.S. of late, led by notable investors such as hedge fund billionaire Bill Ackman and former Facebook Executive Chamath Palihapitiya.

In the past few months, and more so after global lockdowns owing to the COVID-19 pandemic situation, SPACs have come to the fore as one of the hottest buzz words. In this article, we breakdown what SPACs actually are and how they function, and also, what’s in the store for you?

 

What are SPACs and how do they function ?

Once shunned by investors, SPACs, also known as ‘blank check’ companies, have become an increasingly popular method in recent years to list companies on a stock exchange. SPACs are shell companies with no actual commercial operations but are created solely for raising capital through an initial public offering (IPO) to acquire a private company. This is done by selling common stock - with shares commonly sold at $10 apiece - and a warrant, which gives investors the preference to buy more stock later at a fixed price. The structure of SPACs allows investors to contribute money towards a fund without any knowledge of how their capital will be used, thus the term ‘blank-check companies’ is formed. Once the funds are raised, they are kept in a trust until one of two things happen.

First, the management team of a SPAC - also known as sponsors - identifies a company of interest, which is then taken public through an acquisition, using the capital raised in the IPO. Or second, if the SPAC fails to merge or acquire a company within a deadline which is typically two years - the SPAC is liquidated, and investors get their money back.

 SPACs have existed in one form or another from as early as the 1990s, typically as a last resort for smaller companies to go public. The number of SPAC IPOs have waxed and waned over the years in tandem with the economic cycles, and they have been making a resurgence of late.

Notable SPACs include Palihapitiya’s Social Capital Hedosophia Holdings, which acquired a 49% stake in British spaceflight company Virgin Galactic in 2019.

The biggest SPAC on record raised $4 billion in July 2020, led by hedge fund manager Bill Ackman’s Pershing Square Tontine Holdings. Southeast Asian super app Grab announced plans to go public by partnering with Altimeter Growth Corp, a SPAC, Axios reported. The kicker: at an equity value at $39.6B, it would be the largest SPAC ever, breaking the previous $4 billion record.

 

But what’s the difference between a SPAC IPO, and a traditional one?

There are several ways a private company can go public. The most common route is through a traditional IPO, where it’s subject to regulatory and investor scrutiny of its audited financial statements.

An investment bank is usually hired by the company to underwrite the IPO, which usually takes 4-6 months to complete. This involves roadshows and pitch meetings between company executives and potential investors to drum up interest and demand in its shares.

Also, not all IPOs usually succeed. The big co-working-space company WeWork withdrew its high-profile IPO in 2019 amid weak demand for its shares after massive losses and leadership controversies were revealed. Other companies such as Spotify and Slack went public through direct listings, saving on fees paid to middlemen such as investment banks, although there are more risks involved in such cases. While private companies listed through SPACs are similar to reverse takeovers, such as the case for insolvent fintech company Wirecard, they are different in that SPACs start off on a clean slate and have lower risks.

Because SPACs are nothing more but shell companies, their track records depend on the reputation of the management teams. By skipping the roadshow process, SPAC IPOs also typically list in a much shorter time. This has led some investors to become wary of buying shares in companies listed through SPACs due to the lack of scrutiny and due diligence compared to traditional IPOs.

SPAC sponsors also typically receive 20% of founder shares in the company at a heavily discounted price, also known as the “promote.” This essentially dilutes the ownership of public shareholders.

For example, initial shareholders of Palihapitiya’s Social Capital got 20% of the company at $0.002 cent, while public shareholders got the remaining 80% at $10 a share.

 

But how have SPACs fared in equity markets, especially for ordinary investors?

As per a study by Goldman Sachs in 2020, 56 SPACs that completed acquisitions or mergers since the start of 2018 found that they tended to underperform the S&P500 during a three, six and twelve month period after the transaction. A separate study of blank-check companies in the U.S. organized between 2015 and 2019 found that the majority are trading below the standard price of $10 per share. Between 2017 and the middle of 2019, there were slightly over 100 SPACs in the U.S., with an average return of a mere 2%. If there’s one thing that markets hate, that’s uncertainty.

Even before the pandemic, SPACs were already on the rise, buoyed by the equity boom and hot IPO market in 2019. While the pandemic has slowed the pipeline of traditional IPOs, SPACs have bucked the trend. With the quality of management teams improving, fewer disclosure requirements and a relatively straightforward listing process, blank check companies are booming. In fact, funds raised through SPACs outpaced traditional IPOs in August 2020 - a rarity on Wall Street.

 In the first ten months of 2020, there were 165 SPAC IPOs globally, of which 96% of them were listed in the U.S. That is nearly double the number of global SPACs issued in 2019 and five times that of 2015. Of the $56 billion poured into global SPAC listings in 2020, 99% was raised in the U.S., and that figure is nearly 12 times the amount raised globally in 2015 over the same period. SPACs in 2020 raised triple the amount that they did in all of 2019. And in the first two months in 2021, they have raised about 90 billion dollars, compared to 83 billion in all of 2020.

While largely an American phenomenon, SPACs have caught the attention of investors in other jurisdictions. In 2018, Antony Leung, the former finance secretary of Hong Kong, raised $1.5 billion on the New York Stock Exchange through his SPAC, which bought a mainland hospital chain a year later. Other players include Masayoshi Son’s SoftBank, and the investment arm of Chinese state-owned conglomerate CITIC Group. Despite having sponsors from Asia looking to acquire international companies, these SPACs are ultimately listed in the U.S.

It’s a similar story in Europe, which has seen muted SPAC activity. For example, the management team of blank check company Broadstone Acquisition Corp is based in London, targeting private companies in the U.K. and Europe, but is listed on the New York Stock Exchange.

One main reason is the different rules for SPACs across jurisdictions. In the U.S., investors can vote to approve the acquisition the SPAC proposes, or redeem their funds if they do not support the proposed deal. This, however, isn’t a requirement in some European jurisdictions, including the U.K. There is also a lock-in period for British investors once an acquisition is announced until the approval of the prospectus, which ties them into deals that they may not support in that indefinite period.

 

But changes may be afoot.

As SPAC activity reaches fever pitch in the U.S., regulators are putting these blank check companies under the microscope. 

Jay Clayton, the chairman of SEC in the US had remarked, “Competition in the IPO process is probably a good thing, but for good competition and good decision-making, you need good information. And one of the areas in the SPAC space that I'm particularly focused on is incentives and compensation to the SPAC sponsors.” The SPAC boom could be cooled by the Securities and Exchange Commission (SEC) which is reportedly mulling new rules to put some constraints on blank-check companies. Possible measures considered by the SEC, according to a Reuters report, could include changes in accounting rules, how ‘safe harbor’ rules are applied and scrutiny over the growth projections used in marketing.

However, investors like Palihapitiya have defended SPACs transactions, saying that they are no different from the fees that banks collect in a traditional IPO process.

What about India? 

India’s regulatory trapdoors imprison many young dreams of pouncing on big cash in form of SPACs. India’s regulations have failed to evolve in the dynamic global financial architecture.

Under LRS or the Liberalised Remittance Scheme by the RBI in India, resident Indians are allowed a maximum investment of 250,000 dollars per annum in foreign assets. Now imagine if a first-generation founder owns 10% of a billion-dollar valued company, their cross-border share swap becomes impossible, as they’re entitled to 100 million dollars of shares. Under LRS, they get only 0.25% of the wealth.

The other problem that arises under Indian laws is the capital gains debacle. Since it’ll be a cross border event, the share swap would be treated as a sale and then a fresh purchase contract. It wouldn’t be a tax neutral merger like it happens when mergers like these take place domestically. In the above example, the founder would end up paying nearly 20 million in capital gain taxes.

As more ordinary investors jump on the SPAC bandwagon around the world, experts are concerned that this will overheat markets and affect any fragile economic recovery.

While SPACs provide a straightforward route to invest through a trusted intermediary, it’s performance so far means that it is a dicey bet for ordinary investors. 

-        - Finsurety Advisors LLP