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Special Purpose Acquisition Companies (SPACs) have become an increasingly common way of raising money to acquire a company. In many cases, they have replaced traditional initial public offerings (IPO) as the preferred way of capital raising. While SPACs have been around since the 1980s, 2021 saw a record-breaking increase in the number of SPAC deals undertaken in a single year. Therefore, understanding SPACs is an important aspect of modern-day private equity and capital raising. This article will explain what a Special Purpose Acquisition Company is and how they work.
What Are SPACs?
SPACs (sometimes referred to as blank check companies) are a type of shell company that is set up for the sole purpose of acquiring another company. The individual or company that manages the SPAC is known as the SPAC’s sponsor. The sponsor will offer shares in the SPAC to the public through a traditional initial public offering (IPO).
Usually, the public will evaluate the merits of the investment on the basis of the sponsor’s investment thesis. For example, the sponsors may only look at high-growth companies in the technology sector as potential acquisition targets. The sponsors must disclose the investment thesis in a publicly-available document called a prospectus.
Importantly, at the IPO stage, the sponsors will not typically have identified the acquisition target. Consequently, compared to traditional IPOs, the law requires the SPACs’ sponsors to disclose far less information. This is a SPAC’s key differentiator from traditional IPOs, where the public knows which business it is buying shares in. However, like traditional IPOs, banks will underwrite the listing. Similarly, the sponsors will invite institutional investors to commit to purchasing a certain percentage of shares upfront.
Investors are commonly large banks, high-net-worth individuals, and members of the public.
The most common markets for SPACs are stock exchanges in the United States, such as the New York Stock Exchange. However, the London Stock Exchange now lists SPACs.
How Do SPACs Work?
Once the sponsor has finalised the IPO, the sponsors place the proceeds in a trust account. The terms of the trust obligate the sponsors to use the funds only to acquire a target company according to the terms of the prospectus. The SPAC will then typically have two years to complete the acquisition. If it does not acquire a target company in this timeframe, the sponsors liquidate the SPAC and return the IPO proceeds to all the investors.
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Why Use a SPAC?
Some investors prefer SPACs because their structure offers certain advantages compared to other methods of capital raising.
Using a SPAC allows the sponsors to raise money much more easily and quickly than through a traditional IPO. Likewise, sponsors can prepare the SPAC’s financial statements in a matter of weeks rather than months. Sponsors do not need to compile historical financial results in the prospectus because there is no operating company at the time of the IPO.
On the whole, this means that the whole process can be completed in a matter of weeks. In comparison, a private company raising money by doing its own IPO can take up to a year or longer.
Additionally, the acquisition target obtains certain benefits. For instance, the target company can negotiate a higher price for its shares because the IPO proceeds are held on trust for two years. This in turn increases the value of the investment when the sponsors complete the acquisition.
Separately, the investors stand to potentially benefit from the sponsor’s expertise and guidance.
Risks of Using a SPAC
Investors rely on sponsors to manage the investment and identify the target company. With minimal regulation on the disclosure process and the typical two-year time limit in which to complete a transaction, the sponsors are not always incentivised to find the best target possible. Where demand for target companies outweighs supply, sponsors can end up overpaying, thus failing to generate appropriate returns in the long-term. For these reasons, SPACs have attracted criticism and controversy.
Therefore, investors should undertake as much due diligence into the management capabilities of the sponsors before committing to the SPAC. A good sign is a sponsor willing to act as a lead investor by participating in the IPO (rather than simply managing the SPAC).
Key Takeaways
The SPAC process has become a popular way of raising capital in the past couple of years. It is an alternative to traditional IPOs because SPACs raise money more quickly and efficiently without the same degree of administrative burden for investors and the SPAC’s managers.
Investing in a SPAC, however, is not without risks. The disclosure process is less robust because you do not know what company the SPAC will ultimately acquire. Therefore, you are at the mercy of the SPAC’s sponsors to identify a valuable target and generate healthy returns in the long run.
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Frequently Asked Questions
Special Purpose Acquisition Company (SPAC) is a shell company set up to raise public cash for the sole purpose of completing an acquisition of a target company.
A: An Initial Public Offering (IPO) is when a private company is listed on a public market (such as the NASDAQ or London Stock Exchange) for the first time.
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