What Are SPACs? - Why should you trade them?

March 29, 2021 12:40 UTC

If you follow the financial press you have no doubt recently read about SPACs and probably wondered what they are and whether you can trade them.

In this article we will be examining those questions and also looking at the pros and cons of SPACs, why people use them and at current trends. 

What are SPACs

What Is a SPAC?

SPAC stands for Special Purpose Acquisition Company. As the name implies, a SPAC is a company that is set up solely with the purpose of acquiring one or more companies and bringing them to the public markets, helping it, or them, to avoid the IPO process.

So, why does anybody need a SPAC?  Before we look at that question, it is probably worth reminding ourselves about IPOs. 

What Is An IPO?

Private companies that want their shares traded on exchanges need to go through a process called the Initial Public Offering, or IPO. The process is also referred to sometimes as going public.

Before a company goes public, only employees, their relatives and qualified specialist investors like Venture Capitalists are able to buy shares in the company and these cannot be freely traded.

In contrast, after a company goes public, anyone can buy and subsequently sell the company’s shares through a broker like Admirals (formerly Admiral Markets).

To protect the general public from buying shares in scams or unstable businesses, financial regulators prescribe strict minimum standards of financial health, good governance and reporting transparency that a company must meet before going public. 

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Why Would a Company Want to Avoid an IPO?

After going through an IPO, companies’ founders and other early backers are able to sell their shares much more easily and the company is able to raise money on much better terms than private companies can. This, and the associated prestige, are the main reasons for private companies to go public.

However, making the necessary changes and proving compliance with the standards to the regulators is an arduous process that has several other drawbacks; the first of which is the expense.

The Costs of an IPO

First, investment banks charge companies 5-7% of any money raised – a minimum of £50m for every £1bn raised!

Additional fees are required for lawyers, accountants and consultants who help the company prepare and to PR and other advisors who help the company cope with subsequent life in the public spotlight. 

The Risks of an IPO

An IPO is very demanding of management’s time, requiring much of the attention of the CEO, CFO and their direct reports for several months. 

It can also be risky. As the company goes from being “nobody’s business” to being “everybody’s business” things like past management behaviour, employee and customer contracts, as well as past financial accounts are forensically examined. Any slip up or inconsistency can suddenly become front page news and tarnish the reputation of senior managers for the rest of their careers. 

Wework is an extreme example of what can go wrong with an IPO. The company found itself front-page news for the wrong reasons due to information about its past behaviour that gradually emerged in the run up to its planned IPO in 2019. This led to the IPO eventually being withdrawn. The episode was embarrassing for its early investors and for CEO Adam Neumann who was ultimately forced to resign.

The Share Price Uncertainty of an IPO

Another drawback is that when a company comes to market through an IPO it commits to sell a number of its shares – but it does not know how much money it will get for those shares.

The investment bankers who manage the process are often accused of under-pricing shares during IPOs, for the benefit of their loyal institutional investors. The resulting “pops” of 30-40% on the first day of trading is good for new investors and makes for good press coverage but it is money left on the table as far as the company and its original investors are concerned. 

Given all this, it is no surprise that many managers choose to avoid the IPO process if they can – and this is where SPACs come in. 

How Do SPACs Work?

A SPAC begins life when a group of sponsors float a shell company on the stock market, raising a pot of money.

To do this, the SPAC goes through the traditional IPO process but, because it has no history or operations, it is able to do this much more quickly and cheaply than a traditional business is able to.

When a traditional company goes public, it releases detailed information about its finances, history and future plans. 

By contrast a SPAC will, at most, provide information about the sponsors and the sectors it will conduct its search for an acquisition in. Some of the sponsors are very clear and focused about this and some are more vague. 

Members of the public buy shares in the SPAC’s IPO hoping that the SPAC will, first, find an attractive private business to buy and, second, strike a good deal when it does.

This is why SPACs are sometimes referred to as “blank cheque companies” 

After its IPO, the SPAC puts the money raised on deposit and begins its search for private companies keen to be listed on the exchange. 

Often, the desired target costs more than the SPAC has available. In these cases, the SPAC raises additional funds by selling more of its shares on the market.

Let’s say, for example, that a SPAC raises $500m in its IPO and it then finds an attractive target that agrees to be bought for $2bn. After lining up the deal, the SPAC will announce this to the market and raise another $1.5bn by selling more of its shares.

In the US, investors in the SPAC IPO will buy shares at $10 a share and they will also get warrants entitling them to a discount during later share sales. These warrants act as an incentive to buy shares in the IPO.

In practice, the acquisition of the private company by the SPAC can be paid for by a combination of cash and SPAC shares. That way, the private company’s  founders and managers can continue to hold equity in the merged entity, just as they would after an IPO.

Sponsors get to keep a portion of SPAC shares in return for their work. This typically ranges between 5% and 15% but can be as high as 20%. These shares have the effect of diluting other shareholders.

The rules of each SPAC differ but some commit to returning the money to investors if there is no successful acquisition within 2 years.

That sounds like a good feature for investors but it can act as an incentive for the sponsor to do any deal as the deadline approaches.

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Some Stats and History

SPACs have been around for many years but had a suspect reputation as only buying doubtful businesses keen to avoid the transparency associated with an IPO. However, the very successful acquisition of Richard Branson’s Virgin Galactic by Chamath Palihapitiya’s SPAC in 2019 started to change that perception. The venture went public at a valuation of $2.2bn and is currently worth $7.7bn.

Virgin Galactic Holdings ChartDepicted: Admirals MetaTrader 5 - Virgin Galactic Holdings Daily Chart. Date Range: 15 October 2018 - 19 March 2021. Date Captured: 19 March 2021. Past performance is not necessarily an indication of future performance.

Another SPAC, Diamond Eagle Acquisition Corp. went public in December 2019 with its shares priced at $10. It soon announced a merger with gambling technology platform DraftKings and the deal closed in April 2020. Shares rocketed and are currently trading at over $67.

Other successful deals, like Opendoor and Nikola Motor followed and soon SPACS became “perhaps the hottest asset class in American equity markets” according to the FT.

Nikola Corp Daily ChartDepicted: Admirals MetaTrader 5 - Nikola Daily Corp Daily Chart. Date Range: 8 January 2020 - 19 March 2021. Date Captured: 19 March 2021. Past performance is not necessarily an indication of future performance.

In the first two months of 2021, 235 SPACs raised $72bn, according to Refinitiv. This is more than was raised by traditional IPOs.

The boom is gathering pace and one concerning sign of a potential bubble is the number of “celebrities” getting involved.

Celebrity Sponsors

Joanna Coles recently left her job as US editor of Cosmopolitan to sponsor a SPAC, following a trail blazed by others, such as ex-NBA star Shaquille O’Neal, baseball legend Alex Rodriguez and Colin Kaepernick, the American football player made famous by pioneering the taking of the knee.

Famous hedge fund manager Bill Ackman raised the biggest SPAC in the middle of 2020, at $4bn. At least Ackman has a solid reputation as an investor and he limited his sponsor-shares to around 6%, and made them conditional on performance.

SPACs Head To Europe

Now the craze is coming to Europe.

In February 2021, a new SPAC, Tailwind International, raised $345m in New York with the explicit intention of buying European technology companies.

Fearful of missing out on listings, the London Stock Exchange has recently made noises about the need to change UK listing rules in order to encourage SPACS to list in London. Such calls have been backed by Lord Jonathan Hill, former European Commissioner for Financial Services.

Amsterdam is said to be thinking along similar lines.

Conclusion

As we have seen, SPACs can be a very efficient way to cut the costs, risks and timescales associated with taking a company public.

However, their structure can be hugely beneficial to their sponsors at the cost of dilution to early investors.

The “blank cheque” nature of SPACs, the fact that investors in a SPAC IPO don’t know what they are investing in should be of some concern.

Also troubling is the increasing participation of celebrities lacking the desired business knowledge to make solid investments. 

So should you get in on the act? As is often the case, the final judgement should be based on the details: the reputation and experience of the sponsors, their share of equity, the conditions under which they get it, the sector being targeted and the value of the warrant – these are all factors that need to be considered before making the best decision.

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Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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