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Feb 25, 2021
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SPACs and why you might want to skip this trend

Written by
Naomi Oba

While I certainly enjoy a good Netflix binge, occasionally, I feel the need to watch something educative. This is how I ended up watching “The China Hustle.” This documentary taught me that between 2008–2016 there was a real boom of Chinese companies that went public in the US via a reverse merger. Many of these companies turned out to be a scam.

5 years later and reverse mergers continue being popular. The easiest way to conduct a reverse merger is by the creation of a Special Purpose Acquisition Company (SPAC). If you’ve recently come across that acronym, that’s probably due to their increased popularity. SPACs are en vogue with celebrities like Shaquille O’Neal or Paul Ryan (former speaker of the House)starting their own.

We’re barely 2 months into 2021 and SPACs have already raised $40 Billion. But how do SPACs operate and what are they good for?

How do SPACs work?

SPACs — are also known as “blank check companies.” They raise money through an IPO from private equity firms as well as retail investors.

As the name of the SPAC suggests, a SPAC needs to acquire another company and has 2 years to do so. When going public, SPACs won’t usually disclose too much information regarding what company they’re looking to acquire. Reasons for that include avoiding unwanted scrutiny and keeping all options open. Sometimes, SPAC issuers will announce an industry they’re targeting, yet there is no guarantee they’ll go through with it.

SPACs don’t have commercial operations. However, they’re allowed to use some of the interest earned on money collected by their shareholders.

If a SPAC fails to find a company to acquire within the 2 years time-frame, they’ll return the money to their investors.

As soon as a target company is identified, it’ll be publicly announced, and the SPAC will hold a proxy vote in which shareholders decide whether they want to acquire this company or not. If more than 50% of the shareholders agree, the target company will be acquired. It’s worth noting that SPACs lose a little bit of negotiating leverage with each day that passes.

Acquiring the target company

Surprisingly, SPACs often go for target companies that cost more than the amount they raised during the IPO. You might wonder how that works? To cover the full amount, they’ll bring in private equity or rely on debt financing. Once the acquisition is finalised, the SPAC will de-SPAC. Even though the SPAC is already a publicly trading company, the target company still needs to gain approval from the SEC. Upon approval, the ticker of the SPAC changes to the name of the acquired company. Investors now own shares of the acquired company and no longer of the initial SPAC.

One of the most famous reverse mergers in recent years has been Social Capital’s IPOA taking Virgin Galactic public in 2019.

Reasons for a SPAC

If something is booming in financial markets, that’s usually for a reason. SPACs are no different.

However, the beneficiaries of them include everyone except retail investors. Companies being acquired benefit from shorter timelines to go public, having an experienced partner on their side as well as not having to rely on market sentiment.

As SPACs offer a redemption option, the risks for investors are minimized. For institutional investors, SPACs can be particularly attractive as they offer the option to buy further shares at a later point through warrants.

For sponsors of SPACs, they offer easier access to capital, a significant upside of receiving up to 20% shares post-IPO, and the possibility to invest in late-stage companies.

The only real upside for retail investors in all this is, that they can invest in companies before they go public.

Disadvantages of SPACs

With an increasing number of SPACs on the look-out, the supply of target companies might shrink. Another concern — which has been vividly illustrated in the “China Hustle”- is that companies with worse financials than typical IPOs could go public, leading to worse results for investors.

The target company itself can lose out as the SPAC pays them for their share before going public.

The biggest downside of a SPAC is the high risk it poses for retail investors. They pay a lot more than the publicly advertised 3 -5 % flat fee. The hidden cost of SPACs is in the 20% of shares that the sponsor will receive in addition to what the target company would originally have given out.

So, how does that work? Let’s assume a SPAC wants to buy a target company worth USD 100 Mio. For the 100 Mio, they would receive X amount of shares. Yet, as the sponsor negotiates to receive an additional 20% of shares, they decrease the price/share. Instead of buying X amount of shares they now buy X+Y amount of shares. This is great for the sponsor, not so much for the retail investor, as they receive less bang for their buck.

A Harvard study looking at SPACs merging between January 2019 and June 2020 came to the sobering result that SPAC shares issued at $10 will hold just $6.67 per share upon merger.

Another troubling issue with SPACs is that investors will set their confidence in the sponsor, not in the company. Some like Chamath Palihapitiya have made a name for themselves with SPACs while focusing messaging around “increasing the pie for the retail investor.” But while a few SPACs have done tremendously well in 2020, others have even been underperforming the S&P 500 as Goldman Sachs strategists noted.

When celebrities start financial businesses who never set a foot into finance before, I’d see that as a good sign to be careful. Remember, when celebrities started endorsing ICOs?

You’ll also never know what you invest in. To illustrate with a real-life example: Stable Road Acquisition Corp raised $115 Mio to invest in the cannabis industry at the end of 2019. Yet, roughly one year later, the SPAC announced it would invest in Momentus — an infrastructure company for the Space economy. Arguably, smoking enough cannabis might get you high enough to feel like you’re in space. It’s still quite a stretch for the focus of the SPAC to shift from cannabis to space economy, but not unusual and certainly within their rights.

All in all, considering that the biggest beneficiaries of SPACs tend to be their founders as well as big investors — all people with already more than enough money, while retail pays the bill, it’s something I will avoid. Should you consider putting money into a SPAC, remember that there is a hidden fee. As always, do your own research. It’s always better to check twice before having to regret it.

Article Categories:
Business · finance · investing · reverse-mergers · SPACs
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