2020/2021 have been the years of SPACs. In 2020, there were ~250 SPAC IPOs being raised, which was more than the total over the 10 years prior (see statistics here). Then in just first half of 2021, over 300 were raised with over $100bn in funding. Generally I have always felt SPACs are great vehicle for the sponsors but expensive for incoming investors. Nonetheless, I recently took a read-through a SPAC prospectus to understand what it is all about. Important to note is that each SPAC has its own tweaks and quirks. This one that I am looking at, I believe, represents a rather typical structure. Furthermore, these are just my general thoughts and I am sure you can find gold mines in the vast land of SPACs.
SPAC Basics
For starter, SPACs stand for Special Purpose Acquisition Companies. They are blank check companies with no business operations and are set up for the sole purpose of raising capital through initial public offering (IPO) with the goal of buying an existing company. For a more detailed description, you can also check out this article here from Corporate Finance Institute.
For the SPAC that I am looking at, they are raising $400mm IPO proceeds, issuing 40mm units to IPO investors at $10/unit offering price. One unit consists of one share and 1/4 of a warrant. The share and warrant are detachable from each other and will trade separately soon after IPO. Purpose of the warrant is to provide additional incentive for investing in the SPAC, like pre-emptively selling a long-dated option. And usually with an exercise price of $11.50/warrant, 15% above the unit offering price.
Founder Shares and Sponsor Warrants
Now let’s look at how the economics of the founder / sponsor stacks up. Right out of the gate, the founder (or the sponsor) is given a 20% stake of the blank check company. In this case, that would be 10mm shares. Call it the founder shares. So on day 1, as the IPO investor you are basically down 20%, offset by the warrant value. In addition, sponsor will purchase 5mm of warrants (with same exercise price of $11.50) for a nominal price. In this case, the warrant purchase price is $2/warrant for a total of $10mm, which essentially covers the IPO expenses. A summary of share structure before and after warrant exercising is here:
Then for illustrative purposes, let’s assume the acquisition makes money at 1-5x of the original investment of $400mm. What would the resulting return to the IPO investors look like, given dilution from founder shares and sponsor warrants:
Risk-Return to IPO Investors
As you can see, the original acquisition needs to make at least 25% over time for IPO investors to break even. Like any merger and acquisition, a positive return is never guaranteed. But let’s say the sponsor is skillful enough to make a 3x on it over 5 years, which is a commendable 25% annual return. IPO investors would make only 15% a year. That’s fairly expensive. In the context of a 2/20 private equity fee model, that’s a 40% performance fee!
On the other hand, let’s say the acquisition loses money. The sponsor puts in only $10mm for purchase of the warrants but getting 20% of common shares. It would require the value of acquisition to decline by 87.5% before the sponsor realize a loss. Say it another way. Anything above a decline of 87.5%, the sponsor would be making money. Quite an asymmetric risk / return profile, for the sponsor! That being said, some sponsors would chip in on a small percentage of the IPO so would share some dilution on that part of the capital.
Furthermore, the sponsor would argue that if they did not bring the acquired business to the public domain, you would not even have the chance to make this 15%! Fair enough. Obviously invest at your own choice and your own risk. In general, most companies being SPAC’ed already have an intention to go public. SPACs allow them to go public easier than the traditional IPO process. But that kind of more onerous reporting and disclosure are really for public investors’ protection. I wouldn’t mind that, and if they cannot meet the requirement, maybe they should stay private.
Conclusion
SPAC acquisitions are often results of already competitive bidding processes. Competitive processes unfortunately do not often deliver great bargains. Without knowing which business it is buying and what valuation it is buying at, while paying premium into the who’s who SPAC IPO is too much of a speculation to my liking. SPAC becomes SPEC.
