Special Purpose Acquisition Company (SPAC): How Does It Work?

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Special Purpose Acquisition Company (SPAC): A Complete Guide

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5 Min Read    |    March 31, 2021

Initial Public Offering is a familiar term for most of you, right?

A safer route of investment, especially for retail investors and a perfect way to begin the journey in the stock market for beginners.

But, let us consider the perspective of the companies that have to take all the pain of launching an IPO. Right from filing the DRHP and trying to get investors on board to the lack of clarity about the valuation, it involves a lot of hard work, to say the least.

If you want to find out more about IPOs, do remember to check out our IPO: A Complete Guide for more details. You can read it here.

The perfect example of the dubious situation that companies face before their IPO hits the market is WeWork. On top of this, if you add the fluctuating market conditions, mainly after the COVID-19 pandemic, you will land up with quite a quagmire of a situation.

Under such vascillating conditions, companies have been searching for a less risky way to raise funds and the answer to their quest is SPAC!

But, what are SPACS?

How do SPACs Work?

Are SPACs a good investment?

Let us find out!

Explained: What is a SPAC?

The term SPACs has created a buzz on Wall Street since the start of this year. For those who are unaware, media firms like BuzzFeed, Vice Media, Bustle Media Group, etc are planning to decode the path of SPACs to raise money for the investors. In fact, not only the media industry but other industries are in the process of exploring this new concept to raise money

But, what exactly is SPAC?

A special-purpose acquisitions company (abbreviated as SPAC) is a non-operating corporation set up by the investors with the aim to raise funds through an initial public offering. The money collected through this path is further used for the acquisition of any other company. One of the most important points that you must know about SPAC is that whatever money is garnered through the IPO process, it is kept in a trust until and unless the concerned business is acquired using the collected capital.

But, if the acquisition gets delayed (due to unprecedented reasons) then the fund’s money is returned to the investors after paying the broker and bank charges.

One of the recent examples is that of Group Nine Media that went on to form its SPAC in December last year and on January 15th, it went public. Soon, Group Nine Media is expected to acquire other media firms.

Further, if the rumours are to be believed, the idea of SPAC is estimated to become a mainstream thing!

SPAC Concept: A Background

If you are thinking, the concept of SPAC has recently hit the market, then let me tell you that it is not true.

The concept of a shell company or SPAC arose around 40 years ago. Unfortunately, it vanished for a long time after some people defrauded investors by creating SPACs. As a result of such incidents, SPAC became ill-reputed and eventually faded.

But, came the year 2020 and the concept of SPAC was re-ignited. According to the Indian Express, a total of 248 SPAC IPOs were launched last year.

According to data sourced from SPAC Insider, a portal that maintains a record of SPAC deals, of the 755 such IPOs by blank-cheque companies since 2009, 248 happened in 2020 and 281 in 2021, so far.

Major Characteristics of SPAC

  1. The SPAC has no commercial operations because it is a shell company and does not deal with any products or services.
  2. The only asset possessed by a SPAC is the total fund that is raised through its IPO.
  3. Generally, SPAC is either formed or sponsored by a group of institutional investors, professionals from the financial market, hedge funds of high-net-worth individuals.
  4. SPAC is often termed as a ‘blank check company’.

How Does SPAC Work?

In order to understand the definition of SPAC in a better way, it is crucial for you to grasp the working of a special purpose acquisition company.

The entire process can be primarily divided into three parts and each of the parts is explained below.

The Role of Investors

The formation of SPAC is initiated when a group of either HNIs or experienced business people come together to pump in the capital needed at the initial stage and in return they get a certain percentage of stake in the SPAC. These business executives can also be called the founders of sponsors of the SPAC. The business executives who put in their money are usually experienced individuals from their respective fields and they do hold a reputation in the market.

You must be wondering why is the reputation of these business executives important, right?

Well, SPAC is just a shell company, therefore it is the reputation or name of the investors or the business personals that acts as the main factor to attract funds from the investors. If some known faces or names are associated with the SPAC, it creates a level of trust among the investors’ community.

Launching the IPO

The next step involves launching the initial public offering of the shell company formed (SPAC). So as to issue the shares publicly, the team of SPAC sponsors who raised the initial capital to hire any investment bank. The investment bank handles the entire process of IPO and they charge some amount in return for the services they provide.

Also, the shares that are offered through the IPO process are generally available at a unit price. Remember since the SPAC is a non-operational company, its IPO prospectus lacks information like performance, history, etc. The main focus of the prospectus of any SPAC IPO lies on the sponsors.

Finally, whatever money is raised through the IPO process gets collected in a trust account and it is not touched until and unless there is an availability of a suitable private company for acquisition.

The Final Step of Acquisition

Once the capital required for acquiring a company is pooled in by the IPO process, the group of business executives or the SPAC sponsors take their time to spot a good company to take over. Now, the time of spotting a suitable company can range from 16-24 months. It varies from industry to industry.

The final stage of acquisition involves voting among the SPAC founders or sponsors so as to know their view regarding the acquisition deal. Once the acquisition is complete, SPAC founders or sponsors have two choices.

  • Either redeem profit through the SPAC shares they hold
  • Or, replace their shares in the SPAC with the shares of the newly acquired company

In the case where the acquisition process remains incomplete due to unavoidable reasons or the SPAC sponsors are not able to find the right company to acquire, then SPAC is ended and the money collected through IPO is returned to the investors.

Why are SPACs Becoming Popular?

As mentioned in the former part, SPAC IPOs have become the buzzword on Wall Street and other parts of the world, since last year.

But, what is that?

Why is the concept of SPAC IPOs gaining popularity when we have traditional IPOs?

Let us find out!

Well, there is no sure answer to this query as to why all of a sudden companies are weighing the options of taking the route of SPAC for raising funds instead of going public through conventional IPOs. But, having said that, there are possible reasons that can be quoted here and they are mentioned as follows-

  • In the last couple of years, several traditional IPOs like that of WeWork (a unicorn) have failed terribly. The situation became so dire for WeWork that it affected its valuation and reputation in the market.
  • With SPAC IPOs the pressure of investors and their scrutiny reduces solely because the SPAC that goes public is not a real company, has no operations or performance history. Therefore, investors have nothing (no financials, goals, future planning, etc)  to analyse and they mainly make their bets on the fame and market reputation of the SPAC sponsors.
  • Finally, companies belonging to risky industries like media are more likely to choose the path of SPAC.

Conclusion

In 2020 where many popular investors and people from the media industry went on to launch SPAC IPOs, others are planning to do so.

For instance, the ex-NBA basketball player and legend, Shaquille O’ Neal is planning to form a SPAC with three former executives of Disney. Through the SPAC, they are planning to spot and acquire companies from technology as well as the media industry. Although the concept of SPAC IPO is becoming mainstream and in 2021 more eminent people are expected to join this bandwagon but it continues to attract its fair share of criticism.

Investing in SPAC results in fewer profits for retail or individual investors like you and me. Further, there are many SPACs that have underperformed in the market and many believe that the trend of SPAC would soon go out of fashion.

While there are SPACs like that of DraftKings and Virgin Galactic that performed exceptionally well, but if you look at the statistics of the last 5-6 years, then the news is not that merry! Between 2015-2020, the average return gained by investors through SPAC is less than the returns offered by companies that went public opting for the traditional IPO method.

Therefore, the future of the concept of SPAC is hazy! 


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