Although they have been around for decades, SPACs – or Special Purpose Acquisition Companies – grew increasingly popular during the COVID-19 pandemic, with recorded SPAC initial public offerings (IPOs) jumping from 59 in 2019 to 613 in 2021.
And they have attracted some very popular figures, from all backgrounds. Basketball Hall of Famer Shaquille O’Neal, rapper and record producer Jay-Z, television personality Martha Stewart have all been involved with SPACs. Billionaire CEOs Barry Sternlicht, Jahm Najafi, and Bill Ackman have also invested in SPACs.
The SPAC movement has also been integral to the electric vehicle (EV) battery sector, with the likes of Polestar, Nikola, and Lordstown Motors all listing on the NASDAQ via SPAC mergers.
However, the foundations and making of SPACs have some serious flaws.
These flaws result in high levels of share dilution, with the shareholders at the time of the SPAC’s merger tending to bear the majority of the costs. These issues extend even deeper when publicly listed companies in different jurisdictions are involved – not just with share dilution, but also redeeming shares and an overall confusion with the listed stock price.
An Overview on SPACs
A SPAC is a shell company without commercial operations that is created to raise funds to acquire and merge with another company, thereby making that company public.
There are two separate transactions by which a SPAC brings a company public.
Firstly, the SPAC goes public through its own IPO, raising initial capital through the process. The second step involves the finding a public or private company to merge with. This brings the company public in the U.S. and is typically combined with an additional capital raise.
The SPAC begins with a sponsor forming a corporation and then working with an underwriter to take the SPAC public in an IPO.
The sponsors are usually organised by large private equity, venture capital, hedge funds or even high net worth individuals who act as the manager of the SPAC IPO and merge. They also invest a nominal amount of capital in the SPAC.
Prior to the IPO, the sponsor obtains a block of shares at a nominal price that is adjusted to 20% of the post-IPO equity. This is known as the sponsor’s ‘promote’ and is essentially the compensation for setting up the process of the SPAC and supporting the SPAC’s management while the SPAC seeks a company to take public in the U.S.
Once the SPAC goes through the IPO, investors provide funds in the shell company in exchange for shares within the company and a fraction of a warrant to buy another share.
(At this stage, investors are unsure of what the SPAC will merge into, so are rewarded with these partial warrants.)
The funds generated from the SPAC’s IPO are placed in trust and is invested in Treasury notes.
Once the SPAC IPO is conducted, the SPAC has up to two years to find a target to merge into.
Once the merger is announced to the public, the SPAC’s current shareholders have the right to vote against the transaction and elect to redeem their shares.
If the SPAC requires additional funds to complete a merger, it may issue debt or even additional shares, such as a private investment in public equity (PIPE) deal.
Once the shareholders approve the SPAC merge and all regulatory matters have been cleared – the merge is successful. This now means that the acquired company gets access to capital and becomes public whilst the investors get ownership in the form of shares and partial warrants if they choose to remain shareholders.
A key feature of SPACs is that, when the SPAC proposes a merger, shareholders have the right to redeem their shares at a price equal to the IPO price of the SPAC’s units plus interest accumulated in the trust.
A rule of thumb is the amount of money raised is a quarter of the expected enterprise value, although there is a range around this.
When SPACs Attack
There are some series costs that are inherent in the SPAC structure. These costs ultimately extract value from the SPAC shareholders, the target, and its shareholders.
As previously mentioned, the sponsor receives a block of shares equal to 25% of the SPAC’s IPO proceeds, or equivalently, 20% of shares outstanding after the IPO.
This acts as a form of compensation; however, it also dilutes the value of the SPAC shares.
So, while shareholders initially buy SPAC units for $10.00 each in an IPO, after accounting for the promote, there is only $8.00 ((100%-20%) x $10)) in cash for each outstanding SPAC share immediately following the IPO.
The promote also creates a dysfunctional incentive for sponsors.
At the outset, it makes creating a SPAC very attractive, regardless of whether a sponsor has realistic prospects for negotiating a winning merger. SPAC sponsors obtain 20% of the company, whilst only investing a nominal amount. Even SPACs that enter into value-destroying mergers can generate tens of millions of dollars for the sponsors.
Another source of dilution results from the warrants that the SPAC IPO shareholders receive.
If the share price settles above $11.50 up to 5 years post-merger, shareholders of the SPAC IPO can claim warrants to purchase more shares. And because exercising these warrants increase the float, they cause dilution for shareholders merged into the SPAC.
In relation to publicly listed companies in other jurisdictions that get selected for SPAC mergers, there are several profound issues.
European Lithium’s (ASX: EUR) recent SPAC merger agreement will be used to illustrate this.
On October 26, 2022, European Lithium entered into an agreement with Sizzle Acquisition Corp., a special purpose acquisition company, stating that the lithium company will merge into the SPAC and become a NASDAQ-listed company called Critical Metals.
In consideration for the Transaction, European Lithium would be issued US$750 million worth of ordinary shares in Critical Metals, giving them a roughly 80% ownership interest in the combined entity.
The first issue relates to the 80% dilution to the current SPAC IPO shareholders.
When assessing a private company that becomes public through a SPAC, current SPAC IPO shareholders are unaffected by this type of dilution due to the fact that there are no public shares, however, because European Lithium issued 80% of their public shares through this SPAC, current SPAC IPO shareholders get diluted.
The second issue relates to the redeeming of shares.
As previously mentioned, SPAC shareholders have an option to redeem their shares rather than participate in the merger at a price equal to the $10.00 IPO price of the SPAC’s units plus interest accumulated in the trust.
Redemptions to SPAC merges cause two major issues – lower the share price of the company and reduce the cash proceeds that the combined companies will have to fund future operations. If the redemption rate is excessively high, the SPAC is at significant risk of failing to meet its cash minimum condition.
According to SPAC Research/SPAC Alpha, from January to July of 2021, the average monthly SPAC redemption rate ranged from 7% to 43%. However, from July to November, the range soared to 43%-67%, with an average SPAC redemption rate of 60% during these four months.
On December 29, 2021, Virgin Orbit, a company within the Virgin Group which provides launch services for small satellites, closed its transaction with SPAC NextGen Acquisition Corp. II.
Virgin Orbit had expected to raise $483 million in total gross proceeds, including a PIPE investment of $100 million from Boeing, AE Industrial partners, and others.
However, a redemption rate of 82.3% ahead of the transaction reduced the SPAC’s trust account by $315 million and resulted in the company raising less than half of the original anticipated total.
Another issue in regard to public companies merging into a SPAC is the assumption that the value of the merger relates directly to the SPAC share price.
Using European Lithium’s current share price of $A0.10 equates to a valuation of A$134 million. However, based on the share price of the SPAC merger of US$10.20, European Lithium has assumed a valuation of US$750 million.
The company has failed to include the effects of dilution resulting from the redemption possibilities and the 80% dilution of European Lithium rolling into the SPAC.
Whilst SPACs undoubtedly offer certain advantages over the traditional IPO process, these benefits come at a cost that is almost always borne by the SPAC merger shareholders.
And, with the number of SPAC IPOs being priced plummeting from 362 in 1H21 to just 69 in 1H22, investors have clearly caught onto this fact.
Nevertheless, given the lack of clarity regarding the effect entering into a SPAC can have on a company and the confusion these transactions can cause current and potential shareholders, it could be argued that 69 SPAC IPOs is in fact 69 too many.
Whatever the case, there is clearly the need for regulators to investigate these types of transactions further to ensure they are being conducted in a fair and equitable manner for all parties moving forward.
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