Before Reddit investors wreaked havoc and made “short squeeze” the buzz word across finance and market related websites, SPAC was the buzzword in limelight throughout 2020. This article talks about what SPACs are, reasons behind the surge that it has witnessed and what its future looks like.
What Is a SPAC?
A "special purpose acquisition company" is a vehicle used by companies to go public without all the paperwork of a traditional IPO, or initial public offering. It's essentially a shell company created by investors, called sponsors, solely to merge or acquire another business and take it public without the hassles of an IPO.
It is also known as a “blank cheque” company as investors do not exactly know where their investments would go at the time of investing the money. It has no commercial operations. It does not make or sell any product. Its only assets are the money raised in its own IPO, and its only business plan is to buy another company.
How Does a SPAC Work?
A SPAC has to register with the respective regulator (SEC in the US), even if it's small in their world, small means assets under $1 million. They have to keep the investors' money in a trust or escrow account till a target company is publicly announced. Once that's done, if the investors are not happy with the deal, they can recover their funds.
After the investors pool their money, the SPAC goes out and looks for a real company that wants to go public, and they merge together. The company gets the stock ticker and the capital much more quickly than through a normal IPO, typically in just six months.
The investors now own stock in a real company, not just a shell company.This process is known as combination. The sponsor who put the work into organizing the SPAC gets a big chunk of the company as a reward. The mechanism of a SPAC is much like that of a reverse-merger, albeit with a clean balance sheet for the newly combined public entity.
What Are the Advantages of a SPAC?
SPACS are cheap, many of them priced at $10 a share.
They invest in sectors that are hot like, technology, etc.
They are open to individual and small investors.
What Are the Disadvantages of a SPAC?
Investors do not know where or how the money will be used.
There's a long gap between the time when investors pump money into a SPAC and when a company is thought and it starts operations, typically 18- 24 months.
Background
While SPACs have been all over the news over the last year, it isn’t particularly new and its use can be traced back to the 1990’s when they first developed by GKN Securities- an American investment bank.
Over the years they have been relatively uncommon and have been used by companies which cannot afford to raise funds using IPO and in areas where financing is scarce.
But since 2014, SPACs have had a resurgence. To put into perspective, from 2014 to 2019, there have been 184 SPAC transactions as compared to 248 in 2020 alone. There have been several high profile SPACs such as that of Nikola, Burger King and has seen several high profile investors float SPAC companies such as Bill Ackman and Chamath Palihapitiya.
Even celebrities like Michael Jordan and Serena Williams have hopped on this trend. Reason for surge in SPACs The surge in SPAC transactions has been primarily on the back of dwindling liquidity among private companies, induced by the pandemic. Several private companies could not carry out roadshows and got disappointing response from the investors.
As markets filled with uncertainty, private companies scrambled to SPACs to secure the much needed liquidity in the quickest way possible.With the entry of high profile and institutional investors in the SPACs space, more retail investors followed, which eventually led to us writing this article. To sum it up, the surge was a result of speed, control and less uncertainty that SPACs offer.
What Next?
As we move into the recovery phase all around the world, SPACs are likely to play a key role in raising capital. Its popularity hasn’t been restricted to the US, as Europe, Asia and other markets around the world catch up on the trend. We might even see SPACs in India, despite some legal hurdles that need to be sorted out.
While SPACs have gained immense popularity, it is important to not blindly follow the herd. The fall of Nikola is a reminder for investors that there are drawbacks to less regulations and disclosures, and we may see increased oversight from lawmakers in the future.
A much talked about report from Goldman Sachs, an assessment of 56 SPAC transactions over the last two years, showed that the SPACs typically outperformed the market in the first month and quarter, however thereafter the variations in returns were extremely wide. Call it a bubble, a fad or outright genius; it is clear that SPACs are here to stay.
Written By - Nidhi Verma
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