Gary Palar, Samuel Subramaniam, Victor Yan
Special-purpose acquisition companies (SPACs) have become increasingly prevalent in the media in 2020: with companies like Virgin Galactic Holdings Inc (NYSE: SPCE), Nikola Corporation (NYSE: NKLA) and Draftkings Inc (NASDAQ: DKNG) producing imaginary returns (up to 300%+ at peaks) for investors. Here, we explain what SPACs are, we discuss the advantages of this niche investment vehicle, how they work and look at Bill Ackman’s Pershing Square Tontine Holdings as a case-study. Then, we briefly consider the future of SPACs in a space dominated by initial public offerings (IPOs).
Special Purpose Acquisition Companies
A special-purpose acquisition company (SPAC) is a company without operations (termed a shell company) created for the sole purpose of acquiring another business with operations.
It holds only tangible assets, such as cash or other short-term money instruments, is without the burden of liabilities, and so is solely owned by its shareholders.
Why Create a SPAC?
Unlocking value: ‘The purpose of a SPAC varies, but as its name suggests, it is built to acquire‘
There are various reasons why you would create an empty company to acquire another. In many cases, this can be value-generating for investors in the SPAC.
Some of these reasons are:
- Management adds value: Management experience can close deals which may have been difficult otherwise.
- Increased liquidity: Acquiring a private business decreases liquidity risk for shareholders; shares become easier to trade in secondary markets
- Flexibility: Investors can trade their shares while investment managers search for acquisitions
- Transparency: Compared to investors in private equity, shareholders know the intentions of management
- Filing to create the SPAC can be much easier than an operating company filing for an IPO (SPACs don’t have complex operations)
- Reduced costs compared to a normal IPO: The combined costs of creating a SPAC are around ~5.5% depending on the size. A typical IPO underwriting will cost around ~7.5% of proceeds raised.
Timeline of a SPAC
SPACs can typically be around for up to 2 years. This is subject to the agreement made by investors and management of the terms of the SPAC.
If management cannot find an acquisition target within the agreed timeframe, the SPAC is liquidated and all proceeds are returned to shareholders. The amount that makes it back is almost the same minus very small management fees. However, the greater cost in this investment is the opportunity cost investing in one of zero returns, rather than others with positive returns.
There are three basic units associated with SPACs: public units, founder shares and warrants.
Public units are, as the name suggests, sold to the public. Each unit consists of an ordinary share and a fraction of an OTM (out of the money) warrant. Post IPO process, these become separable. These funds are put into the aforementioned trust and held until either an acquisition is approved, or a certain predetermined period elapses. If an acquisition is not actioned within this period, the investment is returned to investors with an allowance for bank and broker fees.
Founder shares, those being purchased by the sponsor, are purchased prior to the SPAC filing. In general, these shares make up 20% of the number of total shares outstanding and are a core component of sponsors’ compensation.
As part of the public units, warrants may be converted into common stock at various strike prices. These are usually exercisable after a considerable amount of time post IPO or a shorter time in the case of shareholder rejection of an acquisition.
Pershing Tontine Holdings: A Case Study
In analysing capital structure, case studies help can make sense of their complexities. In July 2020, Pershing Square Capital Management, a prominent hedge fund run by Bill Ackman, announced their sponsorship of Pershing Square Tontine Holdings – a SPAC that raised approximately USD$4 billion. The deal is set up to offer 200 million units at $20 each, with Pershing Square privately taking approximately USD$1.5 billion units. Ackman’s acquisition candidates consist of “numerous high-quality, venture-backed businesses [which] have achieved significant scale, market share, competitive dominance and cash flow”, a.k.a ‘Mature Unicorns’.
The structure of this SPAC consists of:
i) One share of common stock;
ii) 1/9th of a redeemable warrant, exercisable at $23;
iii) 2/9ths of a warrant, exercisable at $23 (not to be redeemed in connection with a proposed business combination).
The terms of Pershing Tontine: Aligning Investor Interests through Capital Structure
A noteworthy condition of this capital structure is that if a shareholder does not redeem shares from warrants within the aforementioned time periods, warrants are redistributed to those that remain with positions in the SPAC, on a pro-rata basis.
What further illustrates the development of the SPAC entity through this raising is the compensation scheme. Whereas most SPAC sponsors receive Founder Shares in a 20% stake of the company, Pershing is taking no founder shares and paying a considerable amount more for warrants ($67.8m) for a considerably smaller stake (6.21%) with an agreement not to exercise within three years of the closing of the acquisition.
Extending on this, Pershing’s warrants are only exercisable at a 20% premium, aligning incentives with investors as the firm will only make a considerable ROI once the investors have achieved theirs of 20%.
As global markets face heavy headwinds and worldwide recessionary outcomes, IPOs are becoming less and less viable for companies looking to maximise through capital raising (See figure below).
For growing companies seeking certainty in times defined by uncertainty, an alternative to a traditional IPO is needed. A company looking for safety in terms of price per share, trust in management and a structure that promotes long term investors will be increasingly attracted to leveraging the advantages of SPACs.
While the pandemic has caused plenty of chaos and disruption to our natural ways of life, it has also welcomed a transition to new normals in many respects. In this sense, SPACs are certainly the hot issue in 2020; jumpstarting the raising of public capital. Only time will tell if they will structurally shift the equity capital market landscape and usher in a new era replacing their IPO big brothers.
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.