What is SPAC and how does it work? Addressing the Wall Street's latest trend

What is a SPAC?

A Special-Purpose Acquisition Company, or SPACs, is a Wall Street jargon for a shell company with no commercial operation. Also known as blank-check companies, SPACs are formed to raise capital through a public listing and merge with a private company, which intends to go public without going through the hassle of traditional IPOs.

Significant firms like sports betting company DraftKings Inc, and British business tycoon Richard Branson’s space tourism company Virgin Galatic Holdings Inc, are some of the few companies, which went public through a SPAC merger.

A brief history of SPAC

In 1992, the U.S. Securities and Exchange Commission introduced Rule 419 to regulate the market for blank check companies. David Nussbaum, a banker, and his lawyer David Alan Miller came up with the term, Special Purpose Acquisition Company, to differentiate companies going public under the new 1992 rule from 1980s-era blank check companies. Nussbaum and Miller even trademarked the SPAC acronym in 1992. In 2000, the trademark got canceled due to failure to file for continued use.

Nussbaum took his first SPAC, Information Systems Acquisition Corp, public in 1993 and merged with enterprise software firm Neoware. Between 1993 and 1995, GKN Securities, Nussbaum’s firm, underwrote 13 SPAC IPOs, of which 12 had successfully closed their deals, he said in an interview with The Information.

The SPAC explosion

Since the breakout of the COVID-19 pandemic in 2020, businesses got shut with little to no hope for reopening in the foreseeable future. Amid the cash crunch, lots of companies filed for Chapter 11 and Chapter 13 bankruptcy. In a desperate need to raise capital, many private firms considered public listing through SPAC mergers. It takes less time for a company to get listed as a publicly-traded company through SPAC than a traditional IPO. Since then, SPACs began to surge, and the momentum continued into this year.

How do SPACs work

A Special Purpose Acquisition Company is used to raise cash through an initial public offering and investments from other funds to merge with a private company. The private company then gets placed in the stock market, replacing the SPAC.

A SPAC may identify a target sector in its prospectus, though it can change it in the future. Sometimes, the sponsors or the SPAC managers may have experience in the target industry have a track record in investing, which helps them get a better merger deal.

Stages of going public through SPAC

• After a SPAC is being formed, it gets listed in a stock market through an IPO. SPAC offerings typically are priced at $10 a unit. A unit consists of redeemable warrants and some number of shares and, depending on terms. A warrant is a financial contract that allows the holder to buy additional shares in the future at a given price. After the IPO, the SPAC’s units, shares, and warrants begin trading individually.

• The SPAC managers start searching for the target company after the IPO. After the target company has been identified, the shareholders vote on the merger. Following the SPAC merger is announced, the share price gets volatile based on how investors perceive the deal.

• As the merger is completed, the private company gets the SPAC’s place on the stock exchange. The name of the stock and ticker, which was previously in the SPAC’s name, gets replaced with the private company’s name and gets listed. The share price rise and fall based on the new company’s outlook.

Benefits of SPACs

• Once a SPAC finds a target company and announces the merger, both companies can make ambitious forecasts to the investors. That can drive the SPAC’s share price higher before the regulatory documents associated with the merger are publicly released, which is not allowed ahead of a traditional IPO.

• Traditional IPOs can take up to two to three years to finalize, but generally, an M&A between the SPAC and the private company takes two to three months. Also, traditional IPOs are very expensive to execute. In contrast, in a SPAC merger, the SPAC pays for most of the costs.

• SPAC deal terms and the valuation is agreed upon by both companies with an assurance beforehand. Whereas in an IPO, companies do not know how the market will react on the debut date.

SPACs with no merger

A SPAC typically has two years to complete a deal. If it can’t find a merger deal, the SPAC can seek an extension period that requires shareholder approval. If the approval is not granted, the SPAC is liquidated.

Bottomline

The U.S. Securities and Exchange Commission (SEC) is moving towards curbing the recent SPAC boom. Research firm Deal Point Data’s study shows, 247 SPAC IPOs were completed in 2020, raising total gross proceeds of about $75 billion, which is about 48% of the overall IPO market by value. When compared with 2019, there’s an increase of 320% in the number of SPAC IPOs.

In 2021 SPACs have already raised about $95 billion, soaring past last year’s record total, and account for about 70% of all IPOs this year, according to Dealogic.