Special Purpose Acquisition Corporations, commonly referred to as “blank check companies”, are shell companies that go public through an initial public offering (IPO) without having a product, profit, or revenue. They do not have any fixed assets, overhead, or business expenses. In other words, SPACs exist for the sole purpose of raising capital in the hopes of merging with a promising private company.
Typically, the founders and sponsors of these companies have an expertise in a particular industry and fundraise on the premise of merging with a budding company within that space. However, other than having a two-year window to acquire the private company, SPAC leaders are bound by very few constraints as to what company they ultimately identify for purchase, hence their “blank check” label.
Although SPACs are not a new concept, their popularity has skyrocketed over the past 12 months. There are several factors that have amplified this trend:
- While plenty of companies had successful IPOs in 2020, many were also deterred from hitting the public market through the traditional route because of COVID-related market volatility. Instead, many went public via SPACs because of the perceived safety of going public through a merger with an already publicly traded company.
- Not only is there a perceived safety through SPACs, but going public this way is also less of a headache for the management of the early-stage company being acquired. Filing for a traditional IPO is a burdensome process that requires months of preparation, communication with the SEC, and lots of fine print on the dos and don’ts. Mergers with SPACs are not subject to nearly the same level of scrutiny in their regulatory process.
- The demand for early-stage startups (pre-profit or revenue) on behalf of retail investors has grown tremendously over the past decade. Take Uber as an example; they went public after a lot of their growth was already incorporated in the stock price, however, plenty of early seed investors reaped tremendous benefits that were not available to the public prior to their listing. SPACs, in theory, represent a venture capital or private equity fund of sorts, but available to retail investors.
To put the proliferation of SPACs in context, all you need to do is look at the numbers for 2021 thus far. Through six weeks, $40 billion has already been raised through SPAC offerings. In 2020, $80 billion was raised in SPAC offerings, which was a record shattering number at the time. This year’s trend has no sign of slowing down, as there are currently 345 SPACs outstanding in the market, of which 286 are actively looking for a deal. Additionally, there are at least 100 more planned SPAC filings that will be going public soon.
It is tempting to look at SPACs from the startup CEO’s perspective, or even the perspective of a retail investor, and think, “What could go wrong?” From the CEO’s perspective, you are given access to easy initial capital to build your business without the regulatory hassle of filing for an IPO with the SEC. From the perspective of the retail investor, you could be one of the ground floor investors in a company with tremendous growth prospects.
When something seems too good to be true, it usually is
Recall the last time you purchased car insurance. In order to get the best rate, you had to prove a clean record, good driving history, solid creditworthiness, and so on. This information is required because it is the policy underwriter’s job to manage what is called “adverse selection,” or the tendency of persons with higher-than-average risks to purchase or renew insurance policies. Adverse selection occurs when one party attempts to exploit information that the other party does not possess. This same principle has important implications when applied to the process of a company going public. In a traditional IPO process, the SEC acts similarly to the insurance underwriter, ensuring that the company going public follows a strict timeline and reports financials in an accurate and timely manner.
Importantly, the SEC restricts what the companies can project to the public and forbids any direct pitches to retail investors. SPAC offerings do not have any such regulations. The primary responsibilities of the SPAC sponsors, first and foremost, are to attract investors and acquire a company. The two-year window that sponsors must strike a deal is noteworthy because they will not be compensated if an agreement isn’t reached. This condensed period, absent of an SEC vetting process, is ripe for ignorance of potential underlying company issues and represents a significant risk for investors.
What do SPACs tell us about the state of markets?
The popularity of these investment vehicles over the last twelve months is a manifestation of the overall market’s appetite for speculation. Although interest rates have crept above the lows we saw last year, cheap borrowing has only added fuel to the fire. Valuations for promising early-stage companies have soared as more SPACs enter the space and pursue a dwindling set of attractive opportunities. SPACs have yet to receive intense regulatory attention yet, however, there are many risks that point to this possibility in the future.