Return of the SPAC
Domestic growth of SPACs, misaligned incentives, and a look into cross-border transactions
Welcome back! In case you missed my last post, I took the time to explore the increasing demand for sustainable investments and what that means for the future reporting of nonfinancial, ESG disclosures.
Return of the SPAC
As many of us know, the 90’s born investment vehicle is back and making noise like never before! It’s quite easy to look at the sizeable amount of capital raised in 2020 (exceeded in just the first two quarters of 2021 alone) and understand why the term SPAC has taken over our newsfeed, becoming a hot topic not only amongst Wall Street gurus, but retail investors and even… celebrities?
The 30,000 Foot View ✈️
It is commonly argued that a SPAC transaction is merely a form of a reverse merger. The rationale here is that the private company, or “target,” will enter the public market by means of a business combination. The acquisition of the “target” is executed by a non-operational, “blank check” company, otherwise known as your SPAC (Special Purpose Acquisition Company).
Sponsor Team
The SPAC is formed by a management team referred to as your “sponsor(s).” The sponsor(s) is typically an individual with extensive, industry-specific experience who will work to raise cash in the IPO in order to stockpile into a trust.
Money raised by the sponsor team is only deployed from the trust upon acquisition of the target company, resulting in the target subsequently taking the place of the SPAC in the public market. For this reason, it is common that the sponsor(s) will take responsibility for upfront costs associated with the initial offering.
CAVEAT: There is a timeline.
The timeline for the acquisition, otherwise known as the “De-SPAC” transaction, is traditionally 24 months following the IPO. It is within this period that a sponsor will work towards hunting down an ideal target to take public via an acquisition.
An important aspect to take into consideration is that in light of recent regulations, the sponsor(s) must return all cash back to investors in the scenario a SPAC is unable to successfully acquire a private company within the allotted time (unless granted an extension by shareholders). Additionally, regulations now allow for a 100% return of cash to investors who find they are not in favor of the target company in question.
A Trip Down Memory Lane
“Pump & Dump” 📈
Following regulation targeted at blank check companies for their common affiliation with “pump and dump” penny stock schemes in the 1980s, the SEC issued Rule 419 in order to publicly declare what would constitute a blank check company; including:
“(i) Is a development stage company that has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person; and
(ii) Is issuing ‘penny stock,’ as defined in Rule 3a51-1 (17 CFR 240.3a51-1) under the Securities Exchange Act of 1934 (‘Exchange Act’).”
Dotcom Era 💻
In 1993, investor David Nussbaum leveraged the protective principles of Rule 419 in order to create an investment vehicle in which the structure of a blank check company could be used in the form of a SPAC. Following his innovation, twelve of Nussbaum’s thirteen SPACs had gone public and successfully completed acquisitions. However, with the ease of private companies going public during the midst of the dotcom bubble, SPAC momentum had slowed.
U.S. Housing Crisis 🏡
Fast forward to the mid-2000s and we begin to see SPAC deal count pick up again. Leading up to the 2008 housing crisis, SPAC IPO’s accounted for nearly 25% of all IPO’s.
Following 2008, IPO activity had begun to slow, leaving SPAC-based IPOs with just a single transaction in 2009. More so, approximately 64 SPACS (raising $8.9B in capital between 2003 and 2010) had been forced to liquidate due to an inability to identify or come to an agreement with a related target for acquisition. But lo and behold… the dead has risen!
Covid Times 😷
Using data provided by SPACInsider, we are able to visualize the abrupt growth in SPACs today. Looking at the YOY growth for FY20 compared to FY19, we can see a growth rate of 320% in IPO counts attributable to SPACs, supporting a growth rate of 513% in gross proceeds raised via SPAC transactions for a total of $83B across 248 IPOs in just FY20.
(source: https://dealogic.com/insight/ma-highlights-first-half-2021/)
In 2021, the momentum surrounding SPACs held strong up until the announcement of potential SEC intervention. However, even with the slowdown in the SPAC IPO market, activity has still outpaced FY20 with a total of 413 IPOs YTD, resulting in gross proceeds of approximately $122B.
So Why Now? Uncertainty, Fear, & Liquidity.
COVID-19 may have been the saving grace for SPACs. If we rewind the clock to pre-pandemic days, it was common to find media outlets discussing the continuous decline in the number of listed companies in the United States. This was largely attributable to the following pre-COVID trends:
Growing amount of capital available in the private market via venture capital.
Increased M&A activity resulting in buyouts of early-stage companies by large dominant players.
(As of 2019, there were only 4,266 listed companies in the United States, a decrease of roughly 47% from the record high of 8,090 in 1996.)
However, in the onset of COVID-19, uncertainty and fear plagued the market, leaving numerous private players worrisome of a liquidity crisis. The question of whether private, series funding would sustain itself throughout the pandemic meant private companies needed a quick alternatives for cash. This set the foundation for the return of SPACs, an alternative that could get money into the pockets of private companies with merger processes taking as little as three to four months.
Time is 💵!
The headache associated with the traditional IPO is a product of the highly demanding time, and effort, invested in the preparatory work of the offering. Now mix in the added components of pricing and size uncertainty and you’ll see why the traditional IPO can quickly lose favorability to a SPAC amongst private company management toying with the idea of going public.
Time is money baby! We need to remember that a SPAC is non-operational in nature. What this means is that outside of cash and limited investments, there are no liabilities, profit & loss, or other assets that a SPAC must worry about in the disclosure process for the IPO, significantly speeding up the timing of the offering.
(Source: “Public to Private Equity in the United States: A Long-Term Look.”)
Choose wisely…
Earlier I have introduced the concept of a “sponsor,” the individual raising money on behalf of the SPAC in order to pursue the acquisition of a target company. Given SPACs have no operating history prior to the acquisition, it becomes increasingly important for outside investors to pay close attention to the experience and professional background of the sponsor(s) in question.
Now, there are upsides and downsides to the sponsor-led structure of a SPAC. If we think about a SPAC from a venture capital lens, the sponsor structure can be extremely beneficial.
Why so? Well, SPACs provide an ability for investors in the public market to be able to buy into a vision or idea behind a company that may traditionally be considered too early-stage or not yet have traction in the greater market.
But on the flip side, the SPAC sponsor structure can also create pressure that results in what may be perceived as a misalignment of incentives.
Pay Day!
It’s typical for the sponsor(s) to pay underwriting and legal fees associated with the initial set-up and subsequent merger in return for a “promote.” The promote, which in theory can be seen as a return on investment for upfront costs and management expertise, is roughly a 20% ownership in the target company via “founder shares.”
Where this stake can get messy is at the intersection of (1) a pressured timeline to complete an acquisition; and (2) an understanding that only a successful merger will result in the sponsors significant payout.
“Looming over these firms is a two-year deadline to do a deal or hand back cash to investors.”
With that being said, there is self-incentivized pressure by the sponsor team to complete the acquisition before the two-year timeline to avoid returning cash to investors, forgoing the tremendous upside the SPAC structure provides.
This creates a pressure amongst sponsors to move quickly following the IPO, which in turn may result in inadequate due diligence and an overall poorly sought out acquisition in order to meet the deadline.
Does Supply Meet Demand??
Increasing this risk of poorly performing, operating companies being snatched up by SPACs is the fact that deal count has reached record highs in the past year, and into FY21, with still 438 SPACs looking to pursue an acquisition.
The risk here is that the supply of companies actually ready to go public and perform to the standards of investors may not meet the demand of those sponsors rushing to complete an acquisition, resulting in the pursuit of more risky acquisitions that leave retail investors with poorly performing share price post-merger.
So if an increasingly high concentration of SPACs in the U.S. are rushing to acquire what is a potentially dwindling availability of domestic, “quality” target companies, then where do you go?
Cross-Border Transactions ✈️
Europe’s focus on SPAC growth comes at a time in which U.S. activity has sharply declined due to SEC scrutiny; however, they remain largely a U.S. game while substantially outpacing Europe and other parts of the world in the number of IPOs completed throughout the years.
Given how crowded the domestic market is and the limited amount of quality, domestic targets that may be left to acquire, there are various reasons for U.S. SPACs to participate in cross-border transactions as they race against the clock to avoid potential liquidation. Partner John Lambert of KPMG summarizes a few reasons below:
There are early-stage overseas companies that represent attractive acquisition targets with high-growth stories.
U.S.-based SPACs can bring their domestic experience of capital-market transactions to a company in a foreign country.
Foreign targets may be looking to join U.S.-based SPACs to tap into the liquidity and efficiency of execution of the U.S. market.
Accounting Framework
The post-merger process has an ability to FURTHER complicate financial reporting when you are dealing with cross-border transactions, with the root of it falling on your respective framework: GAAP vs. IFRS.
Upon the completion of the acquisition, the target company will become a “predecessor” to the SPAC and will replace the domestic entity’s financial statements with those of its own. However, given that the acquisition takes place following the registration statement, the target’s financial statements are not required to be presented under GAAP at the point in which the proxy/registration statement is filed.
Conversion to GAAP
The conversion between IFRS and U.S. GAAP is a transformative process for an entity, including potential system/process changes, complex accounting policy adoption, reconciliations, etc.
A quality conversion between GAAP and IFRS is a timely ordeal, all the more difficult under the stressed timeline encapsulated in the deal process. With today’s environment ripe for global M&A, buyers and sellers must align on the need for translatable financial data.
In order to provide reliable data without slowing down the deal process, it becomes pressing for those involved in a SPAC transaction to identify and understand conversion requirements prior to and/or during the negotiation process. A prior understanding of key differences involved in the transformation of the target company’s financial and accounting policies will best prepare the target for becoming the predecessor in the public market, and by doing so, becoming a US GAAP preparer.