The Evolution of the SPAC
It seemed like everyone was talking about special purpose acquisition companies (SPACs) two or three years ago, but today, those discussions have largely died down. In fact, a quick internet search reveals a significant number of articles outlining the problems with the SPAC model — and suggesting a variety of different ways to fix them.
With so many obstacles, fixing the SPAC model may be easier said than done. However, that hasn't kept people from trying. Well-known activist investor Bill Ackman tried his hand at fixing some of the issues with one of his SPACs. More recently, another SPAC sponsor has taken steps to try to correct these issues, and some other experts are also weighing in on the SPAC issue.
SPACs offer an alternative way for companies to go public. Instead of holding an initial public offering, privately held companies can merge with a so-called "blank-check company." These companies are essentially empty shells that hold an IPO to raise money so that they can acquire a privately held operational company.
The SPAC model has been around for decades, albeit in various forms, but the number of SPAC deals exploded in 2020. In 2019, 59 SPACs were created with $13 billion invested, but 2020 saw 247 created with $80 billion invested —accounting for more than half of the new publicly listed companies in the U.S.
In just the first quarter of 2021, 295 SPACs were created with $96 billion poured into them. Many companies were attracted to SPACs during those two years because SPAC mergers shortened the going-public process while offering them better terms than a traditional IPO.
Upon its creation, a SPAC has 24 months to merge with a privately held company. To merge with that operational firm, the SPAC raises money by selling shares, usually starting at $10 per share. The capital raised is then placed into a trust account.
For investors, a key piece of the SPAC puzzle is the warrants that typically come with any purchased shares. Warrants give investors the right to purchase a set number of common shares from the issuer at a designated price on a certain date.
Investors buying into a SPAC typically purchase units consisting of shares and warrants. For example, one SPAC unit may consist of one share of common stock and either one warrant or a fraction of a warrant. Investors can exercise whole warrants to receive more shares by a pre-set date. The terms of these warrants can vary greatly from one SPAC to another, so investors are advised to do their due diligence on each.
The problems with SPACs
Investor euphoria in the early 2020s drove the SPAC market through the roof. More recently, however, a number of SPACs have underperformed. Paul Dadwal, founder and CEO of Ari & Co. Capital (no relation to Ari Zoldan, the author of this article), tied the weak stock-price performance seen in many SPACs with a critical timing misalignment between what the various stakeholders in a SPAC want.
"A major issue with SPACs is the inherent misalignment of investor time horizons, with sponsors focused on short-term rewards, potentially disregarding realities of the target company's business, and retail investors are focused on much longer time horizons,” Dadwal explained. “There is significant pressure to identify a target company quickly, which also often results in cutting corners during the due diligence and valuation process. This scenario is a perfect storm that creates the conditions for subpar stock performance.”
Over time, investors began to realize that most of these transactions were a raw deal for them — while handsomely rewarding the SPAC's sponsor (its creator). For example, one study found that the median cumulative return through Aug. 17, 2021 for sponsors in SPACs brought public or liquidated between January 2019 and March 5, 2021 was 507%. Minus the concessions, vesting and forfeitures, the median SPAC sponsor return was still 284%.
On the other hand, most investors lost significant amounts of money on their SPAC investments, often in the triple-digit percentages, with the only noteworthy exceptions being SPAC arbitrage investors, whose gains tend to average a mere 16%. One other critical point about SPACs is that investors who buy shares before they announce a target company have the option to dump their shares before the merger completes if they don't like the deal. When investors redeem their shares, they receive back the amount of cash they invested, plus interest.
Other issues with SPACs include a lack of shareholder-aligned incentives for sponsors to choose a target wisely, dilution of shareholder value, and the high costs associated with SPAC listings. Additionally, the complexity of SPAC deals can cause problems for investors who don't take the time to understand them.
Finally, SPACs allowed for forward-looking statements without any consequences for companies that gave projections that would clearly be impossible to meet. Such statements are not allowed with traditional IPOs, which also require 10 years of operating history.
Bill Ackman's proposed SPAC fixes
Hedge fund titan Bill Ackman offered some potential fixes for some of the issues in his SPAC, Pershing Square Tontine Holdings. Sponsors normally receive shares (often 20% of the shares) for a nominal amount, compensating them even if the company's stock plunges. However, Ackman described this practice as "egregious," so he didn't take any with his SPAC.
Ackman also changed the terms of the warrants to try to entice investors to keep holding the shares after the merger by limiting the potential for dilution from the warrants. For example, Tontine Holdings made two-thirds of the warrants undetachable, encouraging investors to hold the shares for the long term instead of dumping them when a target company was identified. Additionally, investors wouldn't even receive those two-thirds of warrants if they redeemed their stock before the merger closed.
Unfortunately, we didn't get a chance to find out how well Ackman's attempts to fix the SPAC model worked. Tontine Holdings ended up liquidating because it was unable to reach a deal with a target company — despite the fact that at the time, it was the largest SPAC ever.
A private equity approach to SPACs
Another SPAC, TLGY Acquisition Co., also employed a variety of changes to the typical SPAC structure to try to fix the model. The company is currently preparing to merge with Verde Bioresins, developer of a proprietary bioresin that could disrupt the traditional petroleum-based plastics industry.
TLGY has adopted a private equity approach for its SPAC model, prioritizing long-term investments rather than the short-term benefits of transaction fees. Additionally, for 50% of its economics, the company has set a time-based performance target of 35% for the internal rate of return (IRR), which is much higher than the performance standard seen in most other SPACs with other criteria, such as being pegged simply to a price range of $12.50 to $15 without the compounding of IRR.
TLGY Acquisition also put some measures in place to align the sponsor's interests with those of its investors. For example, a significant portion of the sponsor’s economic interest is tied to that 35% IRR. In other words, both sponsors and investors are motivated to help TLGY achieve its high IRR target.
This term should drive a longer-term mindset and holding period rather than a short-term plan that involves redeeming the shares after a short-term gain. Most SPACs tie only 10% to 12% of their economic interest to their target IRR, so TLGY's alignment is significantly stronger.
Use of non-detachable warrants
Like Pershing Square Tontine Holdings and a few other SPACs, TLGY Acquisition also opted for non-detachable warrants. However, unlike the others, TLGY is pooling all of its non-detachable warrants to non-redeeming shareholders, even if it means that millions of units go to just a few shareholders because all the other shareholders redeem. The company is providing an option to convert these warrants to common shares.
Using non-detachable warrants holds back a significant portion of the economics that are given out at the IPO for non-redeeming shareholders who actually fund the company — rather than allowing those who do not fund it to take all the economics. This merit-based compensation better aligns public investors with the sponsor and the company.
This non-detachable structure incentivizes investors to keep their shares rather than redeeming them because they offer the potential for an increasing amount of upside and downside protection in the stock beyond the initial investment if redemptions end up being high. As mentioned earlier, these warrants give investors the right to buy more shares of the merged company at a set price, meaning investors may be able to pick up more shares of the combined company at a significant discount from their selling price after the de-SPAC process. Investors may also be able to convert them into a smaller number of common shares to realize a much higher market value for immediate trading and downside protection in case the price declines.
Upon close, the non-redeeming public shareholders' right to convert the non-detachable warrants to common shares further cements the alignment of investor and sponsor interests. Non-detachable warrants could also reduce the likelihood of a large-scale redemption, stabilizing the post-merger stock price.
Investing in SPACs
All of these attempts to fix the problems with previous SPACs suggest this IPO alternative probably won’t be going anywhere. They also demonstrate that sponsors don’t necessarily need to follow the status quo when planning a SPAC. In fact, sponsors might want to consider these and other novel fixes for the problems that have plagued SPACs in years past.
Meanwhile, investors interested in the SPAC model might want to take note of those that do take novel steps to fix the previous problems. Finally, there is one other critical element of a successful SPAC that all stakeholders should consider when trying to gauge the likelihood of success: communication.
Alyssa Barry, principal and co-founder of Canada-based IR Labs, noted the similarities between SPACs and the popular capital pool company (CPC) model in Canada, which also offers the target company a faster, alternative way to raise funds through venture capital or private equity. She emphasized the importance of communication with both transaction types.
“With both SPACs and CPC transactions, success hinges on early engagement with the investment community – meeting analysts and institutional investors out of the gates to share your story,” Barry said. “But ultimately, it comes down to performance and effective communication with your investors. If your investors believe in your vision and you’re executing on your plans and communicating that clearly to the market, the greater success companies will have post-transaction.”
Ari Zoldan is CEO of Quantum Media Group, LLC. TLGY Acquisition Corp./ Verde Bioresins is a client of Quantum Media Group, LLC
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.