Special Purpose Acquisition Companies (SPACs) have risen to being the star vehicle of raising private capital, after IPOs have become rarer since the government-imposed lockdowns began a year ago. Wall Street was particularly fond of the structure during 2020, leading to a record level of capital raised by SPACs. According to the President of the NYSE, Stacey Cunningham, SPACs are not only a trend but a sustainable alternative to traditional IPOs. SPACs are companies with no operational activity established for the purpose of raising capital on the public markets to acquire an existing company. The potential investor, however, does not know which company might be acquired. Therefore, investments in the SPACs are based on the basis of an investment strategy proposed by the founders of the vehicle. Unlike traditional investment funds, SPACs do not impose restrictions on investor profiles. Any individual or legal entity with access to the stock market can acquire shares. SPACs are generally offered at around USD 10 per share and are there for made accessible to a very broad range of potential investors. Will SPACs be the future of Private Equity by driving its democratization?
Private Equity reaching out to the general public
In the investment world, SPACs seem to mirror current consumerist trends focused on immediacy, dematerialization of exchanges and on wide accessibility. Each SPAC is set up with the objective of investing in a single company. If the SPAC does not invest in a target company within two years, capital raised will be returned to investors. The funds raised through the SPAC are placed in an interest-bearing trust, meaning the investors recover their invested amounts plus interest, deducted by all operating costs incurred at the time of the initial investment. Typically, 2% of the SPAC’s value is taken as an underwriting fee and a total amount of approximately USD 2 million is held in reserve to cover the operating costs of the SPAC until its merger with the target company. The same mechanism applies if the investor is not satisfied with the company acquired by the SPAC and wishes to withdraw from the transaction. In addition to being able to exchange shares at any time, the investors obtain a certain number of guarantees allowing them to change their mind at any time and exit the SPAC almost instantly. This flexibility does, however, have consequences. On the flipside, the individual investor has to waive any protection regarding their ability to bear potential losses, their risk tolerance and their ability to understand all the components of their investment.
The democratization of the investment manager profession
Democratization does not only affect investors, but also investment managers. In theory, any person can establish a SPAC as long as it meets the requirements of the stock exchange on which it will be listed. Thus, personalities from around the world from politics, sports or Silicon Valley have embarked on the SPAC adventure in American markets. However, traditional investment managers should not be concerned about this new vehicle. In weakly regulated environments, such as the environments SPACs operate in, risk management is the responsibility of investors. In the absence of supervision, they can only rely on publicly available information without being able to verify its veracity. Thus, mostly they will focus on what they consider to be a safe bet, i.e. the leading investment companies with a reputation to maintain. The major players in Private Equity are the ones who have a role to play with the SPACs.
Who benefits from the SPACs?
A closer look at the performance of SPACs in recent years indicates that the investor has not been the big winner of the phenomenon. Except for a few shining transactions, the listing levels after the De-SPAC (the phase that ends with the merger with the target company) have often been disappointing. In addition, the compensation mechanism for SPACs managers has room for improvement. Indeed, they are typically remunerated upon completion of the transaction by which they generally obtain a 20% stake in the merged company. As a result, there is a strong incentive to complete a transaction and for that transaction to be substantial in size. This can lead to transactions sometimes up to five or six times the value of the SPAC. On the other hand, there is very little incentive to negotiate the terms of the acquisition to obtain the best price for investors. In this quest for substantial transactions, the SPACs willingly partner with large institutional investors in "PIPEs" (Private Investment in Public Entity). PIPEs constitute a pool of investment opportunities for Private Equity funds that still have significant levels of capital to deploy. Although it involves investing in a company that will be listed on the stock exchange, the negotiations around the PIPE are generally carried out discreetly and are the subject of a preliminary agreement prior to the merger. PIPE partners therefore have access to privileged information about the company being considered for the merger, the size of the transaction and its terms. According to Morgan Stanley data, PIPEs provided USD 12.4 billion of additional capital to 46 SPACs over the year 2020. Finally, in addition to PIPEs mainly concerning the very large alternative players, Private Equity funds can find buyers among the SPACs for companies they wish to remove from their portfolio. SPACs are more than just a new competition – they appear to be new partners in the alternative investment market.
The rapid deployment of SPACs and their accessibility have made their recent success. Although these vehicles seem to challenge traditional Private Equity practices by providing flexibility to investors and openness to the general public, they do not overshadow established players who find in them either new partners or a new tool for raising capital. If the SPACs are a first step towards the democratization of non-listed investment, they would benefit from learning the lessons of the Private Equity industry about the protection of the individual investor and the mechanisms of investment manager compensation.