SPACS: a primer
SPACs are created to raise capital with the sole purpose of acquiring one or more unspecified private companies after going public. SPACs aren’t operational — they essentially serve as a temporary cashbox used to identify a merger target and facilitate its access to public markets.
SPACs are formed by sponsors with specialized financial capabilities — usually institutional investors or private equity firms. The sponsor handles the groundwork necessary for the SPAC’s IPO. In some cases, the sponsor also secures additional funding, such as private investment in public equity (PIPE) commitments or debt financing.
The SPAC can’t identify potential targets for acquisition prior to its IPO, but it can specify a particular industry or geographic area of interest.
Once the SPAC completes its IPO, it can begin reaching out to potential merger candidates. SPACs typically target companies that are two to three times their size to mitigate the dilutive impact of the equity structure.
When an agreement is reached and is approved by shareholders, the transaction is completed, and the SPAC is considered closed. The target company survives as the publicly listed entity. Compared to a traditional IPO, the process can cut the time to public listing by several months — with far less administrative work.
Why SPAC sponsors should be diligent about business diligence
SPAC sponsors conducting due diligence on possible targets typically focus on tax, finance and accounting issues, rather than on broader business. A narrower approach made sense in the early days of the SPAC boom, because many sponsors had specialized expertise in the industry they were targeting, and there was ample supply of privately held companies well-known to investors.
However, as sponsors dig deeper for suitable targets, the risk exposure has elevated. Some companies taken public via a SPAC have struggled because sponsors failed to fully scrutinize the assets they were acquiring. Issues such as poor business models, operational risks and inefficiencies or lack of enough executive talent weren’t properly evaluated and addressed until the target companies became public.
These limitations can have serious consequences. Some recent under-performing SPACs have been damaged by short-selling, and some have even been hit with shareholder lawsuits.² At the same time, the Private investment in public equity (PIPE) market has become increasingly selective in backing up SPACs, which further limits the potential for success.
Although it’s early for many SPACs, a significant portion have delivered negative total shareholder returns, or TSR, with performance that lags many traditional IPOs and overall market.
To overcome these challenges, SPAC sponsors must expand their review beyond tax and finance and conduct holistic business diligence and value creation planning. Many early-stage private companies are less mature than their larger private counterparts or established public companies, so it’s vital that sponsors fully understand the assets they are acquiring — including the associated talent — and develop an operational strategy for success.
Helping target companies thrive post-transaction
Business diligence isn’t new; it is what companies do prior to any deal. But many sponsors lack the expertise and focus, and at times come in with a bias toward closing the deal to conduct full and objective diligence. They must be prepared to conduct in-depth strategic analyses of potential target companies beyond the traditional tax, finance and accounting functions, including:
- Business model and current go-to-market strategy
- Current and potential markets, including competition
- Growth narrative
- Forecasts of sales, revenue, profitability, headcount and other critical metrics. These can be especially challenging to properly vet at private companies without experience in providing financial reporting and guidance
Sponsors should also put appropriate focus on operational diligence, including a review of current contracts, a detailed study of customers and their financial strength, operational risks and implied cost structures. They should assess implications of potential carve-outs, as the target companies may have included only the attractive business lines or assets ahead of de-SPAC to boost their valuations.
Finally, a value creation plan, a road map for long-term success that will enable the company to deliver strong TSR, should be a non-negotiable. As part of this plan, sponsors work to anticipate areas where the target company will need additional support, resources or talent to achieve its projections.
Together with an in-depth study of tax and accounting structures, the business diligence and value creation plan can prepare companies properly for going public — and help them thrive and grow post-transaction.
On the flip side, as target companies consider an ideal SPAC sponsor, they should also pay close attention to how the sponsor is approaching diligence. The more invested the sponsor is in the diligence process, the more likely that they will deliver superior shareholder value creation post-transaction, and ultimately thrive as a public company.
Positioning for long-term success
Even in a fast-paced market, an in-depth business review is necessary strategy. SPAC sponsors should have a healthy skepticism of the private companies they are targeting — especially those in emerging or unfamiliar industries — and taking the time to fully understand the company they are taking public can save time and trouble down the road.
Remember, the SPAC sponsor’s responsibility extends beyond the actual transaction close; ensuring that a target succeeds post-acquisition is vital to reducing risk exposure — and protecting both sponsor investment and reputation in the marketplace.