Decoded: What is SPAC and is it the real thing or a misplaced hype?

Special Purpose Acquisition Companies, or SPACs, are listed shell companies created with the sole purpose to acquire unlisted or private companies and then merge with the latter

Special Purpose Acquisition Companies, or SPACs, are the hottest new thing on Wall Street today. Their sponsors present them as a brand new asset class that offers investors an opportunity to invest in private companies at an attractive valuation. So, what is SPAC and is it the real thing or a misplaced hype?

What is a SPAC?

At the simplest, SPACs are listed shell companies created with the sole purpose to acquire unlisted or private companies and then merge with the latter. SPACs don’t have business operations or any revenue of their own but are created to raise capital through an initial public offering, or IPO, to acquire private companies later on. This is done by selling shares to the general public, just like a regular IPO. Investors also have the choice to purchase a warrant that gives them an option to buy more shares at a later stage at a fixed price.

These are also called “blank cheque companies” as SPAC investors have no idea about where and how their capital will be utilised.

Once the capital is raised, it’s kept in a trust till a target is found and acquired. If a SPAC fails to find the right acquisition target within two years, investors get their capital back.

As SPACs don’t have business operations, or a track record to speak of, they are largely sponsored by celebrity investors or high-profile CEOs who have the ability to draw investors in an IPO.

The sponsors reward themselves by buying up to a fifth of the SPAC’s total shares or capital at a huge discount to the issue price. For example, if a regular investor pays Rs 100 per share, sponsors get the same share at Re 1 or even less. The fee is called “Promote” in industry parlance and results in stake dilution of ordinary shareholders that hurts their long-term returns.

How do SPACs make money or provide a return to their investors?

Once SPACs get listed on the bourses, they use the capital raised during their IPO to acquire a private company and merge with it. Post-merger, the SPAC changes its name and identity to reflect the business operations of the acquired entity. The share price of the SPAC now reflects the business and finances of the acquired company.

SPAC sponsors claim that they can use their skill and experience to acquire a high-potential private company at a valuation lower than what it had commanded had it listed through a traditional IPO. This, they say, greatly improves the post-listing (or merger) gains for SPAC investors.

For example, in 2019, Richard Branson-promoted space company Virgin Galactic listed on the bourses through a merger with a SPAC sponsored by venture capitalist Chamath Palihapitiya. Virgin Galactic share price has tripled since its listing compared to a 50 per cent rise in S&P 500 index during the period.

The success of Virgin Galactic had led to an explosion in new SPACs, especially in the United States. According to Bloomberg, SPACs have raised more than $100 billion since the beginning of calendar 2020.

So why are SPACs controversial?

Critics see SPAC as a vehicle for the rich and famous to sidestep regulatory scrutiny and make unfair gains at the expense of ordinary shareholders who are sold shares at par or full value.

Traditionally, a private company gets listed through IPO, which is a four- to six-month-long process and requires it to make an exhaustive list of disclosures about its finances, business operations, future prospects and the promoter/s’ background. This results in a close scrutiny of the company by the media, financial analysts and the market regulator.

SPACs sidestep this entire process and offer private companies the opportunity to list directly. This saves companies time, besides the financial cost involved in hiring merchant bankers that underwrite the IPO.

This fast route to listing is the biggest draw of SPACs, especially in the post-pandemic period that has seen a big boom in IPOs and when valuation of tech companies is at an all-time high.

Others see SPAC as a means for rich and famous bankers and CEOs to encash their popularity and reputation without risking any of their own capital. For example, Palihapitiya had bought shares in his SPAC at 0.002 cents per share, while ordinary shareholders had paid $10 for the same shares.

This has put SPAC at the centre of debate on income and wealth inequality that is now a hot political issue in the United States and several other countries.

How have SPACs performed on the bourses?

According to a study by Goldman Sachs, companies that got acquired by SPACs have tended to underperform the S&P 500 within three, six and 12 months after the merger and listing.

Early this week, Reuters reported that the IPOX SPAC Index that tracks the performance of listed SPACs is down 12.5 per cent in the last two months compared to the 2.4 per cent decline in the broader US market during the period.

Analysts attribute SPACs’ poor performance to a large equity dilution inherent in their IPO pricing. According to a Bloomberg study, ordinary investors typically pay $10 for share worth $7 net of the Promote cost. This imposes a stiff financial cost on ordinary shareholders, suppressing their returns for a long time.

Are SPACs coming to India?

The shell companies, or SPACs, are currently not allowed to raise capital through IPO in India. However, this could change as many Indian start-ups plan to use SPACs to get listed in the US. This has led many to petition Sebi to allow SPACs or similar investment vehicles to raise capital through an IPO.