SPACS vs. IPOS: What’s the Difference?
Defining an IPO
An initial public offering (IPO) is the first time a private company makes its shares available to the public, usually through one or more exchanges.
To undergo an IPO, a company must first find one or more underwriters. The role of the underwriter is usually taken by an investment bank, which helps the company determine the issuing price of its stock and, amongst other things, distribute the stock to a strong investor network.
Once an underwriter is found, the company files a prospectus to the Securities Exchange Commission (SEC). This prospectus is the company’s blueprint; it outlines its historical performance along with all information that investors require to make an informed decision. Think of a company as a closet at a garage sale and the prospectus as a description of all the contents it has inside.
After creating and filing a prospectus, the company can now undergo a roadshow, where it attempts to garner the interest of institutional investors and other big-money players. The pricing of the IPO will ultimately depend on how much interest it garners as well as other variables such as market conditions and the company’s perceived value.
Once the company goes public, it immediately allows for certain conditions to arise. First, the company can now raise funds directly from the public offering and use these to expand its operations. Second, access to the public market creates a medium for private investors and equity holders to offload their stakes for profit and offers a liquid environment for outside participants to trade and invest. Third, the company’s market capitalization can now be used as a currency for future mergers, acquisitions, and financial transactions.
While an IPO offers a host of benefits, most notably the strong elevation into public perception, it’s often a long and arduous process. As the covid-19 epidemic introduced a high level of uncertainty, the desire for a streamlined version of “going public” culminated in the explosion of Special-Purpose Acquisition Companies - or SPACs.
SPACs are not a new thing. They’ve been around as far back as the 80’s and 90’s and their popularity, along with other nontraditional funding methods (think reverse mergers), ebbs and flows with a calm regularity.
This pattern, however, has taken an explosive turn in the past two years. Between January 1st 2020 to the time of this post, 738 SPACs with a valuation of over $200 billion have undergone an IPO. In comparison, 1 SPAC with a valuation of 36M underwent an IPO in 2009.
Defining a SPAC
A Special-Purpose Acquisition Company (SPAC) is a company created with the sole purpose of raising funds and investing those funds into an acquisition or merger with an existing company.
A SPAC raises funds through an initial public offering (IPO) and exists afterwards as a shell company, meaning it has no assets (other than the cash raised from the IPO) and no operations of its own.
This characteristic of a SPAC is probably a large reason for the rise in its popularity. Compared to operational companies, SPACs have significantly less paperwork to file with the SEC in order to initiate an IPO. Because of this, a SPAC’s IPO can be completed within months, while a traditional company’s IPO process can take anywhere between six months to over a year.
The pandemic drastically increased the wealth of the upper-class. With investors more eager than ever to throw money around and an environment that brimmed with uncertainty, SPACs provided a route to access the markets quickly and efficiently.
Benefits of a SPAC
SPACs grant their sponsors - the initiators of the SPAC - a lot of freedom.
According to the Securities Exchange Commission, “if you invest in a SPAC at the IPO stage, you are relying on the management team that formed the SPAC.” This team may identify the target industry or company for its acquisition in its IPO prospectus, but it’s not obligated to do so. Additionally, even if the team did identify a target, it’s not obligated to pursue a target in the identified industry. In short, a SPAC management team can set a target for almost any industry and not be held liable if it chose to pick a different route.
Additional freedom is granted in the management of the cash raised in the IPO. These proceeds are generally held in relatively safe interest-bearing instruments and are supposed to serve as ammunition for the company’s merger or acquisition. The SEC, however, indicates that there’s “no rule requiring the proceeds be invested in only those kinds of instruments,” providing further flexibility to SPAC sponsors.
Finally, SPACs that undergo an IPO have up to three years to find and consummate their initial business combination through a merger or acquisition. While some SPACs have opted for a shorter period of 18 months, sponsors may be eligible to extend its already lax three year deadline if certain conditions are met.
One of the key specialities of a SPAC is its ability to market a strong management team. SPACs with public relationships to celebrities and seasoned financiers have an ability to create a “hype” that is often reflected in its stock price and IPO. Digital World Acquisition Corporation’s ties to Donald Trump’s new social media project is a potent reminder of this.
The SPAC Track Record
Returns from SPAC operations have been considerably weak. A glance at the SPAC exchange-traded fund (SPAK) shows a 31% decrease since February 19, 2021 compared to the SPY’s 17% increase and the QQQ’s 15% increase in the same time period.
A deeper dive into SPACs shows a cyclical price cycle. In the initial six month post-IPO period, price erupts in an almost euphoric manner, but this is short-lived. Goldman Sachs analysts show that after the initial six months, most SPACs underperformed the Russell index by 42 percentage points.
A glance at the charts of famous SPAC deals like NKLA, DWAC, and CMLT shows a microcosmic version of the SPAC price cycle as a whole: euphoric buying, panic selling, and a descent into public indifference.
Perhaps due to a mixture of low regulation, emotionally-driven decisions, and euphoric trend-following, the SPAC industry has not fared well. After all, the list of benefits described for SPAC sponsors could all be perceived as risks to an investor.
Despite this, some SPAC deals have, so far, emerged as unlikely winners in the markets, particularly DraftKings (DKNG).
Only time will tell if the trend is meant to continue.
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