Understanding SPAC

The extent of my knowledge is that SPACs are useful tools to get a company to go public. I know that they look for "targets" to take public, and they deal with all the outreach and financial structuring. 

What I don't know is how the deals are actually structured, how they are valued, and what the risks are.

1) Deal structuring

Do SPACs end up acquiring private companies or do they get acquired? Or does that kind of depend on how the capital structure works out?

2) Valuation

Essentially, if I'm investing in a SPAC, am I making some sort of Merger Arb move? How is SPAC's valuation determined before/after they announce the target? 

What other factors besides the person/team behind it go to valuating SPACs?

3)  Risks

What information is SPACs required to reveal?

How is the valuation of the target determined?

Any other risks?

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Comments (39)

Jan 29, 2021 - 9:42am

This is a good topic and I will even give you an SB:)    I have periodically read about these entities but still do not fully understand them.  I would think that the private equity guys here should be able to provide some insight.  It seems like investors give the entity a bunch of cash but do not know exactly what they are going to do with it.  My impression is that they are going to use the cash to buy assets or merge or something like that. The articles I have read imply that the rationale for setting up a spac is partly regulatory in that is is just easier and less complex than going the traditional IPO route.  The initial part of the deal seems easier but what about the regulatory and other issues regarding acquiring assets or merging?  I would like to know more about them.  

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Jan 29, 2021 - 10:01am

1) SPACs acquire the target via a reverse merger by which the target becomes the surviving, publicly traded entity. 

2a) Prior to a deal, a SPAC's valuation is the NAV of the corporate shell. Common share holders have priority claim on the escrowed trust account in liquidation after customary liquidation expenses / working capital carve outs. It is easier to think of this generally as just $10.00, or whatever price the SPAC IPOd (99.9% is $10.00). Post deal announcement, the valuation is based on how much of the target the SPAC is buying and at what multiple, just like any other acquisition. 

2b) You can arbitrage the SPAC pre-deal in several ways. First, if you participate in the SPAC's IPO you will receive one Unit for every $10.00 you invest. Each unit is comprised of one common share and some fractional warrant, call it 1/3, which you get "for free". 50 or so days after the IPO, the Units can separate and the common share and warrant will trade separately. Let's say the warrant trades at $1.50, because you own 1/3 that is an implied price of $0.50. If you sell the warrant, then your cost basis is reduced by $0.50 and so effectively you bought the $10.00 trust value at $9.50, i.e., making a 5.25% return. This is pretty riskless and leverageable for hedge funds although the bet you make is that the warrant will trade will and the trust will not trade below trust value, but that is very characteristic of today's SPAC market. The other way to arbitrage SPACs is to buy common shares in the secondary market at a discount to trust. When a SPAC finds a target, shareholders have the option of either participating and rolling their shares into the new company or redeeming for their pro-rata trust value. So, if a SPAC is "expiring" in three months with a trust value of $10.00, and you purchase shares at $9.90, you will make a 1% total return but 4% IRR over those three months. It is not large amounts, but again it is essentially riskless and you can leverage this. Given how exuberant the market is for SPACs these days, this trade is very hard to come by but you could deploy $1bn+ doing this in March during the sell off. 

2c) Aside from the team behind the SPAC, other factors that affect pre-deal valuation / trading are things like jurisdiction and permitted carve-outs from the trust account. Some sponsors have in the past tried to be aggressive with carve-outs but the market is pretty good at catching that during the IPO process. 

3a) SPACs are required to disclose their trust account value in quarterly and annual SEC filings just like any other company. The prospectus, and updated versions, are always on file as well. Prior to the business combination, the company's proxy statement will walk through the history of the SPACs engagement with the target and diligence process. Also in the proxy statement will be the company's estimate of the trust value per share at the time of the merger with instructions on what shareholders need to do in order to redeem for that value. Frequently, the company's estimate of trust value per share is "wrong" by either 1) just using the value from the most recently filed 10Q or 2) using the value estimated on the day the proxy was put together. Both of these methods fail to take into account interest accrual from those dates until the actual day you receive your check if you redeem. 

3b) Valuation of the target is done just like any other acquisition process, via bankers. SPACs are unique in that they are permitted to release forward financial projections while in a traditional IPO you cannot. SPAC valuation targets are generally inflated vs. what a private market or other strategic player might pay because 1) SPACs have a defined time line and are incentivized to "pay up" to get a deal done so the sponsor doesn't lose their at-risk capital and 2) the promote structure means the target management (if they want to stay) will lose more equity ownership than they otherwise might in another process, so you gross up the consideration paid to them so they become indifferent to the dilution. 

Jan 29, 2021 - 10:50am

1) SPACs acquire the target via a reverse merger by which the target becomes the surviving, publicly traded entity. 

2a) Prior to a deal, a SPAC's valuation is the NAV of the corporate shell. Common share holders have priority claim on the escrowed trust account in liquidation after customary liquidation expenses / working capital carve outs. It is easier to think of this generally as just $10.00, or whatever price the SPAC IPOd (99.9% is $10.00). Post deal announcement, the valuation is based on how much of the target the SPAC is buying and at what multiple, just like any other acquisition. 

2b) You can arbitrage the SPAC pre-deal in several ways. First, if you participate in the SPAC's IPO you will receive one Unit for every $10.00 you invest. Each unit is comprised of one common share and some fractional warrant, call it 1/3, which you get "for free". 50 or so days after the IPO, the Units can separate and the common share and warrant will trade separately. Let's say the warrant trades at $1.50, because you own 1/3 that is an implied price of $0.50. If you sell the warrant, then your cost basis is reduced by $0.50 and so effectively you bought the $10.00 trust value at $9.50, i.e., making a 5.25% return. This is pretty riskless and leverageable for hedge funds although the bet you make is that the warrant will trade will and the trust will not trade below trust value, but that is very characteristic of today's SPAC market. The other way to arbitrage SPACs is to buy common shares in the secondary market at a discount to trust. When a SPAC finds a target, shareholders have the option of either participating and rolling their shares into the new company or redeeming for their pro-rata trust value. So, if a SPAC is "expiring" in three months with a trust value of $10.00, and you purchase shares at $9.90, you will make a 1% total return but 4% IRR over those three months. It is not large amounts, but again it is essentially riskless and you can leverage this. Given how exuberant the market is for SPACs these days, this trade is very hard to come by but you could deploy $1bn+ doing this in March during the sell off. 

2c) Aside from the team behind the SPAC, other factors that affect pre-deal valuation / trading are things like jurisdiction and permitted carve-outs from the trust account. Some sponsors have in the past tried to be aggressive with carve-outs but the market is pretty good at catching that during the IPO process. 

3a) SPACs are required to disclose their trust account value in quarterly and annual SEC filings just like any other company. The prospectus, and updated versions, are always on file as well. Prior to the business combination, the company's proxy statement will walk through the history of the SPACs engagement with the target and diligence process. Also in the proxy statement will be the company's estimate of the trust value per share at the time of the merger with instructions on what shareholders need to do in order to redeem for that value. Frequently, the company's estimate of trust value per share is "wrong" by either 1) just using the value from the most recently filed 10Q or 2) using the value estimated on the day the proxy was put together. Both of these methods fail to take into account interest accrual from those dates until the actual day you receive your check if you redeem. 

3b) Valuation of the target is done just like any other acquisition process, via bankers. SPACs are unique in that they are permitted to release forward financial projections while in a traditional IPO you cannot. SPAC valuation targets are generally inflated vs. what a private market or other strategic player might pay because 1) SPACs have a defined time line and are incentivized to "pay up" to get a deal done so the sponsor doesn't lose their at-risk capital and 2) the promote structure means the target management (if they want to stay) will lose more equity ownership than they otherwise might in another process, so you gross up the consideration paid to them so they become indifferent to the dilution. 

What is the advantage to the target over doing a traditional IPO?

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Feb 1, 2021 - 4:13pm

Worked on a SPAC in 2014-15, back then it was not a very popular option:

- Quicker than an IPO: a few months vs. 12-18 months for a standard IPO in the UK partly - lighter DD, no need to build a book, reorganise the cap table or "dress up" the business

- Cheaper than an IPO: the money has already been raised by the underwriters and apart from legal fees everything is cheaper

- No IPO window constraint: even if the market tanks, you can still press ahead with the listing

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Jan 29, 2021 - 11:31am

Milton Friedchickenman

When thinking about a SPAC, it's helpful to make a distinction in your mind between (a) the pre-combination SPAC itself and (b) the company it eventually combines with. I'll refer to them as the SPAC and the target, respectively. For your questions:

Deal structuring:

A SPAC finds a company to merge with (the target), so it's doing the acquisition while the target being 'purchased' is the seller. T

he only capital structure element worth calling out is that generally a SPAC targets a company with an enterprise value that's a non-trivial multiple of the amount of cash-in-trust raised in its SPAC IPO. This matters because the existing shareholders of the target are sensitive to the dilution incurred by accepting the SPAC deal.

Let's take a simple example. A $500m SPAC combining with a target who has an enterprise value of $1,000m presents significant dilution to the existing ownership. That $500m SPAC combining with a target at a $2,500m enterprise value is entirely different.

You can thus think of a SPAC as a fish swallowing a (generally much) larger fish.

Valuation:

Yes, you are making a bet that the SPAC management is going to find a worthwhile target such that the future price of the SPAC stock will be greater than when you purchased it. 

There's an important delineation to make here. SPAC IPO investors are in an entirely different position than subsequent non-IPO buyers of the stock on the exchange. An IPO investor is buying a 'unit'. That unit consists of one share and one fractional warrant. Historically that fraction was one-half of a warrant. In early 2020, it became one-third, and in late 2020 there have been some one-quarter, one-fifth, and one-eighth warrant deals. We'll come back to the warrant in a second.

The SPAC receives (illustratively) $500m in cash proceeds at its IPO and hands out 50m units to the IPO investors. Its use of cash is a deposit to a trust account, where the rules of that trust are such that the monies can only be accessed in the event that management presents a proposed combination target for a vote to its entire shareholder base, and a majority (or supermajority; the threshold can theoretically vary depending on the terms of the IPO documents; it generally doesn't vary) votes in favor. 

Here's the wrinkle. The SPAC IPO investors actually have two votes. One is to vote on the deal being approved, and the second is on whether their cash actually gets used on the deal. So you'll often see SPAC mergers going through with a high-90s approval vote, but the actual dollar amount available to the combination target is lower, something like 50-70% of the total amount raised in the SPAC IPO. In our example, this would be something like $325 in cash proceeds to the target.

This is why PIPEs have become such a common term, even to retail investors, lately. A PIPE 'backstops' the SPAC deal. If the target needs $500m minimum as a financing event, the SPAC team (and its bankers) will go bring some investors over the wall and raise something like $200-250m. If 100% of the IPO investors voted yes on the deal and yes to their cash being available in the transaction, the target company would wind up with $750m. But there's almost invariably some leakage and it winds up being like $575m between the cash-in-trust that remains plus the PIPE.

Going back to the warrants, you can see why an IPO investor has a different incentive set than you the retail investor buying the ticker for your brokerage account. They are incentivized to say yes to the deal and no to their cash being used, because there's nearly invariably a significant pop in the security upon deal announcement and they for free at IPO purchase received a warrant with non-zero value.

So it's truly an arb for the IPO investor. For them, it's like taking a call option on the management team's ability to find a deal that will trade well. You receive cash interest while the SPAC searches for a target. You can vote on the deal even going through. You can vote on whether you redeem your cash or keep it in the deal (and you decide that based on how you think the stock will trade). You could even invest further in the PIPE (which always goes through at $10/share; and upon announcement these deals are often trading in the high teens or low-20s depending on how hot a sector it's in).

For the retail investor, it's less like a call option because there's downside risk to the stock without the corresponding structural elements like the double-vote feature or the non-zero value of the warrant.

That whole story didn't directly answer your question about the factors that go into how a SPAC stock is valued. The simple answer is that it's largely about perceived caliber of management plus pure sentiment: rumor about deals found. If it gets out (quietly) that someone is close on a cool company, the funds in the know pile in because they know an LOI announcement will send the thing soaring. There are funds that do nothing other than go in and out of SPAC stocks, at IPO or not.

Risks:

In the prospectus a SPAC will list out everything about its team members. That's more or less what you're buying: that group's ability to execute on an acquisition.

The valuation of the target is usually approached one of two ways. Some SPACs will have a reasoned conversation about what makes sense for the company. Other SPACs are oriented purely towards what the public market will support. That usually shows up as a significant disconnect between what people in the former camp are willing to offer to a target versus those in the latter camp. Over the course of the past year, the ratio of people in those two camps has changed considerably. 

Good luck.

I am permanently behind on PMs, it's not personal.

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Jan 30, 2021 - 1:20am

I work on the management team for my firm which is a leader in SPAC activity and can testify that this is a fantastic explanation of the SPAC product as well as the anon guy above. It's important to understand how these work as a financial instrument given their prevalence both amongst PE and super-experienced management teams capable of raising capital.

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Jan 29, 2021 - 12:09pm

Associate 2 in PE & APAE have good responses. I'd also recommend checking out Matt Levine on Bloomberg. He wrote a good opinion piece explaining how the combination of the share + warrant structure is enticing because of its inherent downside risk protection (via share) and what is effectively a call option on the acquisition target (warrant).

Jan 30, 2021 - 12:31am

SPACs and reverse mergers in general are very common with scammy Canadian companies with like $12 in revenue. Somehow became very popular in the US but the mechanism is the same. Pump and dump - just more discrete. 

Jan 30, 2021 - 9:03am

This is a more academic take but a really good one that discusses SPACs and frankly the dilution inherent in them especially to investors (mostly retail) who stay in the trade. There can be all kinds of arguments made such as: buyer beware, or redeem at trust or do your DD, but given that hedge funds are raising money like crazy to trade SPACs and find stuff "risk free" means that someone is footing the bill... See link below. I hope that this helps. As a person who previously traded convertibles (amongst other things), the trades are actually quite simple...

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3720919

I used to do Asia-Pacific PE (kind of like FoF). Now I do something else but happy to try and answer questions on that stuff.
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Jan 30, 2021 - 3:41pm

So do I understand that on a super-high level, SPACs are basically like raising PE funds, but with the exception that the SPAC raises public money through an IPO versus private capital allocations? Investors believe in the management team and strategy of the SPAC's prospectus, allocate money to it, and then the SPAC uses that to buy a company. Kind of the same model as a PE Sponsor finding LP's to commit capital to their fund, which is then used to purchase companies that the Sponsor finds attractive?

Jan 31, 2021 - 11:18am

Kind of but PE funds get 20% of profits after a hurdle return (8% annualized).

SPAC sponsor put in a miniscule amount of capital and get 20% of the SPAC company as compensation. So IPO investors day one have essentially funded the SPAC 100% but only get 80% of the company. Since management's cost basis in the SPAC is next to nothing they are incentivized like heck to get a deal done, whether its good or bad for other shareholders.

I used to do Asia-Pacific PE (kind of like FoF). Now I do something else but happy to try and answer questions on that stuff.
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Jan 30, 2021 - 6:46pm

Dumb question, but how is this commonly pronounced? "Es-pack" or "spack"?

Array

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Feb 1, 2021 - 3:08am

The special purpose acquisition company(SPAC) is formed to raise money through an initial public offering to buy another company. The investors of the SPACs can range from well-known private equity funds to the general public. In SPAC the selling can be an attractive option for the owner of a small company which is often private equity funds.

Feb 1, 2021 - 10:15am

I hate to be so cynical, but the main reason SPACs exist is because it allows the company to issue forward-looking projections, allowing companies to pitch narrative-driven companies with no path to profitability to retail investors at astronomical prices. The lower administrative burden is secondary. Source: I have heard this straight from the mouth of multiple people planning to raise SPACs.

Feb 1, 2021 - 10:28pm

So, I assume with a SPAC, because the process is fairly quick and relatively cheap, it's a good way of making a private investment liquid, right? Like, if a half a dozen people owned shares in a private company, a reverse-merger IPO could be a pretty decent method to achieve liquidity, right? 

Array

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Feb 3, 2021 - 4:12am

Basically yes that is a big solution SPACs are able to provide. A lot of companies which have been taking advantage of combining with SPACs aren't always of the highest quality and would likely not receive much investor interest in a traditional IPO process. Given how hot the SPAC market is right now and the oversupply of SPACs looking for targets, many private companies which likely shouldn't be public companies are able to cheaply raise capital and circumvent a lot of the song and dance required to successfully launch a traditional IPO. I'd be interested in seeing whether the capital infusion they receive actually helps accelerate their growth and allows them to become a decent publicly-traded company over the next few quarters and how the street will position their views on earnings given often times the company going public via spac is unknown to the rest of the world etc until a deal is announced.

Also interested to see how regulation affects the SPAC market going forward - something I feel people aren't focused on enough at the moment. The regulatory requirements to take a company public through a traditional offering tend to be more thorough and in depth with vetting from the engaged bank, investors, and analysts. So I wonder if and when the SEC will step in with more stringent requirement on public listings via SPACs.

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Mar 14, 2021 - 8:43pm

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