SPACs: Hype or an attractive source of funding?

What do Serena Williams, Jay-Z and Shaquille O’Neal have in common? It is SPACs (Special Purpose Acquisition Companies), listed acquisition vehicles, that have raised more than USD 104 billion through 327 IPOs (Initial Public Offerings) in the first five months of 2021 alone, already surpassing a very strong year in 2020.¹

Over the past year, SPACs have been a driving force for financing in various sectors, especially technology, fintech, e-mobility and healthcare. Lucid Motors, Nikola, Fisker, QuantumScape, Canoo or Luminar are prime examples from the e-mobility sector: business models that promise growth and future profitability encounter investors with great financial firepower able to provide access to much-needed growth capital for companies. Hence, traditional financing via Venture Capital has seen competition from this phenomenon over the last couple of months.

While the vast majority of the SPAC IPOs have occurred in the USA (c. 99%), there have been a few SPAC IPOs in Europe recently, predominantly in Germany and the Netherlands – Deutsche Börse expects between 12 and 30 SPAC IPOs in Europe in 2021. Moreover, the fact that most US SPACs have a global mandate and are increasingly looking abroad for investment opportunities means that they may become a viable financing option for innovative players looking for growth capital in Europe.

Companies that trigger the SPACs’ interest typically need to invest heavily and build capacity before the targeted growth rates and profitable margins can be achieved years later. In light of negative cash flows and uncertainty, this requires risk-oriented investors as a solution to the “chicken and egg” problem of cash demand and return.

However, more recently the stock market performance of selected SPAC entities that have executed an acquisition has been dismal: concerns about ill-conceived business plans, e.g. over-promising and over-favourable outlook towards investors and increasing regulatory scrutiny, have dampened the appetite to invest in SPACs, both before and after they have merged with a target.

In this article, we start by giving a brief introduction into SPACs, followed by the developments of the past few years. In particular, we look at the relevance of SPACs in the M&A market, the pros and cons relative to Venture Capital/Private Equity, the role they play in various sectors and the current skepticism surrounding SPACs.

1. How do SPACs work?

A SPAC is formed to raise money through an IPO to merge with another company (the “target”). At the time of their IPOs, SPACs have no existing business operations or even stated targets for acquisition – typi­cally their mandate is very broad in terms of sector and geography. The initiator of the SPAC (the “Sponsor”) receives 20% of the shares of the SPAC for a nominal contribution. Investors in SPACs can range from former CEOs to well-known private equity funds to the general public.

Following the IPO, SPACs have approximately two years to merge with a target or they must return their funds to investors. Typically, the targets are high growth companies, e.g. in the electric vehicle, space exploration or online gaming space – many with no or limited significant actual revenues and earnings. In many cases, significant additional PIPE (Private Investment in Public Equity) money is obtained to fund the transaction. Once a target is identified, SPAC shareholders can vote on the merger and have the option to redeem their shares if they do not like the merger.

The process of merging with a target company through a reverse takeover is called the “De-SPAC” process. Post-merger, i.e. after the reverse takeover, the target operating company is the surviving entity and will be a public company: the operating business becomes a publicly traded company that effectively “takes over” the public company status of the SPAC.

Figure 1 outlines an illustrative SPAC deal structure and lifetime cycle.

Source: Own illustration

 

2. Evolution of SPACs and current firepower

SPACs are not a new phenomenon. Prior to the financial crisis in 2007, there was a boom in SPAC IPOs and many M&A practitioners will recollect the “frenzy” present at the time. However, the 66 SPAC IPOs in 2007 pale in comparison to the 575 SPAC IPOs since January 2020 (see Figure 2). Of these 575 IPOs, 424 are currently searching for targets.²

Source: SPAC Insider (26 May 2021)

In terms of the amounts raised, SPACs are no longer a niche: Since January 2020, SPACs have raised USD 188 billion, with an average IPO size of US$ 327 million (see Figure 3). The fundraising is very much centered in the US, accounting for c. 99% of the fundraising. In Europe, there have been 10 SPAC IPOs raising USD 1.3 billion in 2020 and 2021 YTD.

Source: SPAC Insider (26 May 2021)

The relevance of SPACs in the M&A space is remarkable. In addition to the cash in the listed entities, SPACs typically use additional PIPE funding when merging with a target company. Furthermore, SPACs typically invest in companies where the SPAC and PIPE investors hold a significant minority share in the combined entity. As a result, average ratio of SPAC equity capital to target M&A enterprise value in 2020 has been roughly 5x, resulting in a theoretical deal volume from the SPAC IPOs of nearly USD 1 trillion. Bearing in mind that SPACs have two years to invest their money, significant SPAC investment activity is to be expected in the coming months and years.

3. Target considerations: SPAC vs. Venture Capital/Private Equity

Funding of innovative start-ups has traditionally been the domain of Venture Capital. In 2020, global venture funding grew 4% year over year to USD 300 billion.³ Given the large amounts raised recently in SPAC IPOs means that SPAC funding has already become a viable alternative funding source. Most notably, as shown further below, SPACs have displaced Venture Capital in selected industries in the past months, e.g. the financing of e-mobility start-ups.

Oftentimes, companies engaging in a SPAC transaction have received several rounds of Venture Capital funding to allow them to achieve the necessary size and technological advances necessary for engaging in a SPAC transaction.

Based on general hypothesis, Figure 4 the relative pros and cons of certain criteria the target and its shareholders need to consider when contemplating to obtain external equity funding.

Source: Own illustration

 

4. Becoming a US-listed entity

Particular from the perspective of a European target, the prospect of becoming a US-listed target may be daunting as a SPAC transaction will trigger enormous reporting requirements in a very short timeframe (pre- and post-closing) that are much higher than typically applicable for PE/VC funding. The process will require close collaboration with M&A advisors, lawyers, auditors and the SPAC. Furthermore, additional entities may need to be set up – for European targets, Netherlands entities have often been chosen for a US listing (e.g. Curevac or Mytheresa).

Before becoming a US-listed entity via a SPAC transaction, significant reporting requirements are triggered in a very short timeframe, e.g.:

• The target company financial statements need to be audited under the PCAOB standards (incl. pro forma accounts)

• Interim financial statements need to be prepared

• Management Discussion and Analysis (“MD&A”)

• Other non-financial information for a Form S-4/proxy statement and a “Super 8-K” (to be filed four days after closing); these documents comprise comprehensive prospectus-like information, detailing the transaction, the business, risks, etc.

• Successful response to SEC comments

As a listed entity, significant reporting/compliance requirements apply, e.g.:

• Filing of 10-Q (Quarterly) and 10-K (Annual) formulas

• Investor relations, arnings calls, ad hoc press releases, road shows

• Sarbanes-Oxley (SOX) compliance, incl. (a) effective control over financial reporting, (b) CEOs / CFOs acknowledge responsibility, (c) data security and (d) documentation of SOX compliance

From a governance and organizational perspective, to fulfil listing requirements, significant further personnel resources, capabilities, systems and processes need to be built up, e.g. quite often including support functions such as finance, treasury, tax, IT and investor relations.

Potentially reduced reporting and governance requirements may result from classification as “emerging growth company (EGC)” and “foreign private issuer (FPI)”. For companies with less than USD 1 billion and a predominantly non-US shareholder base and predominantly non-US directory/assets, there is a good chance that reduced reporting and governance requirements apply.

5. SPAC deal activity by sector

In Q1 2021, SPAC deal activity has been strongly focused on the automotive (particularly e-mobility) and software sectors, as shown in Figure 5.

Source: Statista, Refinitiv, Thomson Reuters

The SPACs‘ strong presence in automotive/e-mobility financing is remarkable: Highly attractive valuations and the creation of liquidity and a potential exit route has led to strong competition for other financing options such as Venture Capital, Private Equity or even Strategics as external sources of financing. Prominent examples of multi-billion USD SPAC transactions in the e-mobility space comprise Lucid, ree, Faraday, Arrival and Fisker. Most of the companies that were SPAC-ed have little to no significant revenues. One exception to the dominance of SPACs is Rivian, which has received USD 7 billion in funding since 2019 from Amazon and several financial investors.

Other prominent recent large-cap SPAC transactions comprise media company Universal, transportation company Grab and office rental company WeWork. These transactions show that SPACs can do deals of a size that even large-cap private equity would consider bulky.

6. Recent developments

Following a spectacular rise in share prices of SPAC-ed entities in the beginning of 2021, there has been an equally spectacular decline in share prices since mid-February 2021, which has continued to date. A market capital weighted index shows that c. 50% of the market cap in mid-February 2021 has been eroded (see Figure 6).

Source: SPAC Insider (26 May 2021)

Furthermore, new IPOs have plummeted in April and May 2021 to a combined 30 from a monthly average of almost 100 in Q1 2021.⁴ This was attributed to more intense regulatory scrutiny and cooling retail investor interest. Concerns related in particular to the following topics:

• Conflict of interest/Incentives of SPAC: If the SPAC fails to do a transaction within two years, the money is returned to the investors. The Sponsor obtains 20% shareholding of the SPAC and, as a consequence, a significant share of the merged entity – as long as a deal is done! There are less hurdle rates that are typically found in Private Equity and Venture Capital, whereby the Sponsor is only remunerated if significant value is created. One hypothesis could be that sponsors have a strong incentive to do a deal and may not engage in the same intense due diligence as a VC, ever more so the closer the two-year deadline approaches.

• Business plan of the target company: SPACs, in contrast to traditional IPOs, are subject to the PSLRA Safe Harbor provision, allowing them to make financial projections. Also, impending partnerships that were disclosed by the targets have failed to materialize. This has led to class action lawsuits in some cases, such as against Nikola, Canoo and Lordstown Motors.

• Circumvention of listing rules: The IPO process for the SPAC is typically straightforward as there are no operations. The De-SPAC process is then a reverse merger and the eventually listed entity might not be subject to the same IPO rules as is the case in a traditional IPO. This is sometimes called “arbitrage on regulation”.

• Treatment of warrants: In April 2021, the SEC issued accounting guidance that would classify SPAC warrants as liabilities instead of equity instruments. This required a large number of SPACs to rework their accounts.

 

7. View on Europe

Several German and European investors have recently backed SPACs and listed the SPACs either in the USA or Europe, including:

• Lakestar SPAC I (EUR 275 million): Backed by VC investor Klaus Hommels, the entity is listed in Frankfurt. The SPAC is currently in discussions to engage in a transaction with travel company Hometogo.

• 468 Spac I SE (EUR 300 million): Backed by VC investors Alexander Kudlich, Ludwig Ensthaler und Florian Leibert, the entity is listed in Frankfurt.

• EFIC1 (EUR 415 million): Backed by former Commerzbank CEO Martin Blessing, the entity is listed in Amsterdam and is focused on the fintech space.

• Rocket Internet Growth Opportunities Units (EUR 250 million): Backed by VC investor Rocket Internet, the entity is listed in the New York.

• Further SPACs are backed by Leo Apotheker (former SAP CEO), Christian Angermayer (VC investor) and Klaus Kleinfeld (former Siemens CEO).

In addition, several Germany-based targets have been or are currently in the process of being SPAC-ed. Most prominently, air taxi company Lilium merged with the SPAC Qell Acquisition Corp., with the share price currently being slightly below issue price, at USD 9.93 (as per 14 June 2021). Other targets currently contemplating a SPAC transaction are Lilium’s competitor Volocoptor, fintech Solarisbank and e-mobility start-up Sono Motors.

Interestingly, the UK, typically known for a very active stock market, has so far not joined the SPAC momentum. Between January 2020 and March 2021, there were only 10 SPAC listings, raising less than USD 400 million. However, the UK’s Financial Conduct Authority (FCA) is currently considering changes to the listing rules for SPACs.

Overall, SPAC transactions in Europe are still not as commonplace as in the US, but it is to be expected that this will change as more and more US SPACs will look beyond the USA to find innovative targets.

8. Outlook

SPACs have experienced a remarkable rise to prominence over the past 12 to 18 months. For the coming months we expect the following developments:

• With their tremendous firepower, SPACs will play a very prominent role in the M&A market until at least 2022: With the large number of SPACs currently searching for acquisition targets, their impact on M&A activity has only begun to be seen in the market. The limited time window to execute a transaction may result in a theoretical deal volume from the SPAC IPOs of nearly USD 1 trillion in the near-term. Tech driven sectors with promising growth potentials like software, technology, fintechs, e-mobility and aerospace will be top of SPACs’ agenda.

• The SPAC impact will spill over from US – more SPAC transactions to come to Europe: Given the large number of SPACs in the market, we see these companies looking increasingly abroad in search for attractive targets. In addition, several SPACs have listed or are in the process of being listed in Europe. The same applies in Germany, where companies like Lilium, Volocoptor or Solarisbank currently discussed in the market may just be the starting point.

• The market will develop a more nuanced perspective on SPACs and their targets: The target companies of SPACs have been of very different quality. The same is true for the capabilities of SPACs to identify the right targets and their ability to support the target in becoming a public company. However, the stock market has treated these companies in a relatively undifferentiated way. We expect that as true quality crystalizes in the months to come, the market will reflect this in the valuations.

• Regulatory scrutiny will be a continuous topic going forward: There are increasing concerns about the regulatory treatment of and litigation against SPACs in the USA and their impact on new SPAC IPOs, structuring of SPAC incentives and disclosure of financial forecasts. Developments on this front will have a material impact on whether SPACs will prove to be a flash in the pan or an enduring source of financing for innovative firms.