Special purpose acquisition companies (SPACs) have been creating a buzz in the Asian market recently. Even though SPACs have been used as alternative investment vehicles in the West for decades now, it was only recently that they have come into vogue in many Asian countries like Singapore. Today, more and more seasoned investors and management teams are already turning to SPACs to reduce the growing market volatility risk of traditional initial public offerings (IPOs).
As at the time of writing, we already have three SPACs listed on the Singapore Exchange (SGX) within the first few months of 2022. They are – Vertex Technology Acquisition Corp (VTAC) backed by Temasek Holdings’ Vertex Venture Holdings, Pegasus Asia backed by Tikehau Capital, and Novo Tellus Alpha Acquisition (NTAA).
As the SPAC frenzy continues in Asia, more and more questions arise about how beneficial and risky they are, especially for investors. To understand more about these “blank check companies” and their increasing popularity, this article lays down all the things that every investor should know before joining the SPAC boom.
What are SPACs?
SPACs are entities created solely for the purpose of company acquisition or merger. In other words, they are vehicles designed to acquire or merge with an already existing company. A SPAC usually acquires another company by raising capital through an initial public offering (IPO). To understand better how SPACs work, it is helpful to think of them in terms of the two critical stages of their lives – before and after acquisition.
The first stage takes place between the IPO and the business combination. Here, the SPACs are first formed by a group of investors called the “sponsors,” who are usually professional fund managers or former senior executives of big corporations with M&A expertise. During the listing period, SPACs are shell corporations that have no operating business. This means that, unlike the regular companies that investors ordinarily invest in, SPACs do not have any area of business operation that generates revenue.
At the point of IPO, the investors then obtain units of a SPAC that consist of a share and a part of a warrant. The warrant can provide investors with an additional advantage should their target company eventually outperforms. Pending the acquisition of the target company, majority of the proceeds raised during the IPO will be placed in an escrow account. The sponsors usually have two years to complete an acquisition, which can be extended for one year, subject to some conditions.
If an ideal target company is found, a simple majority of the shareholders and independent directors should vote in favour of the transaction for the SPAC to either proceed merging with the target in a process called “business combination,” or de-SPAC in which case the target will be listed on the exchange. On the other hand, if no ideal target company is found, the SPAC will be liquidated at the end of its life, and the proportionate share of the escrow account will be returned to the shareholders.
The second stage in a SPAC’s life only takes place when a successful business combination has been carried out. After such business combination, the investors will then become the shareholders in the target company. Here, their investments will already be in an operating company instead of a shell corporation with no operations. This will be similar to what the investors are used to in regular IPOs.
Benefits of SPACs for Investors
Over the recent years, an increasing number of investors around the world is already choosing SPACs over the traditional IPOs. This is primarily due to the fact that these IPO listings are usually heavily oversubscribed, giving retail investors so little share of the pie. SPACs, on the other hand, can provide investors with some opportunities to gain more. As a matter of fact, some calls SPACs the “poor man’s private equity” since it gives investors access to deals that are ordinarily in the area of private markets.
The favourable terms of SPACs for investors are mainly due to the nature of their processes. With SPACs, the sponsors will be using investor money to search for the best private companies to take public. In theory, these professional sponsors should be able to find viable companies that are prepared for public markets and acquire them at decent valuations. In the long run, the hope here will be for the acquire company to expand and deliver long-term shareholder value, under the constant guidance of the sponsors.
Aside from providing opportunities for more gains, the structure of SPACs can also offer more flexibility to savvy investors. Here, investors are given the chance to vote on the business combinations that the sponsors bring them. If they are not convinced with the proposed target or its valuation, they can reclaim their proportionate share of the escrow account, regardless of how they vote. Those who reclaimed their capital can nonetheless still retain the warrants that come with the SPAC’s units, and they can still benefit from the upside in case the target company outperforms.
Risks of Investing in SPACs
The risks associated with investing in SPACs depend on the value or prices of the investment. If investors invest at prices around the book value of the SPAC during the first stage of its life, there will likely be less risk since the investors will still have the option to reclaim their capital during the period of business combination or liquidation.
However, for those investors who buy SPACs at substantial premiums to the cash value in the escrow account – which usually occurs when there are rumours of an attractive acquisition coming – risks of heavy losses should the share price correct subsequently are in place. Moreover, more risks can also arise in the second stage of a SPAC’s life once the combined company starts trading. At this point, the investors will no longer be protected by their redemption rights.
If the target company was acquired at too high a valuation, or if the SPAC has too many dilutive elements, the market can also punish the share price of the SPAC. In the United States, it was found that an overwhelming majority of SPACs fall below their IPO-price following business combination. Even Grab, its biggest SPAC merger to date, has not been immune to this downside.
Additionally, if an investor’s SPAC sponsor is unable to source a viable target company, their monetary losses may not be large, but they will nonetheless still incur an opportunity cost of having their money sit in an underperforming vehicle.
Critical Areas Investors Must Keep in Mind
Analysing financial metrics early on is not so much relevant when it comes to SPACs since they do not have any operating business at IPO. Instead, what investors should do is to study the expertise and track record of the sponsors since these are the individuals who will be searching for a target company that the investors will eventually own. Some of the relevant questions that the investors must ask include whether the sponsors have enough experience in such acquisitions, and whether they can collaborate to help the eventual target expand.
Aside from being industry-leading experts, it is also necessary for the sponsors to demonstrate that their long-term interests are consistent with that of the investors. What the investors should look for are sponsors that deploy reasonable amounts of capital to co-invest in a SPAC rather than merely rely on their promote for upside. Sponsors with longer lockup periods for their shares and warrants are also preferable since it shows that they are dedicated and are in here for the long-run.
Provisions on Dilution
The dilution that is inherent in the structure of SPACs is one of the most common criticisms of these entities. This dilution may come from the warrants that the investors receive at IPO, which may be retained even if they reclaim their capital. Aside from this, the sponsor’s promote may be another source of dilution. In Singapore, SGX has already laid down some provisions that can help cap the dilution that arises from both warrants and sponsor promote.
Depending on the target company’s size, additional capital may be needed at the point of de-SPAC. Institutional investors ordinarily take part in the private investment in public equity (PIPE) round, which can be quite helpful in boosting and validating the transaction. Moreover, a large PIPE can also reduce dilution. Conversely, the lack of any PIPE may mean that a closer audit or examination could be warranted.
Target Company Valuation
Corporate valuation in Singapore is always a critical process. The same thing is true when it comes to SPACs. Paying excessively for a target company is usually a recipe for share prices to crash sharply once the combined entity begins trading. This situation is made even more complicated by the fact that most SPAC targets are high-growth technology companies, which are quite unlikely to be profitable.
Given the market developments in SPAC listings in the West over the past years, the increasing interest to introduce SPAC in the capital markets of Asian countries like Singapore is not quite surprising anymore. This, along with the demands of investors for more rewarding investments, set the foundation for the promising future of SPACs in the country. However, just like everything else, investing in SPACs comes with both benefits and risks. It is important that you understand all the key criteria and rules before making any moves. To make sure you are always making the right decision when it comes to your business, it is highly advised to seek the assistance of experts at all times.
Here at Max Lewis Consultants Pte Ltd, we offer a wide range of services that are all designed to improve and expand your business operations. From local and international tax planning to transfer pricing advisory and business valuation services, we provide all the assistance that you need to make sure your business is always on the right track. If you wish to know more about how our services can help your business grow, feel free to contact us today.