The SPAC Demystified: Understanding the Most Popular Investment of 2021

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We’re only just over a month into 2021 but it’s certainly already been a wild year for the markets! Volatile swings all week long and new SPACs and their announcements springing up left and right.

Wait, what was that word? SPAC?

Oh, SPACs, the new ‘in-thing’ for investors. SPACs are all the rage right now, but they’re not the easiest thing to understand. And if we don’t understand something, we might end up getting our hands burnt.

What is a SPAC?

A Special Purpose Acquisition Company (SPAC) is a company which has no operational business, but raises money through their IPO in order to eventually merge with a private company to take the private company public.

Ok, I know it sounds confusing already… example time!

Virgin Galactic (NYSE:SPCE) is a company that dabbles in suborbital (meaning it doesn’t exactly leave Earth) space exploration for the purpose of tourism as well as for science missions. The company was founded in 2004 by Virgin Group founder, Sir Richard Branson.

But did you know that Virgin Galactic went public via merger with a SPAC?

Virgin Galactic was originally a private company, but was taken public through merger with Social Capital Hedosophia Holdings Corporation (NYSE: IPOA), a SPAC run by famed SPAC investor and venture capitalist, Chamath Palihapitiya.

How Does a SPAC Form and Merge?

A SPAC is first formed when a team of investors, also known as sponsors, come together to form the management team of the SPAC.

Generally, the SPAC will have an idea of what kind of company they are looking to merge with, for example green energy companies or genomics related companies. This gives investors an idea on what is the likely future for the SPAC and also potential companies they may merge with.

Once the team is assembled, the SPAC will IPO on its own, issuing units to the investors, which consist of one share and one or partial warrants. The money received from investors will then be placed into a trust account until the merger occurs.

What are Warrants?

After reading that last paragraph, you might be thinking: What the heck are warrants?

Warrants essentially give their holders the right (but not the obligation) to purchase shares from the company at a fixed price. This fixed price is usually $11.50 but it can be different depending on the SPAC.

In general, one warrant will convert to one share although this is also dependent on the SPAC management. Some SPACs use different ratios, for example, 4 warrants to convert to 3 shares.

Warrants allow investors to leverage their investment as 1 warrant is usually much cheaper than the share of the SPAC at any point in time.

However, the risk here is that if the SPAC doesn’t find a company to merge with by the deadline, then the warrants will end up worthless, whereas shareholders will have their money returned to them.

All the information regarding the warrants of a SPAC can be found in an SEC filing, known as the S-1 or the IPO Prospectus.

In the above excerpt from Bridgetown Holdings Ltd’s S-1 filing, the SPAC has issued 5,000,000 units, of which each unit consists of 1 share and ⅓ of a warrant. 1 Warrant can be converted to 1 share of the final company.

The excerpt also gives the exercise price for the warrants which in this case is $11.50 per share and that they can be exercised within 30 days of the completion of the merger.

Technically, warrants expire 5 years after the merger of the SPAC and their chosen target. However, note that most SPACs include a clause which allows them to redeem all of their warrants at $0.01 if the shares trade at $18.00 per share for 20 trading days out of a 30 day period. A written notice will be issued to you prior to the redemption but this is something that many investors may overlook when buying warrants.

Back to the Process

Generally, SPACs have to find a target within 18-24 months to merge with. If they do not, they will either dissolve or they will request an extension from the SEC.

If dissolved, warrants become worthless and shares are returned to investors at the original unit issue price (usually $10), plus the interest earned on the money held in the SPAC. This is important as often people view investing into SPACs at close to $10 as being generally low risk since the ‘price floor’ is set at $10.

For investors, there are a few key events to note in a SPAC’s lifecycle. The first would be the Letter of Intent (LOI). The LOI is a document signed between the SPAC and the private company, where the private company selects the SPAC to go public with. At this point, the merger might still fall through and the company might not follow through with the deal. However, this will usually cause a price spike.

The next step will be the Definitive Agreement (DA). This is when the agreement becomes binding. At this point, investor’s presentations and press releases will also be released to the public.

After this, the final step will be the shareholder vote. If you hold shares of the SPAC here, you will be allowed to vote for or against the merger.

Once the merger is passed, the ticker of the SPAC will convert to the company’s ticker, for example, IPOA to SPCE. In fact, once the merger is complete, you’ll never know that it went public through a SPAC unless you looked into its past.

Why SPACs?

Companies use SPACs to allow them go public without the regulatory hoops that are generally associated with a traditional IPO. As such, SPACs do tend to allow smaller companies to IPO more easily as compared to traditional IPOs.

Moreover, the management of the SPAC will generally continue to assist in the management of the new merged company and may lend their expertise to them when required. This is beneficial to the private company as they benefit from the knowledge and experience of the SPAC management.

Lastly, SPACs also bring new funds into the merged company and this allows them to expand their business much more easily in the near future.

What Investors Should Look Out For!

So, as investors, what should we look out for when investing in SPACs?

One of the key issues with investing in SPACs is the hype leading up to the merger. The hype around certain SPACs push the market capitalisation of certain SPACs to insane valuations, to the point that once the merger is passed, share price tumbles right after as short term investors cash out their profits. The table below shows the average three-, six-, and twelve-month returns of SPACs after merger for SPACs that have merged in between Jan 2019 and Jun 2020.

One of the reasons why this occurs is due to the dilution resulting from warrants which are allowed to be exercised after the merger succeeds. In addition, on most brokers and finance sites, the market capitalisation is usually computed with (Number of Shares) * (Share Price). However, this does not show the true market capitalisation as there are shares held by other investors which are not trading on the market. As such, the SPAC market capitalisation is often inaccurate and should be computed by yourself.

One trick to identifying the ‘true market cap’ of the company that the SPAC will merge with and eventually become will be to simply search up the “SPAC Name/Target Company” + “Investors Presentation”.

This will usually yield a slide deck detailing some key information about the SPAC and the target company. For example, for the SPAC, IPOE, on page 37 of the investors presentation, you can see that the Pro Forma Shares Outstanding is 865.1 million shares.

To compute the market capitalisation of the final merged company, simply take the (Shares Outstanding) x (Current SPAC Share Price).

I’ve been burnt by a SPAC before so I know how much it hurts to misunderstand a SPAC and lose money because of it. I got into the SHLL (later, Hyliion) at ~$26 in mid August 2020. I rode it all the way to $48 before selling it on the night of the merger. The story would be great if it ended there.

Just days after the merger, the share price of the new company, HYLN, fell all the way to $40. Thinking it was a good dip and misjudging the market capitalisation of the company, I entered again.

I eventually cut my losses when HYLN was at $28 in October 2020. Today, it still trades under $20 a share.

Know What You’re Investing In

To sum up, I hope this article clears a lot of confusion over how SPACs work and what is important when investing in SPACs. While there is a lot of hype over SPACs now and many investors have made ridiculous gains through SPACs in the last year alone, do tread with caution and do your due diligence before making your move. Good luck!

Photo by Cytonn Photography on Unsplash