Up in the Air
The SPAC market has grown into a multi-billion-dollar powerhouse, attracting hundreds of new entrants alongside private equity. But with signs of cooling, can the boom last?
Some say it started with Twinkies.
When The Gores Group took Hostess Brands public through a reverse merger in 2016, it was the culmination of a quiet effort happening within private equity to institutionalize special purpose acquisition companies— better known as SPACs.
Also called “blank check companies,” SPACs raise money through an initial public offering with the promise that they will merge with an unspecified company, effectively taking that business public.
Prior to the pandemic, the SPAC market was slowly gaining steam as high-profile general partners like CC Capital Partners and TPG started looking seriously at the vehicle for taking midmarket and high-growth companies public.
By 2020, the SPAC market had grown into a multi-billion-dollar powerhouse, attracting hundreds of new entrants alongside private equity, including celebrities and retired athletes. Now, even Shaq has a SPAC.
According to data provider SPAC Research, $83.4 billion was raised for new SPAC issuance in 2020. That number was surpassed early in 2021, as SPACs raised $100 billion in the first quarter alone. By April 2021, there were a total of 560 active SPACs, 434 of which were still seeking a target.
In the years after the Hostess deal, the combination of successful SPAC transactions and updates to the approach—like the use of pipe capital—has drawn in well-respected sponsors and investors to the SPAC market.
Yet launching a SPAC comes with risks. The market has drawn scrutiny from regulators and private equity limited partners, and signs of cooling this spring have raised the question: Can the SPAC boom last?
A SWEET DEAL
Prior to the 2010s, SPACs were known as the option for less-than-high-quality companies to go public with the help of less-than-high-quality sponsors. This left many investors with underperforming holdings once the deal went through. Meanwhile, SPAC rules allow investors to vote against a merger while still collecting interest on their share of the SPAC. Some investors became more interested in that arbitrage than in the company itself. The resulting dynamic created even more uncertainty about what would ultimately happen with a SPAC deal.
A sluggish IPO market in the mid-2010s led some private equity firms to reconsider the structure. Taking a company public through a SPAC has some distinct advantages. The timeline to market is shorter, ranging from months to up to two years. SPACs also lack many of the trappings of an IPO. Launching a SPAC doesn’t require lining up an investment banking team to list the company and host a roadshow, and there is significantly less accounting and disclosure work. SPACs can also be a better fit for middle-market companies in niche industries, or tech companies that may not have an IPO-ready revenue structure.
Sponsors with a deep understanding of the midmarket and the technology industry started using SPACs to take companies public. Firms like CC Capital Partners, The Gores Group and TPG brought along their existing investor and investment banking relationships, effectively institutionalizing and destigmatizing the market, culminating in the SPAC boom that started last year. The acquisition of Hostess was one of the deals that helped pave the way.
Apollo Global Management and consumer industry investor C. Dean Metropoulos bought the Twinkies-maker in 2013 for $410 million. Ahead of Hostess’ merger three years later with a SPAC sponsored by Gores, Apollo and Gores leaned on the PIPE market—private investment in public equity—to validate the company’s go-to-market story and valuation.
After a SPAC announces its intention to combine with a business, it “must offer its public investors the option to either redeem their common stock for the original purchase price or to sell their common stock to the SPAC in a tender offer,” according to a tip sheet published by law firm Mayer Brown LLP. “This redemption option inherently creates uncertainty as to the amount of cash available to the combined company following the initial business combination.”
By selling equity to private investors through a PIPE deal, the SPAC raises committed capital. Because the capital is committed, the PIPE money helps to estimate the SPAC’s valuation and how it is likely to trade.
“Initially, we used the PIPE market out of necessity to deliver more proceeds [in the Hostess deal],” explains Jennifer Kwon Chou, managing director at Gores. “But now it’s become a big part of our playbook, and you see it a lot with other SPACs in the market today. If you see that the PIPE is oversubscribed—that’s an indication that you’ve got a good deal.”
Gores Holdings, Inc., the SPAC sponsored by a Gores affiliate, announced on Nov. 4, 2016 that it had completed the acquisition of Hostess Brands in a deal valued at $2.3 billion.
In the years after the Hostess deal, the combination of successful SPAC transactions and updates to the approach—like the use of PIPE capital—has drawn in well-respected sponsors and investors to the SPAC market.
“If you see that the pipe is oversubscribed—that’s an indication that you’ve got a good deal.”
Jennifer Kwon Chou
Managing Director, The Gores Group
Interest from retail investors has bolstered this trend further. They can’t participate in IPOs, and a decline in the number of companies going public has led to fewer opportunities to invest in emerging industries. With SPACs, these investors have a new avenue to add companies like DraftKings or Skillz to their portfolios.
Private equity helped to usher in the SPAC era, but there are still operational considerations for GPs and other investors. Raising a SPAC alongside existing private equity funds requires careful conflict mitigation when choosing potential target companies and identifying independent financing. Limited partners also have raised red flags about alignment of interests, given the different economics between SPACs and traditional GP transactions.
“It’s often a question of bandwidth,” explains Carol Anne Huff, co-chair of capital markets at law firm Winston & Strawn. “If a private equity firm decides to raise a SPAC, they’ll need to be able to provide resources to manage that vehicle.”
Even if managers have run concurrent investment strategies in the past, they may still have to address LP concerns about where the firm’s leaders are focusing. “We have seen some smaller firms opt to bring in a new president just for the SPAC to deal with that so that there are clearly delineated teams,” Huff says.
Dan Moore, co-portfolio manager of investment firm DuPont Capital’s merger arbitrage strategy, which invests in a variety of SPACs, adds that evaluating the full slate of a sponsor’s activities is an important part of the diligence process. “When we think about investing in SPACs, we aren’t just looking at the target company; we’re looking very closely at the team. There are a lot of repeat issuers in the SPAC space right now, so you can start to evaluate a track record.”
On the other hand, if it’s the sponsor’s first SPAC, Moore and his team want to understand if the SPAC is its sole focus—and if not, what else the sponsor is involved in and where it’s getting financing. “When you have this much money coming into a space this quickly, diligence is critical,” he says.
Roger Aguinaldo, senior advisor at investment firm CC Capital, adds that it’s important for LPs to understand the economics behind a SPAC and how they differ from a traditional private equity fund. CC Capital has been involved in several SPAC transactions focused on middle-market companies, in addition to traditional private equity investing.
Because SPACs operate on a shorter timeline and ideally end up in the public markets at a significant multiple within two years, it may be tempting for GPs to focus more closely on the SPAC than a traditional fund that’s midway through the investment cycle. “I think it’s totally fair for LPs to raise these issues, and GPs should be able to have clear answers on how they intend to manage the process,” Aguinaldo says.
Regulators have raised questions about the accounting practices used by SPACs, as well as how issuers determine the projected value of a SPAC.
For some firms, the pivot to SPACs has meant a more comprehensive shift overall. Six years ago, The Gores Group decided to forgo raising its next private equity fund to focus entirely on SPACs. “We made a conscious decision to build a franchise in the space,” says Gores’ Jennifer Kwon Chou. “We have done a lot of work aligning our attention, as well as our diligence process, to make sure that we’re going to continue being successful in SPACs.”
CATCHING UP OR SLOWING DOWN?
After watching companies with no revenue along with high-tech businesses in nascent industries go public through celebrity-sponsored SPACs, it can be tempting to view all this activity as just a flash in the pan. But plenty of strong companies are coming to market this way, too. In August, CC Capital used its SPAC Collier Creek Holdings to take potato chip-maker Utz public after nearly 100 years as a family-owned business.
Although recent activity suggests that SPACs will remain a popular avenue for taking companies public for at least the next few years, it won’t be easy for everyone, and it’s not without some risk.
Despite record levels of fundraising, the SPAC market started to show signs of cooling off in March and April.
“We’ve seen a bit of a slowdown in the PIPE market, which has had a knock-on effect with SPACs,” says Burke Dempsey, head of investment banking for Wedbush Securities, a wealth management and advisory firm. “A lot of folks are simply catching up, given the level of activity. But I think there is also a growing realization that there are a lot of SPACs out there looking for targets and they’ve got a finite amount of time to identify one. So I would expect the PIPE market and investors generally to spend more time scrutinizing potential deals to make sure everything lines up.”
A little over a year into the initial boom, the catch-up period is also creating new barriers to entry for first-time SPAC issuers. There are already plenty of SPACs for investors to consider, and many of them are backed by repeat sponsors and well-capitalized veteran teams. If the PIPE market starts to dry up for SPACs, it could be challenging for new issuers to run a smooth process free of financing hurdles—especially if a proposed merger hits a speed bump and investors start voting against it.
There is also the question of identifying target companies. Mark Solovy, managing director at lender Monroe Capital, argues that plenty of companies could go public through a SPAC transaction, but founders and sponsors ultimately must share the same goals if a deal is going to be successful, just like in a private equity transaction. Solovy co-heads the technology and tech-enabled business services finance group as well as the SPAC group at Monroe, a repeat issuer.
“There are always a lot of dynamics at play when a SPAC issuer is trying to determine the best company to secure and complete a transaction with. You might see an experienced SPAC team pass on a company and then that company has more appeal to a different veteran team. Or a first-time SPAC issuer thinks they have a unique story with a certain target,” he says. “However, it’s going to take some time for all of that to shake out in the process. This is where an experienced SPAC investment team proves to be an advantage for a successful business combination.”
“A lot of folks are simply catching up, given the level of activity. But I think there is also a growing realization that there are a lot of SPACs out there looking for targets and they’ve got a finite amount of time to identify one.”
Head of Investment Banking, Wedbush Securities
Early data on the current generation of SPACs suggest the market tends to favor repeat issuers over first-timers, because they know SPACs well and can tell a compelling story for the public market. Meanwhile, the Securities and Exchange Commission is increasing its supervision of SPACs, which could put additional pressure on first-time issuers who aren’t as well-versed in the process.
In March and April, the SEC began taking a closer look at the SPAC market, given the amount of money raised over a very short time frame. Regulators also raised questions about the accounting practices used by SPACs, as well as how issuers determine the projected value of a SPAC. The scrutiny has been effective at slowing down activity in the market, and some of the largest SPACs have updated their disclosures in an effort to stay on the right side of the regulations.
Market dynamics may also dampen SPAC activity going forward. Several high-profile SPACs have underperformed against investor expectations, which could have a chilling effect on new issuers. If both financiers and investors are taking a harder look at new SPACs as they come to market, it could keep overall transaction volume down.
It’s too early to predict how the current SPAC boom will play out, but private equity may be in a good position either way. A continuation of the trend will benefit those firms that have launched SPACs of their own. On the other hand, if a significant number of the newly listed companies falter over the next few years, there will be plenty of public companies to take private. Watch this space.
Bailey McCann is a business writer and author based in New York.