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Inside In Full: Everything you wanted to know about SPACs (but were afraid to ask)

Over the past several months, the capital markets have seen a flurry of activity in the SPAC world.

Inside P&C Research

This has also included an intersection with the InsurTech world with the recent acquisitions of Metromile and Hippo.

Our piece below looks at (a) how they work; (b) how they differ from the IPO route; (c) investors and potential conflicts; and (d) the longevity of this business model.

In summary, we anticipate the SPAC market to start approaching equilibrium over 2021. Once the dust settles, SPACs that show a differentiated proposition, an alignment of interests with investors, and a merger partner with a clear value proposition will rise to the top. In contrast, the others will settle at the bottom.

Below, we highlight four important aspects of SPACs, from the very basics to the existential issues, that an interested follower of the business model should know.

First, a SPAC or a Special Purpose Acquisition Company is a shell company set up by investors and sponsors to raise capital through an IPO.

Simply put, the process involves investors giving a sum of money to the founders with the funds being held in a trust account. These founders, in return give investors a share and a fraction of a warrant to buy another share.

The founder generally has up to two years to find a target to reverse merge into – failing which it has to return the money with interest. If consummated, the acquired company gets access to the capital and becomes public while the investors get ownership in the form of shares and warrants if they choose to stay. Alternatively, they can redeem their shares in the SPAC with interest.

Shares and warrants also allow the investor base to trade them in the usual secondary market creating upside/downside opportunities. A rule of thumb is the amount of money raised is a quarter of the expected enterprise value, although there is a range around this.

In most cases, SPACs will put together a deal with PIPE investors in case additional capital is needed to pursue an acquisition with a target company. PIPE stands for Private Investment in Public Equity, and potential investors will be wall crossed and have access to information when the SPAC managers are evaluating opportunities. As we discuss later, PIPE investment plays an important cost reduction function in the SPAC economics.

 Looking at history, blank check companies are not a new phenomenon and were picking up steam in 2007-2008, pursuing real estate acquisitions at that time. However, with the bursting of the real-estate bubble, this form of financing remained on the back burner thereafter and has only witnessed a resurgence in the past few years.

Apart from the speculative aspect of investor interest, part of this growth could also be attributed to “unicorn” IPOs such as Uber, Lyft, etc., struggling in 2019. This led to a debate around that time as to where Wall Street bankers’ allegiances lie, and the IPO valuation process eventually led to a slowdown in new IPOs.

This also coincided with an increase in retail investor interest in speculative assets and a higher level of risk tolerance. Enter SPACs, which appealed to the investor base by suggesting they were cutting out the middlemen to some extent, reducing the volatility associated with an IPO process, and nimble enough to move on new opportunities quickly.

 Second, there’s a common misperception that SPACs are meaningfully cheaper than a traditional IPO.

One of the benefits of utilizing a SPAC is the quicker and easier access to capital, although it is rarely a cheap exercise. Unlike a regular IPO that involves one transaction. SPAC’s lifecycle includes at least two transactions – the SPAC IPO and the merger.

Both transactions bear associated expenses and are largely passed to the combined entity shareholders, either directly or through equity dilution.

Taking a SPAC public costs around 6% (as a percentage of gross proceeds), which largely consists of underwriting commissions and legal fees. These costs are effectively deferred until the merger is consummated. However, after merger this percentage will drop since PIPE money increases the gross proceeds for the target company.

The merger costs as a percentage of gross proceeds can vary significantly, again largely depending on the amount of PIPE money involved. As a rule of thumb, these costs are in the range 3%-8%. For example, Hippo incurred costs of 4.2% of the gross proceeds in merger expenses, while Metromile incurred 7.4%.

Combining the SPAC IPO and merger expenses results in around 6%-12% total costs as a proportion of the funds raised for the combined entity. This does not look too bad relative to the 6%-8% typical cost base for a regular IPO raising up to $1bn in gross proceeds.

However, this comparison is misleading because what makes the ultimate de-SPACing expenses double or sometimes even triple is dilution.

When a SPAC goes public, its ownership structure is designed in a way to ensure that the founders own a certain percentage of the company even though their monetary investment might be negligible. These shares – referred to as the promote - are granted to the founders to structure the SPAC and search for a promising target.

The ownership is typically set at 20% of the total SPAC shares. Within a combined entity, the founder’s stake will be diluted to a low to mid-single-digit percent. It’s important to remember that the founders provided no capital in exchange for these shares, which materially dilutes the combined entity ownership.

It is easier to get your head around the founder shares dilution effect by imagining that the target company is the one acquiring the SPAC. It pays $10 per share to all its shareholders, the price at which the SPAC floated, while its price should be more like $8, other things equal, given that the founders received their 20% stake for free.

Of course, target company management is aware of that, which often leads to the founder ownership being renegotiated at the time of the merger. It takes a form of restrictions on a fraction of the founder shares or even results in an outright forfeiture of a portion of the shares.

For example, out of their implied 6% ownership in Metromile (resulting from the initial 25% fixed stake in the SPAC), the founders forfeited 0.9% and agreed to put restrictions on another 4% that vest in two tranches at $15 and $17 per share price. It means that on a fully diluted basis, founder shares diluted Metromile's equity base by 5.1%.

Similarly, RTPZ founders’ entire 0.9% ownership in Hippo will vest in three equal installments at $12.5, $15, and $20 per share, or automatically in 10 years.

The dilution story does not end with founder shares. Unlike most regular IPOs that offer common shares to the public, SPACs offer so-called “units” to the public. Each unit typically consists of one common stock and a fraction of a warrant (typically one-third, one-fourth, or one-fifth) with an exercise price of $11.5.

These warrants are a source of a potential dilution. For example, looking at two recent issues illustrates this issue. Hippo may have to issue 1.4% more common stock if all its warrants are exercised. Metromile could issue 6% more shares should the warrants become exercised.

It’s important to distinguish the warrants from restricted shares. Upon exercising the warrant holders provide actual capital to the firm at the exercise price in exchange for shares. Therefore, warrants are not as dilutive for book value per share as vesting stocks. At the same time, warrants may never be exercised if the stock does not trade above the exercise price. Hence, warrants are highly dilutive and put pressure on the well-performing SPACs’ valuations.

The costs from the SPAC IPO and merger, as well as the potential equity dilution from the founder shares and warrants can go as high as 15%-25% versus the typical cost of 5%-7% for a regular IPO involving deals with up to $1bn capital raise. Direct listings are an even cheaper way to go public that have every chance to gain popularity as NYSE recently allowed firms going public via this channel to raise capital.

Third, a SPAC process can bring a good network together.

What do Shaquille O'Neal, Paul Ryan, Ciara, and Chamath Palihapitiya have in common?

They are on a list of 50 and growing celebrity, political, and business figures that have recently supported SPACs.

As discussed earlier, a good network is a huge positive based on their pedigree and experience in launching successful businesses. But there is a growing trend where celebrities are willing to endorse SPACs like late-night TV commercials.

These endorsements have grown to such an extent that the SEC had to issue an investor alert earlier this month warning about differing economic interests versus investors.

This could potentially end badly as the sourcing team's quality declines coupled with pressure to deliver a merger target or return the money.

If several SPACs do end up blowing up down the road, we would not be surprised to see additional interest from regulators. Last week, Reuters reported that the SEC had sent letters to banks asking for information voluntarily on the underwriters managing the risks.

Based on what this first uncovers, it is possible we will see additional checks and balances in the system, which could slow the growth.

We did notice an interesting dichotomy when researching insurance SPACs versus the broader market.

Apart from the Pine Technology SPAC, which is backed by AmTrust executives, many of the other teams do add value to the process.

These SPACs include executives with sourcing networks, experience as M&A dealmakers, and some track record of value creation.

Additionally, insurance has witnessed an explosion in the InsurTech space. Several companies banking on their tech DNA hope to upend the traditional way of writing personal and commercial insurance. SPACs give them the ability to come online quickly and provide an additional potential source of capital.

Fourth, the SPAC market is maturing fast and should help investors sift through the glut.

One of the arguments against the rise of the SPAC companies is that unscrupulous operators are cashing in, and investors will be left holding the bag.

However, there are ETFs in the marketplace that serve as a proxy for the market's state. One of the most widely cited ETFs, Defiance Next Gen SPAC - which tracks both active and recently merged empty shells – has plunged 23% since its peak in mid-February.

 Investors are no longer as naïve as discussed in the business press. There is increased public and investor scrutiny around the disadvantages of SPACs and speculation around a potential glut of blank check companies, which likely added fuel to the sell-off.

Coupled with this is an active short market for many of these SPACs. Some of the highest shorted empty shells have a short interest of up to 30% of the float, the level of short interest that is considered extremely high for regular stocks in the public market.

There is a clear pressure on the management team to perform and be vigilant for the investor base. If most of these short bets come true over time, this will have a chilling effect on the growth in SPACs and serve as a self-correcting mechanism.

Some insurance-focused SPACs also have a substantial short interest. Delwinds Insurance Acquisition, formed by The Gray Insurance Company, has 13% short interest as a percent of the float. Cohen & Company’s third blank check firm INSU Acquisition Corp III, has a short interest of 5%.

In summary, we anticipate that the SPAC market will start approaching equilibrium over 2021. SPACs are viewed as an easier alternative versus IPOs or direct listings. However, investors are fast learning that a SPAC, with its inherent dilution and limitations, is different than what they might have signed up for.

Once the dust settles, SPACs which show a differentiated proposition, an alignment of interests with investors and a merger partner with a clear value proposition will rise to the top. In contrast, the others will sink to the bottom.


Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.

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