“Nations, like individuals, cannot become desperate gamblers with impunity. Punishment is sure to overtake them sooner or later.” — Charles Mackay
Special-purpose acquisition companies (SPACs) have gone viral. They accounted for half of total initial public offering (IPO) funding in the United States last year, up from 20% the year before and less than 10% in 2015.
Blank-check or shell companies have operated under various incarnations throughout financial history. They usually remain niche products with little general appeal, except in the late stages of the economic cycle.
The ongoing market dislocation has encouraged yield-seeking investors to take risks and fee-hungry dealmakers to get creative.
Public Markets’ Comeback
This series of SPACs could unleash a migration of unicorns reared in recent years by venture capitalists (VC). Many of the 600-plus herd plan to list on stock exchanges.
Who would have guessed? Only three years ago, experts were predicting an exodus from the public markets because they were too restrictive relative to their private market peers. Fund managers preferred either to shuffle portfolio assets among themselves — through secondary buyouts — or to blitz-scale start-ups for an indefinite period.
But to reach their full potential, bull markets depend on the benevolence of policymakers. The Railway Mania that gripped the United Kingdom in the mid 1840s was facilitated by the government’s decision in 1825 to repeal the Bubble Act, which had been passed following the South Sea Bubble of 1720.
That Act put tight limits on the formation of new enterprises. Once these restrictions were removed, anyone could invest in a new venture. Twenty years after the repeal, conditions were ideal for individual investors to fund railway companies. Many of these investors, Charles Darwin and the Brontë sisters among them, lost out as the bubble burst in 1846 and 1847.
Ever since the 2008 meltdown, governments have encouraged regulators to do whatever it takes to keep the economy afloat. In 2015, the Securities and Exchange Commission (SEC) voted to implement Title III of the Jumpstart Our Business Startups (JOBS) Act. Since January 2016, Americans no longer need to be accredited investors to fund start-ups.
Small investors have become fair game.
Sponsors’ Appetite For SPACs
That is fortunate for SPAC sponsors. After a decade of boundless money creation, there is ample cash sitting idly in savings and brokerage accounts.
SPACs can siphon some of it. They are indeed fantastic vehicles for fund managers facing an intensely competitive landscape. Hedge funds have experienced withdrawals. PE and VC firms have seen limited partners (LPs) — some with firepower and desirable brands, like Fidelity and BlackRock — invest directly in buyouts and start-ups.
Alternative asset managers are looking for an easier fundraising path than the time-consuming process of marketing to LPs. PE expert Alec Gores and impact investor Chamath Palihapitiya have not raised private funds for some time. Both are SPACs fanatics. As private capital becomes commoditized, SPACs provide direct access to capital from speculators and non-accredited individuals.
Since a blank-check company has no track record, no expensive audited and lawyer-vetted financial report is required. Better still, unlike traditional IPOs, as acquisition vehicles, SPACs can make forward-looking statements. Which explains why, as it prepared to merge with a SPAC, 28-month-old online car dealer Cazoo was within its rights to claim it would quadruple revenues to $1 billion this year.
Indeed, things are heating up. After 10 years of government-backed economic growth, many portfolio assets must find new owners. They may be underperformers like WeWork or highly speculative ventures like Virgin Galactic, or their existing investors may be contractually obligated to exit.
If SPACs’ benefits to sponsors are clear, the public investors’ trade-offs are equally patent.
Generally, about three-quarters of SPAC shareholders tender their stock for redemption upon a merger — though many hold onto warrants granting rights to buy more shares later. The shortfall is usually made up through private investment in public equity (PIPE) platforms. For instance, Cazoo’s SPAC was half-funded via a separate PIPE.
But most of the shareholders selling out ahead of de-SPACing are institutions. Some are regular speculative traders of these deals and are known as the “SPAC Mafia.” That leaves smaller investors exposed to what is often lackluster post-merger performance.
On average, SPAC structures have led to a 12% decrease in value of the merged entities after six months and 35% after one year, according to research from Michael Klausner, Michael Ohlrogge, and Emily Ruan. The most recent batch of SPACs is not faring any better. By mid-March, the blank-check vehicles that IPOed in 2021 were trading at just 1.7% above their IPO price on average compared to a 28% return for traditional listings.
Beside poor stock performance, contractual arrangements put public shareholders at a disadvantage. As the SEC observes:
Klausner, Ohlrogge, and Ruan offer a similar assessment:
“We find that [SPAC] structure — built to support a circuitous two-year process from IPO to merger — creates substantial costs, misaligned incentives, and on the whole, losses for investors who own shares at the time of SPAC mergers.“
On average, traditional IPOs cost public investors up to 27% of total proceeds, including underwriting fees and the typical first-day “pop.” But a SPAC’s expenses are much greater. They include the “promote,” or the 20% stake allotted to sponsors without a proportional investment; the underwriters’ fee; and dilution related to share redemption. This can add up to over 50% of proceeds.
To palliate the negative economics, sponsors have enticed investors through PR stunts and endorsement from celebrities like Andre Agassi, Peyton Manning, and Shaquille O’Neal. Such practices are ancestral. Financiers tend to recycle manipulative techniques that were successful in the past at drawing the gullible and the clueless.
In his instructive exposé, The Great Crash 1929, John Kenneth Galbraith recounts how sponsors of investment trusts — the favorite speculative channels of the Roaring ’20s — included college professors, famous economists, politicians, and at least one British marquess as well as a colonel. He makes no mention of sports heroes.
So what’s the benefit for SPAC investors?
Apart from the opportunity to back transactions from Bill Ackman, KKR, and other seasoned professionals, it is hard to identify any. Even the nickname “poor man’s private equity funds,” which implies some kind of democratization of the financial market, doesn’t hold up. Large funds compose 85% of SPAC shareholders.
And there is no shortage of risks associated with SPACs. Even an accomplished investor like Palihapitiya can be humbled by an exuberant market, as recent investigations into alleged improper business practices at Clover Health testify. Unlike an IPO, former Goldman Sachs CEO Lloyd Blankfein explained, a SPAC does not carry “with it a lot of diligence obligations . . . In the absence of diligence . . . [t]here are going to be things that go wrong.”
Rather than step in, the SEC has issued warnings: “These companies typically involve speculative investments.”
Early-stage projects like Joby Aviation and Archer Aviation provide further evidence. These two electric air taxi companies announced SPAC deals in February that valued them at $6.6 billion and $3.8 billion, respectively. Such eye-popping valuations for pre-revenue, futuristic concepts are unlikely to put dot-com bubble comparisons to rest.
The worst part is that conflicts of interest abound. Sponsors can act as buyers, brokers, and even sellers when using a SPAC to acquire one of their existing portfolio companies.
Yet, these sponsors only fork over a tiny amount of their own money to cover underwriting fees and the cost of sourcing a deal. They lose very little if they fail to find a target or if the post-merger performance disappoints. Most of the risk of failure sits with public shareholders.
On that front, SPACs are in keeping with the PE tradition: The sponsors of a SPAC fully benefit from the upside — through their 20% promote — but outsource the downside. As the SEC explains, sponsors “may have an incentive to complete a transaction on terms that may be less favorable to [public investors].”
Back to the Future?
Many SPACs will die natural deaths: They will be wound up if they cannot find a target, usually within two years of their creation. But if this cycle is allowed to run its course, two major trends are likely to materialize.
First, in financial markets, few strategies can be optimized without a dose of leverage; no innovation is complete without a zest of debt.
Financial engineers will want to share their knowhow with a broader audience. Public corporations have already adopted PE’s obsession with recapitalizations through debt-funded dividend payouts and stock buybacks. But there is room for further leverage.
PE portfolio companies carry an average debt-to-enterprise ratio of 70%, which is twice what it is for similarly sized public corporations. The SPAC market is in for a treat.
Second, those who compare SPACs to a “poor man’s private equity” fail to appreciate that PE and VC funds are diversified portfolios, while SPACs are ordinarily single-asset instruments. Even those that combine several assets tend to invest only in one sector. They bring little diversification benefits. Because of the risk of distress and default, leverage only ever make sense if it is coupled with diversification.
In The Great Crash 1929, Galbraith described the trend of long chains of investment trusts. These were peddled by specialist firms that bought 10% of the equity and raised the rest from the public. The sponsor of the trust, say Goldman Sachs when it launched its namesake Trading Corporation in December 1928, would use that first conduit to seed other investment trusts, which would then launch other trusts, and so on. This pyramidal boom reached its full extent from 1927 onwards when leverage, in the form of bonds, was added into the mix to amplify investment returns.
A similar practice emerged in the subprime bubble of the early 2000s. Diversified pyramids of squared or cubed collateralized debt obligations (CDOs) were all the rage as special purpose vehicles (SPVs) helped banks take the worst mortgages off their books. These private structures sought to hide dodgy assets from prying eyes. Since SPACs are publicly listed, their performance will be more visible.
After being shunned for the past two decades, public markets are back in vogue. Were SPAC fever to endure, it could mark the start of the Roaring ’20s, or their 21st century reincarnation.
Let’s just hope for a happier ending this time around.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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