“Nations, like individuals, cannot become desperate gamblers with impunity. Punishment will surely overtake them sooner or later.” – Charles Mackay
SPACs have gone viral. They made up half of all initial public offering (IPO) funding in the US last year, up from 20% the previous year and less than 10% in 2015.
SPACs raised more money in 2020 than the previous 10 years and more in the first quarter of this year than in all of last year.
The blank check corporation or shell corporation has operated under various incarnations throughout financial history. They usually remain niche products of little public appeal, except in the later stages of the economic cycle.
The constant market turmoil has encouraged investors looking for returns to take risks and encouraged fee-hungry deal makers to get creative.
return to public markets
This series of SPACs could unleash an exodus of unicorns sparked in recent years by venture capitalists (VCs). Many of the 600-plus flock plan to list on exchanges.
Who would have guessed? Just three years ago, experts would have predicted an exodus from the public markets because they were too constrained relative to their private market counterparts. Fund managers have preferred to either swap portfolio assets between themselves – through secondary acquisitions – or large-scale start-ups for an indefinite period.
But to reach their full potential, emerging markets depend on the generosity 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 after the South Sea Bubble of 1720.
This law placed severe restrictions on the formation of new institutions. Once these restrictions are removed, anyone can invest in a new venture. Twenty years after abolition, conditions were perfect for individual investors to fund railroad companies. Many of these investors, Charles Darwin and the Bronte sisters among them, lost out as the bubble burst in 1846 and 1847.
Since the crash in 2008, 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 startups.
Then, in June 2020, individuals were granted the right to invest directly in private equity (PE) funds through their 401(k) plans. PE has traditionally been the preserve of accredited investors.
Small investors have become fair game.
Sponsors desire to spax
This is fortunate for SPAC sponsors. After a decade of creating borderless funds, there is plenty of money sitting idle in savings and brokerage accounts.
SPACs can pull some of it off. They are indeed great tools for fund managers facing an intensely competitive landscape. Hedge funds saw withdrawals. PE and VC firms have seen limited partners (LPs) — some with firepower and coveted brands, like Fidelity and BlackRock — invest directly in acquisitions and startups.
Alternative asset managers are looking for an easier path to raising money than the time-consuming marketing process for asset providers. Private equity expert Alec Gores and influence investor Chamath Palihapitiya haven’t raised private money for some time. Both are SPACs fanatics. As private capital becomes commoditized, SPACs provide direct access to capital from speculators and unaccredited individuals.
Because the blank check firm does not have a proven track record, an expensive attorney-attended audited financial report is not required. Even better, unlike traditional IPOs, as acquisition vehicles, SPACs can make forward-looking statements. Which explains why, as it prepared to merge with SPAC, 28-month-old online car dealer Cazoo was well within its rights to claim that it would quadruple its revenues to $1 billion this year.
In fact, things are getting hotter. After 10 years of government-supported economic growth, many of the portfolio’s 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 the benefits of a SPAC for sponsors are clear, the trade-off for public investors is equally patent.
Overall, about three-quarters of SPAC shareholders bid their shares for redemption upon merger — although many hold on to grant rights to purchase more shares at a later date. Shortfalls are usually made up through private investment in public equity platforms (PIPE). For example, Cazoo’s SPAC was funded in half via a separate PIPE.
But most of the shareholders who sell before de-speaking are foundations. Some of them are regular speculative traders in these deals and are known as the “SPAC mafia”. This leaves smaller investors exposed to an often lackluster post-merger performance.
On average, SPAC structures led to a 12% decrease in the value of the merging entities after six months and 35% after one year, according to research by Michael Klausner, Michael Olrog, and Emily Rowan. The latest batch of SPACs is no better. By mid-March, blank-checked cars going public in 2021 were trading just 1.7% above their IPO price on average compared to a 28% return for a traditional listing.
Combined with poor share performance, contractual arrangements put general shareholders at a disadvantage. As the Securities and Exchange Commission noted:
“SPAC sponsors generally buy shares in a SPAC on more favorable terms than IPO investors or subsequent investors on the open market.”
Klausner, Ohlrog, and Rowan make a similar assessment:
“We find it [SPAC] The structure–created to support a two-year indirect process from IPO to merger–creates significant costs, unbalanced incentives, and, on the whole, losses for investors who own shares at the time of SPAC mergers.”
On average, IPOs cost public investors up to 27% of total proceeds, including underwriting fees and the typical “pop” on the first day. But SPAC’s expenses are much larger. They include “promotion”, or the 20% stake allocated to sponsors without a proportional investment; Insurance fees. and dilution related to stock redemption. This can add up to more than 50% in revenue.
To mitigate the negative economy, sponsors lured investors with public relations stunts and celebrity endorsements like Andre Agassi, Peyton Manning, and Shaquille O’Neal. These practices are predecessors. Funders tend to re-use manipulative techniques that were successful in the past in attracting the naive and the clueless.
In his helpful presentation, The Great Collapse of 1929John Kenneth Galbraith recounts how the patrons of investment funds — the preferred speculative channels of the 1920s — included university professors, famous economists and politicians, and at least one British compound as well as a colonel. Sports champions are not mentioned.
SPACs are risky
So what is the benefit to Plumber investors?
Aside from the chance of transactional support from Bill Ackman, KKR, and other seasoned professionals, it’s hard to say which one. Even the nickname “Private Equity Funds for the Poor,” which denotes a kind of democratization of the financial market, doesn’t hold up. Large funds make up 85% of SPAC shareholders.
And there is no shortage of risks associated with SPACs. Even a shrewd investor like Palihapitiya can be humiliated by an exuberant market, as recent investigations into alleged improper business practices at Clover Health attest. Unlike an IPO, former Goldman Sachs CEO Lloyd Blankfein explained that a SPAC does not carry “with it many obligations of due diligence . . . in the event of non-diligence . . . [t]Here are going to be the things that go wrong.”
Rather than intervene, the SEC issued warnings: “These companies typically involve speculative investments.”
Early stage projects such as Joby Aviation and Archer Aviation provide additional clues. The two electric air taxi companies announced SPAC deals in February worth $6.6 billion and $3.8 billion, respectively. Such dizzying valuations of future concepts before revenue are unlikely to stop Internet bubble comparisons.
The worst part is that conflicts of interest run rampant. Sponsors can act as buyers, brokers, and even sellers when using a SPAC to acquire one of their existing portfolio companies.
However, these sponsors only charge a small amount of their own money to cover the underwriting fee and the cost of getting a deal. They lose very little if they fail to find a target or if their post-merger performance is disappointing. Most of the risk of failure lies with the public shareholders.
On this front, SPACs are in keeping with PE traditions: SPAC sponsors take full advantage of the upside—by being promoted at 20%—but outsource the downside. As the SEC explains, sponsors “He may have an incentive to complete a transaction on potentially less favorable terms [public investors]. “
Back to the future?
Many outer space centers will die natural deaths: they will wind up if they can’t 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, some strategies can be optimized without a dose of leverage; Innovation is not complete without the pleasure of religion.
Financial engineers will want to share their knowledge with a broader audience. Public companies have already embraced PE’s obsession with recapitalization through debt-financed dividends and share buybacks. But there is room for more leverage.
Private equity portfolio companies have an average debt-to-institutional ratio of 70%, which is twice that of public companies of similar size. SPAC market at hand.
Second, those who compare SPACs to “poor man’s private equity” fail to appreciate that PE and VC funds are diversified portfolios, whereas SPACs are typically single-origin instruments. Even those that combine several assets tend to invest in only one sector. They bring little diversification benefits. Given the risk of distress and default, leverage only makes sense when combined with diversification.
in The Great Collapse of 1929Galbraith described the trend of long-chain investment funds. These were promoted by specialized companies that bought 10% of the shares and raised the rest from the public. The fund sponsor, as Goldman Sachs says when he launched his namesake trading company in December 1928, is to use that first channel to seed other investment funds, which will then launch other trusts, and so on. This pyramidal boom reached its full extent from 1927 on when financial leverage, in the form of bonds, was added to the mix to magnify investment returns.
A similar practice emerged in the subprime mortgage bubble of the early 2000s. Various pyramids of square or cube collateralized debt obligations (CDOs) have been all the rage as special purpose vehicles (SPVs) have helped banks remove the worst mortgages from their books. These private structures sought to hide the dodgy assets from prying eyes. Since SPACs are generally listed, their performance will be more noticeable.
After being shunned for the past two decades, public markets are back in vogue. If SPAC fever persists, it could be the beginning of the 2020s, or its reincarnation into the 21st century.
Let’s just hope for a happy ending this time.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: © Getty Images / Rafael Abdrakhmanov
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