Special Purpose Acquisition Companies, or SPACs, are the new way to go public on Wall Street. Current financial market settings, an appetite for novelty, and excessive liquidity are fueling this recent market frenzy.
SPAC has reached 53% market share vs IPOs in 2020 in terms of NASDAQ listings. This year, the market share is getting even higher, reaching 73%. In the first three months of 2021, more SPACs were launched than in all of 2020. And the amount raised from January to March ($100 billion), also surpassed that of 2020 ($83 billion). This is also true within specific industry segments. The clean-energy SPACs market boomed during 2020 and the first months of 2021. The same situation can be found with tech companies. And even in sports. More than 130 sports-related SPACs exist, often sponsored by celebrities like Shaquille O’Neal or Serena Williams.
And SPAC deals are reaching continuously higher expected values—-United Wholesale Mortgage Group –($16 Billion), Lucid Motors ($24 billion), Grab ($40 billion)—while planned ones will probably be even higher.
However, since March 11, the SEC has raised multiple concerns for investors in SPACs. In one announcement, the SEC warned that celebrity involvement in a SPAC does not make it an appropriate investment for all since “Celebrities, like anyone else, can be lured into participating in a risky investment or may be better able to sustain the risk of loss.”
So, are SPAC’s really providing value for the investors?
A novel way for companies to go public
SPACs are blank check companies that go public, raise capital, have no actual commercial operations, and have a two-year lifespan. They are created by a sponsor to raise capital through an Initial Public Offering, and later (within two years) use it to acquire a privately held operating company. If the management team fails to merge or acquire a company within two years, the SPAC will be liquidated, and the investors reimbursed (minus fees and transaction costs).
The shell company sells common stock to the public, with shares commonly sold at $10 each, together with a warrant that gives investors (sponsors) preference to purchase more stock later on at a fixed price. Then, the capital raised through the IPO is placed into an interest-bearing trust until the management team of the SPAC purchases or mergers with a target private company that is then listed on the stock exchange. This is the ultimate goal of SPACs: to find and acquire other companies, at which time more money will have to be raised from investors. The process of acquiring and listing the target private company is called “de-SPAC”.
Between January 2017 and September 2020 a total of 90 de-SPAC transactions were closed, totalling over $90 billion of transaction enterprise value. As of April 19, 2021 there were 430 SPACs identified as actively seeking targets.
Compared with a SPAC, an IPO is a different kind of public offering where there is comprehensive preparation involving the whole organization and a full SEC review process. Consequently, it can take much longer. Related activities in SPACs are also different. Instead of a roadshow, which typically involves thorough due diligence on the company preparing for an IPO, investors in SPACs put money in a target industry segment and a management team.
Oversupply of SPACs and investor returns
A SPAC is a type of reverse merger. In a reverse merger, a private company merges with a listed company and thereby goes public. It saves the private company the paperwork and cost, and also the strict regulatory process, of a traditional IPO. But it exposes later stage investors to added risks.
Reverse mergers have existed for a long time. However, the evidence reveals a pattern similar to prior research on traditional mergers: most destroy value for acquiring shareholders.
What is different now is that SPACs are created by proactive (and often very media-friendly) sponsors, raise significant cash at the IPO, and then search for (typically private) targets.
The flood of cash into SPACs and the euphoria around them, suggest that a bubble is about to burst. Research suggests investors in merged companies lost more than 15% on average if they bought a merged company’s common shares on the first day of trading and held it for a year. However, for pre-IPO institutional buyers losses are capped, and there is a significant possible upside if they exit at the de-SPAC phase at the expense of retail investors.
Avoiding the traditional IPO process is dangerous for investors. The IPO of Wework, the troubled and loss-making co-working company, collapsed in 2019 at an expected valuation of close to $50 billion. It is now riding the SPAC wave. Wework is merging with a SPAC, and will then trade at a significantly lower valuation (around $9 billion).
As in prior bubbles, from the South Sea Bubble to subprime loans, when a great mania emerges, several new companies arise and everything seems rosy. Additionally, when there are lots of buyers with deep pockets looking for sellers, the price tends to go up. Buying companies at expensive prices is a sure way to have low future returns and, eventually, losses.
Be careful when you sign blank checks
Investors looking for a quick and easy return should be careful.
SPACs are trading very quickly to become public listed companies for hefty price tags on the back of misaligned incentives. Managers avoid scrutiny behind a blank check format and have incentives to buy a company or the SPAC is closed. Similarly, in other areas of finance, bad incentives have also led to negative outcomes. This is true of private equity funds pressured to deploy capital in order to get management fees, YieldCos,and explains why normal, cash-rich industrial companies make worse acquisitions.
With the oversupply that is happening, many SPACs will not be able to deploy their capital and will have to return it (minus costs) to investors. And for those that eventually close deals, investors should be aware of the novelty and think about the fundamentals of value creation. Once again, acquiring shareholders, like in the traditional M&A world, are not the ones to capture most of the value from these deals. Critical thinking, a focus on the levers of value, and proper due diligence trumps celebrity involvement.
By Nuno Fernandes, Full Professor at IESE Business School and the author of “The Value Killers. How Mergers and Acquisitions Cost Companies Billions—And How to Prevent It” and “Finance for Executives: A Practical Guide for Managers”, and Tiago Palas Santos, Consultant
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