The future of SPACs
With renewed interest in Special Purpose Acquisition Companies due to the recent loosening of regulation, we examine if the party is over or just beginning
The future of SPACs
With renewed interest in Special Purpose Acquisition Companies following the recent loosening of regulation, read our latest insight series where we examine if the party is over or just beginning for SPACs.
<b>SPACs:</b>
how did they
get so popular?
SPACs: how did they get
so popular?
What connects tennis player Serena Williams, ex-basketball player Shaquille O’Neal and singer/songwriter Ciara Wilson – apart from the fact they’re all famous?
The answer: they’ve all got involved, in one way or another, in the weird (to critics) and wonderful (to fans) world of SPACs.
“SPAC” stands for “special purpose acquisition company”.
That special purpose is to make a return from acquiring another company. The founder, or “sponsor”, lists the company on a stock exchange. But at this point it’s just an empty company that holds cash raised from the IPO. For this reason, SPACs are sometimes known as blank check companies.
Until recently talk of these blank check companies would have drawn blank looks from many investors. Back in 2013 there were only 10 SPAC IPOs in the US, where the bulk of SPACs list. They raised only about $1bn, according to research by data provider Dealogic and Goldman Sachs, the investment bank. By 2020 that number had grown to 228, raising $77bn. And then the SPAC mania became even more intense. In one week alone during Q1 2021, 37 SPACs came to market.
That’s the same number as in the whole of 2013, 2014 and 2015 – and two more even than in 2018, when SPACs had really begun to gather speed. “We, and other leading law firms in the market, saw a surge in transactions and interest in the product in the first quarter of the year”, says Daniel Forman, New York-based partner in capital markets at Proskauer.
We need to explain more about how SPACs work. Investors in the IPO receive common stock and warrants, but the sponsor gets a hefty tranche of shares and warrants – often 20% – at a steep discount. The sponsor then has a certain amount of time to find a real-life business – often two years.
The SPAC then merges with this firm, with public investors generally getting most of the company but the original shareholders usually receiving shares too. Through this backdoor flotation, known as a “reverse merger” or “de-SPAC”, the target business becomes a listed company. In most of the world, investors can vote to accept or reject the merger – and even if they vote against it but are outvoted, they can cash out of their investment before the merger. If they do that, they get back what they invested, plus interest. The sponsor usually also arranges funding from institutional investors, to fund the growth of the new company.
Ana Kekovska
Group Head of Corporate Services
Democratising access
SPACs have become immensely popular with ordinary retail investors in particular.
Sponsors argue that they open up to ordinary Joes and Janes a particular kind of investment otherwise out of their reach: the fast-growing company not (yet) listed in public markets. That’s more of a problem than in the past because rapidly growing companies are taking longer to go public. “It democratises access to private businesses that retail investors have been excluded from for decades”, says Mark Yusko, CEO and CIO of US firm Morgan Creek Capital Management, which invests in SPACs.
Some market-watchers attribute the ratcheting up of the SPAC market to another event: the global pandemic. Ordinary Americans were posted stimulus cheques to support the economy, which boosted their income. People in wealthy countries were also left sitting at home, many of them with little to do because of interrupted social and working lives, and began to dream of making fast profits. In other words, they had means, motive and opportunity.
The cornucopia of celebrities involved in SPACs also helped a great deal with marketing to this constituency.
To satisfy your curiosity, Williams sits on the board of Jaws Spitfire Acquisition, which merged with US 3D-printing company Velo3D in March 2021, in a deal valuing the company at $1.6bn. O’Neal is “strategic advisor” to two SPACs, Forest Road Acquisition Corp and Forest Road Acquisition Corp II. Defenders of these SPACs can point out that rather than being there as a gimmick to help sell the SPAC, O’Neal’s background might be some use: Forest Road has merged with the fitness companies Beachbody and Myx Fitness. Wilson sits on the board of Nasdaq-listed Bright Lights Acquisition Corp. Since it says in its official filing that it’s looking for “businesses that can benefit from celebrity ownership and/or partnership”, it can make the point that Wilson is a relevant expert because she’s famous.
The cornucopia of celebrities involved in SPACs also helped a great deal with marketing to this constituency.
SPACs spread across the world
SPACs are spreading in Europe and Asia too these days, after a slow start.
Twenty listed in Europe in the first half of 2021, says stock exchange group Euronext – half of them on Euronext. A high-profile example is Pegasus Europe. It raised €725m, in an April 2021 listing on Euronext Amsterdam, to invest in European financial companies. Amsterdam is fast becoming the European centre for SPACs: by mid-August 10 had launched this year.
But one major exchange that has come late and rather cautiously to the SPACs party is the London Stock Exchange. The LSE has listed five “acquisition vehicles”, including SPACs, so far in 2021. However, its SPACs are generally very small and very different from the US model. The money is used to fund salaries and due diligence costs on potential targets, rather than to buy the target itself. What’s more, once the reverse merger was announced, trading was suspended. Contrast that with Euronext exchanges, where investors can keep trading into or out of the SPAC.
A March review by the UK Treasury called for looser regulation of SPACs, however. This prompted a consultation by the Financial Conduct Authority, the UK watchdog, suggesting special treatment for SPACs, including allowing the trading of shares even after a takeover announcement. The new rules took effect on 10 August 2021 and have been welcomed by the SPAC community.
These new rules have certainly added a renewed interest in SPACs in the UK, especially in the PE and VC community, but will they change the tentative nature of the UK’s SPAC adoption? SPACs have certainly had their sceptics in the past but is the SPACs party over, or just beginning?
Read more in our next piece
Will the new rules change UK adoption of SPACs?
SPACs hit bump in the road as celebrity stardust loses power
SPACs hit bump in the road as celebrity stardust loses power
Financial market regulators rarely talk about celebrities.
They leave that to the tabloids and celebrity gossip websites.
So it came as a shock when in March 2021 the US Securities and Exchange Commission published an Investor Alert with the word “celebrity” in the title.
More specifically, it was about celebrities and SPACs. “Celebrity involvement in a SPAC does not mean that the investment in a particular SPAC or SPACs generally is appropriate for all investors”, says the alert. “Celebrities, like anyone else, can be lured into participating in a risky investment.” They may, the missive points out, “be better able to sustain the risk of loss”. In short, “it is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment”.
It is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment"
In May the SEC issued an updated Alert listing potential pitfalls for investors in more detail. These included the more favourable investment terms for SPAC sponsors. Critics say this encourages them to find merger targets quickly, without being too fussy. If they can make a profit even from a bad deal, because they have been given shares and warrants at such a cheap price, why look too closely?
If no deal is made, on the other hand, they have to return all the money, so they earn nothing at all. SPAC shares are usually issued at $10 each, but Daniel Forman, New York-based partner in capital markets at Proskauer, a law firm, says sponsors’ break-even levels can be as low as $1. In the same bulletin, the SEC also raised fears that it might be harder for SPACs to find attractive businesses now that there were so many on the lookout for targets including competition from PE buyers and industry consolidators.
How good are the returns?
Many of the SEC’s concerns boil to one question: how good are the investment returns – not for the sponsor who gets the shares and warrants, but for the end-investors?
In August J.P. Morgan Asset Management (JPMAM) looked at all US SPACs brought public or liquidated between January 2019 and March 2021. End-investors buying into the SPAC at launch and holding it right the way through until the reverse merger earned a meagre 4 percent on average – 100 percentage points below a composite of two leading US IPO indices. The absolute return is considerably worse than when JPMAM ran the same numbers in February, though even then SPACs severely underperformed the IPO indices. This suggests that the quality of SPACs is getting worse. Michael Cembalest, chairman of market and investment strategy, dismisses SPACs as a collection of “clearly underperforming and usually unprofitable companies”.
One crumb of comfort is that the top SPACs fare extremely well. An 85th percentile SPAC – one more successful than all but the top 15 percent of them – returned 124 percent. US sports betting company DraftKings is often touted as the classic example: it has risen from a $10 starting price, when it merged with Diamond Eagle Acquisition Corp in April 2020, to above $50 in August 2021.
How did the sponsors do? Incredibly well, because they received so many shares and warrants – often 20 percent of each – at low prices. Because their terms were so favourable, SPAC sponsor returns, after allowing for costs such as concessions made to other parties, averaged 284 percent.
“A Sober Look at SPACs”
End-investors’ returns are hit, among other things, because of the money that’s lost getting to the reverse merger.
Although SPACs issue shares for roughly $10 and value their shares at $10 when they merge, at merger time the average SPAC holds cash of only $6.67 per share, after including the cost of paying back investors in the SPAC who want to cash out of their shares. That’s the conclusion of an April 2021 paper by the European Corporate Governance Institute (ECGI), “A Sober Look at SPACs”. If the target company insists on a one-for-one share exchange in the new company the target shareholders can get the full $10 for their shares, but the SPAC shareholders will see their shares drop from $10 before the merger to $6.67 after it.
This unequal sharing of the benefits explains another finding of the paper: that SPACs usually do pretty badly after the merger.
They tend to drop by one-third of their value or even more. “We wonder whether this is a sustainable situation”, say the paper’s authors. “It is hard to believe that SPAC shareholders will continue to take these losses.”
Another SPAC problem is that the target company they merge with may also be overvalued because of the sheer number of SPACs chasing suitable private companies. “We estimate $129bn of SPAC capital is currently searching for a target”, said Goldman Sachs in an April 2021 note. That figure will be slightly lower now, but not much so, since the SPAC IPO boom peaked only at the end of March.
This points to the general problem with today’s SPAC, in the eyes of critics. It’s not a lasting model if some groups make a lot of money but others lose out, because those who lose out will eventually refuse to play ball.
Do all these criticisms mean the SPAC market’s days are numbered?
We look at all this in our third and final piece on SPACs
Do all these criticisms mean the SPAC market’s days are numbered?
- Definitely
- No way!
- Who knows
SPAC fans say the market will come back to life
SPAC fans say the market will come back to life
The plummeting number of SPACs at the end of Q1 2021 (see previous piece on SPACs) has prompted much head-scratching about how to save SPACs – and about whether they deserve saving.
But some SPAC apostles say there’s nothing massively wrong with them anyway. For that reason, they say, the number of SPAC IPOs should bounce back.
To help them on their way back, some people have called for reforms to SPAC structures or to the information provided to investors.
One idea is to tie sponsor returns in more tightly with the long-term returns of the new company after the reverse merger, sometimes known as a de-SPAC. Sponsors generally have to keep their shares for a year after this, but they pay so little for their SPAC shares and warrants that sponsors will make at least some profit unless the company performs disastrously.
Some SPAC-watchers thinks Bill Ackman has an interesting solution. Ackman’s hedge fund, Pershing Square, has bought shares in Pershing Square Tontine Holdings, launched in 2020, at the IPO price rather than for the usual massive discount. It has also paid $65m for warrants that can only be exercised until three years after a merger is completed and the stock has risen 20 percent.
However, in July he responded to concerns from the Securities and Exchange Commission (SEC) and investors by abandoning a plan to use the SPAC cash to buy a minority stake in a private company, Universal Music, rather than to take control of a company and take it public through a reverse merger.
Investors fretted that this looked more like a high-conviction hedge fund investment rather than a SPAC strategy – this was one innovation too far.
Another idea is to make SPAC structures less opaque to investors. For SEC registration statements the US financial watchdog has started “looking to SPACs to clearly disclose what the costs of purchasing shares and warrants are for the sponsor, and therefore at what point the sponsor would break even”, according to a US lawyer. Such disclosure could force sponsors to redistribute the potential gains more to other parties, including perhaps investors.
Smaller but stronger
Some observers also think the growth of private equity and venture capital sponsors will be good for the SPAC market. For example, US private equity firm TPG Capital floated two SPACs in April 2021, TPG Pace Solutions Corp and TPG Pace Beneficial Corp, adding to its existing stable. The US lawyer thinks their ability to bring capital with them, rather than struggling to secure it through Pipe deals in an increasingly crowded market, is an advantage.
The lawyer believes the increasing presence of PE and VC is part of a general strengthening of the SPAC-verse. “The very challenges that are reducing SPAC volumes may create a more durable and resilient SPAC market”, he says. He predicts “a forthcoming flight to higher-quality sponsors” as less impressive ones find it harder to raise the capital.
Mark Yusko, CEO and CIO of Morgan Creek Capital Management, echoes this. He thinks SPACs have hit the awkward “second wave” that he says all new investment innovations go through, when the realisation that there’s money to be made attracts less qualified people. This will lead to the third wave: “The market will be more discerning because people see: ‘If I just back anything, I will not do well.’” Morgan Creek runs a fund that buys into SPAC IPOs and sells shares when a deal is announced, but keeps the warrants. It also manages an actively managed SPAC exchange-traded fund, SPXZ.
Yusko also believes the structure of SPACs offers attractions. “The design of the SPAC structure is elegant”, says Yusko. “It perfectly aligns the interests of investors and sponsors.” Because sponsors’ capital is locked up for a year or more after merger, “you’d better do a good deal, because if you don’t, your value is going to degrade over time”. Yusko also contrasts the equal access to the SPAC IPO for retail and institutional investors with “the horrible incentive structure of traditional IPOs”. For conventional IPOs, the institutional investors buy the stock cheaply on flotation and quickly sell it on to retail investors, earning a big return that very day that ordinary investors are frozen out of.
Yusko attacks what he sees as the myth that celebrity involvement with a SPAC is a bad sign for investors. “If you tell me Shaq is doing a SPAC, I’m in ten times out of ten”, he says. Shaquille O’Neal has launched two SPACs, Forest Road Acquisition I and II. We mention the first one in our first piece on SPACs. “He’s a great investor who has done a lot of interesting things.”
If you tell me Shaq is doing a SPAC, I’m in ten times out of ten”
Yusko questions the argument that SPACs are flawed investments because returns vary so widely and are so volatile. He says this is only to be expected with securities that are essentially late-stage VC investments in the sectors of the future. “Returns can move exponentially, but you have to suffer through the volatility.” He says last year about two-thirds of SPACs were in five sectors: electric vehicles, autonomy, online sport, e-gaming and space. “It’s hard to value the future today”, notes Yusko. Take Virgin Galactic, which went public in 2019 after merging with a SPAC, Social Capital Hedosophia, and hopes to offer space flights to the ultra-wealthy. “How many space tourists do we have today? Zero. How many will we have in the future? More than zero.”
But Michael Cembalest, chairman of market and investment strategy at J.P. Morgan Asset Management, thinks the SPAC may be an idea whose time is going rather than coming.
“As the Federal Reserve lays out its plans to start slowing its asset purchases, perhaps by the end of the year, areas like the SPAC market that rely heavily on abundant liquidity may be early casualties”, he says. “SPACs may be an exaggerated preview of what lies in store for other overpriced assets unsupported by earnings growth.”
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