Are SPACs Too Good to Be True?

Art by Alessandra De Cristofaro

They are the Wall Street equivalent of celebrity podcasts. The hottest fad in finance these days are SPACs, an easier way to take a company public than the usual regulation-clogged, time-sucking, fee-heavy method.

The special purpose acquisition company, or SPAC, has been around for years, yet only recently has caught fire. “A ton of SPACs are coming this year,” said Scott Colyer, CEO of Advisors Asset Management, which follows them.

Amid all the euphoria, though, it’s worth pointing out that investor input is limited, disclosures aren’t as wide-ranging as with legacy initial public offerings (IPOs), and the founding sponsors tend to make out better than investors. “SPACs solve a lot of problems for issuers,” said Tyler Gellasch, executive director of investment consulting firm Healthy Markets. “Not for investors.”

Another concern is that SPACs may face competition ahead from a proposed alternative to make going public even simpler. Plus, their performance record is mixed, and a lot of them (some 20% and likely more) are tech-tilted, which is a bet on the continued market prominence of that sector.

Certainly, SPACs give their sponsors a lot of flexibility that legacy IPOs don’t enjoy. Using what’s called a reverse merger, they’re known as “blank check companies” because they raise money up front, in an IPO with a player to be named later. After a while, the sponsors of this shell choose an acquisition to make with the cash. SPACs must buy something within a specified period, usually two years. The investors get to vote on whether to accept the acquisition.

Why have SPACs become popular? One explanation is that a lot of companies were poised earlier this year to go public the old-fashioned way, but the stock market’s coronavirus-induced winter tumble thwarted their plans. For their IPOs, they had laid out a fortune and committed vast amounts of time and money—and all at once didn’t know how long they’d be on ice.

Other private businesses, wishing to be publicly traded, took heed. Suddenly, the SPAC express route looked appealing. They discovered there’s a discount, too. With a traditional IPO, the investment bank takes up to 7% of the money raised, whereas with the SPAC version, the freight can be half of that. As a marketing tool, “that near-death experience helped SPACs, as they’re less stressful,” noted Jay Ritter, a University of Florida professor and the eminent authority on public offerings.

Add in the mounting frustration of IPOs during the recent bull market over the “pop.” Namely, a company does an IPO at what its investment bankers considered a fair stock price, and once it goes public, the price unexpectedly soars.

That phenomenon has fostered a lot of frustration in C-suites, miffed that Wall Street was underpricing their shares. Should the price shoot up 20% to 30% after the stock’s debut, this is extra money that could’ve gone into the corporate coffers. “If underwriters did a better job of pricing,” SPACs wouldn’t look as enticing, Ritter said.

When a SPAC goes public, it’s usually at a flat $10 per share, so no pop happens. Any upward share-price moves usually wait until the entity buys a company.

SPAC Attack

As of Friday, there were 95 SPACs created in 2020, and $37.8 billion was raised, by SPAC Research’s count. In 2015, for the entire year, just 20 were launched, with a mere $3.9 billion gathered. Even more amazingly, the SPAC stats this year are almost as big, in the number started and the total sum raised, as regular IPOs.

SPACs Get Very, Very Popular

As of September 11, 2020

Amount Raised in IPOs ($billions) Number of IPOs

Source: SPAC Research

This is an astonishing reversal for SPACs, a technique that used to be an odious backwater, where money-losing companies of dubious worth got to become publicly traded.

Marking this sea change is that big names are getting involved, such as hedge fund impresario Bill Ackman, entrepreneur Richard Branson, basketball great Michael Jordan, and former US House Speaker Paul Ryan. Heavyweight banks like Citigroup, Credit Suisse, Morgan Stanley, and Goldman Sachs are hatching SPACs. This star power has eased a lot of trepidation over SPACs.

A key advantage of a legacy IPO is that an investment bank on the order of Goldman can open doors for a little-known company and line up buyers. Now, with the big boys throwing their considerable weight behind SPACs, that edge is dulled. “They used to be funky, and now they have blue-chip sponsors,” said Raj Dos, a portfolio manager at Bulldog Investors, which invests in the vehicles.

The ease of going public via a SPAC is a powerful lure. With a regular IPO, “you have to spend 12 to 18 months putting it together,” said Brianne Lynch, who oversees business development for EquityZen. The firm invests in private companies and SPACs. “With a SPAC, it’s 90 days.” Onerous federal filing paperwork and numerous road shows render the old IPO experience exhausting.  

SPAC afficionados argue that their method zeroes in on good companies with better chances than others. Nowadays, SPACs tend to favor late-stage venture capital companies or ones nurtured under private equity ownership.

“Most SPACs don’t want a turnaround situation,” said Jim Ross, chairman of FUSE, a SPAC that went public in June, raising $350 million. Ross, who has led State Street’s SPDR exchange-traded funds operation, and his team are looking for an acquisition in financial technology or wealth management.

SPAC leaders also say they bring top-flight management and expertise, along with bountiful capital, to an acquisition. “We coach them,” said Vincent Cubbage, chairman and CEO of Tortoise Acquisition, the SPAC arm of the asset manager. His SPAC raised $233 million in its public offering and later this month will close a deal to buy Hyliion, maker of electric-powered trucks.

A veteran investment banker (Bank of America, Salomon Smith Barney, Lightfoot Capital), Cubbage often has late-night phone conversations with Hyliion’s chief. After a standard acquisition, he said, investment bankers typically walk away. “We remain personally and reputationally invested.”

While a lot of institutional money is in SPACs, they are far from being a core holding, perhaps owning to questions about their long-term staying power, or maybe it’s simply that their prominence is so new. Among pension and endowment funds, just four hold multi-million-dollar stakes in SPACs, although the vehicles are merely a small part of the portfolios.

For some reason, three of them are based in Canada. The largest amount is held by Alberta Investment Management Corp. (AIMCo), which as of mid-year manages US$90 billion in pension and endowment money: Its 56 SPACs are valued at US$616 million, or 0.68% of the plan’s total.

The California Public Employees’ Retirement System, the US’s largest pension fund, lists positions in 43 SPACs, totaling $25.5 million. For sure, this is an eensy-teensy segment of CalPERS’s vast holdings ($400 billion). Canada’s Public Sector Pension Investment Board has $25.8 million from three SPACs, of its US$168 billion portfolio. And the US$92 billion Healthcare of Ontario Pension Plan Trust Fund has 85 of these companies, worth US$530 million.

Will SPACs Be Lax for Investors?

Despite these good points, the reality is that investors can be second-class citizens in a SPAC arrangement. That may not make a difference if a SPAC turns into the next Apple or Microsoft. Still, one downside for investors is that the sponsors usually cream off 20% of the stock.  (Ackman insists that his SPAC won’t take such a big chunk, a pledge that highlights those that do.) “Investors are putting in 100%,” said Prof. Ritter, but receiving only 80% of the equity.

Of course, in addition to their shares, investors often get warrants, which is a boon if the price ascends. On the other hand, these rights to buy new shares also can be dilutive.

Another weakness: less of a say. In a regular IPO, the investors have a voice in number of shares, the offering price, and executive compensation. But with a SPAC, those matters are the sole province of the sponsors. With the merger, investors are left with an up or down vote. They’ve already parted with their money. But they usually “won’t walk away—the terms aren’t bad enough for them to,” said Gellasch of Healthy Markets.

Since SPACs are relative newcomers to the polite society of investing, they haven’t had sufficient time to produce long-term measurable performance. What we do know, using an admittedly short period, is that their returns are at best mixed.

Examining 56 SPACs that had made acquisitions since the start of 2018, Goldman analysts found that they outpaced the market over the month and quarter following the deal announcements. Once the acquisitions were done, the stocks trailed. To be sure, the range of returns was broad, with some doing very well, and some doing lousy.

What’s more, at times SPAC deals fall apart. Take Allegro Merger, a SPAC that raised $130 million in 2018 and this year sought to buy the TGI Friday casual dining chain. Then in April, it scrapped the deal, citing the ill effects of the pandemic. The SPAC dissolved and returned the money to investors. Allegro’s management couldn’t be reached for comment.

The tech concentration is troubling for those who remember how volatile the sector can be. Advisors Assets’ Colyer, whose firm doesn’t invest in SPACs, looks at the large amount of them that are in technology. “This is a frothy time for tech,” he said. Odds are some high-flying tech SPACs may end up with corrections. Aside from the 20% that are directly in technology, according to SPAC Research, a number are tech-related, albeit classified elsewhere.

One celebrated SPAC is Draft Kings, which provides sports betting online (and enlisted Michael Jordan). Branson’s Virgin Galactic is developing commercial spacecraft and plans to send well-heeled tourists on sub-orbital flights. Nikola is listed as an automaker, although it aims to produce electric vehicles.

All have doubled or quadrupled from their offering price, once they locked in their acquisitions. Nikola, however, showed some vulnerability, dipping 9% after a short-seller alleged it had made fraudulent claims (which the company denied).

Beyond that, a competitive threat looms for SPACs: a beefed-up version of direct listings. Slack Technologies’ path to public stocks last year was a direct listing, where a private company’s existing shares are peddled on the open market. Trouble is, that technique raises no additional capital to help the company grow.

The New York Stock Exchange, however, wants to permit companies to direct-list existing shares and new ones, as well, thus raking in fresh funding.  The Securities and Exchange Commission staff approved the change, but the commission itself put the idea on hold, pending review—at the behest of the Council of Institutional Investors trade group. Nasdaq also is interested in permitting an enhanced iteration of direct listings.

If such a thing comes to pass, then direct listings would get a lot of attention, on the ground that they likely would be even cheaper and easier to implement than SPACs.

No doubt, the old way of doing an IPO faces competition now. But SPACs have some vexing weaknesses, and may not end up as the killer app of initial offerings.

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