Companies that issue “blank checks” attract billions of dollars from individual investors and hedge funds seeking capital gains and access to private market returns. These Spac (special purpose acquisition companies), who raise money for the sole purpose of making an acquisition in the long term, promise companies a simpler, cheaper and alternative route to the traditional initial public offering (IPO). They also come with caveats that investors would be well advised to consider carefully.
Spacs are front companies created for a limited period of two years with a promise to purchase another business within that time. When investors place a $ 10 share with a Spac, which then looks for a company to go public, they don’t yet know what their target will be.
Dozens of Spacs are launched every week. According to Bloomberg, Spacs raised more than $ 137 billion last year, ten times more than in 2019. It is estimated that 40% of these investment volumes come from retail investors, which is roughly twice the share of individuals in traditional US stock markets. This has generated a frantic fishing of target companies, often start-ups developing automotive or space technologies, sustainable energies, or older companies specializing in private equity portfolios.
Leading sponsors who raise capital for high-end industries help drive investor demand. The largest Spac to date was born from the $ 4 billion raised last year by Bill Ackman, the founder of the hedge fund Pershing Square Capital. There are many other examples. Venture capitalist Chamath Palihapitiya used a Spac in 2017 to take a 49% stake in Sir Richard Branson’s Virgin Galactic, and reportedly created seven other companies of this type. Just last week, one of Michael Klein’s Spacs bought Tesla rival Lucid Motors. On February 26, the former chief executive of Credit Suisse Group, Tidjane Thiam, reportedly sought a target in the financial services industry for a Spac valued at $ 300 million.
Another significant part of the liquidity comes from hedge funds, in particular Millennium Management, Magnetar Capital and Polar Asset Management, which are active in the Spac market and which may benefit from additional trading rights in warrant-type instruments. Institutional investors can use Spacs as a substitute for low yielding bonds, as they have the option of opting out with certain rights to the shares before a transaction is announced.
In the current context of low yields, one of the attractions of Spacs is that they allow investors to withdraw their money, plus interest, if they do not like the announced target. They therefore buy options on private companies with high growth potential that would normally be out of their reach. If too many investors opt out of the proposed transaction, Spac, which typically takes a 20% stake in the common stock for a nominal price, may also opt out of the transaction.
What’s wrong with IPOs?
Price is one of the most visible flaws in traditional IPOs. Because many investors have a short-term view of the stock, advisers to investment banks feel pressured to undervalue the initial market price. So, as soon as the stock is listed, investors see the immediate payoff. But the founders and owners of the companies involved end up finding that they earned too little and that they actually paid for the IPO out of pocket. In 2020, data shows IPOs surged 40% on average on their first day of listing. Which makes them unattractive for the board of directors of a private company.
In contrast, Spac agrees on the introductory price with the owners of the target company and promises a simpler and less expensive listing process. As Sir Richard Branson explained last month when asked about the launch of Virgin Galactic as Spac in October 2019, the structure “runs through all the galimatia of state-owned companies”.
If the arguments for Spacs sound too good to be true, the downsides should be explored. The common treasury of investors has to pay the advisory fees and bank charges, which dilutes their initial forecasts. Worse yet, a recent paper published by Stanford University law schools and New York revealed that at the time of a merger, an investment of $ 10 per share is barely worth a median amount of $ 6.67 in cash. The study concluded that for “a large majority of Spac” stock prices fall after a merger. Over the next three months, the authors found that Spacs had a median loss of -14.5% and a median difference of -16.1% from the Russell 2000 Small Cap Index.
This means that “investors bear the cost of dilution built into the structure of Spacs and therefore subsidize the companies they bring on the stock market”. However, another study published in December 2020, calculated that the median return of all types of IPOs three months after their listing was over 1.6%.
However, before making an IPO, Spacs show profits. The IPOX SPAC index of classic shares held by listed Spacs has been in existence since the end of July 2020. It has shown an increase of 64.2% since then. Traditional equity markets posted returns of 48.2% for the Russell 2000 Index, 24.6% for the NASDAQ and 17.6% including dividends for the S & P500 over the same period.
Invest in success?
Their detractors also point out that even Spacs which carry out acquisitions do not necessarily support successful companies. For many investors, therefore, the question is whether companies that raise liquidity through a Spac are doing so because they have no other option. What if they’re comfortable with the dislocation between their own investment interests and the Spac sponsor ‘s ultimate goal of inheriting a one-fifth stake in a publicly traded company.
Virgin Galactic, often cited as an early example of the current Spac frenzy, has passed its original 2007 deadline for bringing commercial spaceflight to market. Last week, she announced the appointment of a new chief financial officer hours before reporting a loss of 31 cents per share in the fourth quarter on zero income. That hasn’t stopped its share price from quadruple in sixteen months of listing, nor singer Justin Bieber and actor Leonardo DiCaprio from reserving seats on these flights. Two other companies linked to the space sector have announced their intention to go public through Spac. Astra, which develops space platforms, could be worth $ 2 billion in an IPO, and Momentus Space, whose Russian CEO is legally barred from reviewing projects developed by his own company under U.S. national security.
If more Spacs are rushing for fewer opportunities, there is a risk that the value of mergers and Spac shares will swell as deals approach. Mr. Klein’s stake in Churchill Capital IV had more than halved two days after the February 22 announcement of a deal with Lucid. For months, investors bought shares based on rumors, then sold their stakes when they saw the details of the deal.
A significant portion of the capital seeking opportunities may not find a target and end up being returned to investors. In the end, disappointments could tip the market, in the event that investors are frustrated by the insufficient number of acquisitions and by possibly unfounded future financial projections.
The new Spac market lacks readily accessible global benchmarks and past performance figures. Therefore, a high profile success story tends to increase inflows to these instruments. On the cusp of widespread adoption of Spacs, there are also clear signs that investors are over-praising the shares of these shell companies, since they are traded in the complete absence of fundamentals.
A second threat could potentially materialize following a sustained rise in interest rates, in the wake of a resurgence of inflation, which could reduce the relative attractiveness of these instruments. A situation that seems however unlikely this year.
As long as the low interest rate and low yield environment persists, markets will continue to seek ever more sophisticated sources of return. As long as the Spac market does not turn into a bubble, lack credible target companies, or get bogged down in lawsuits, these instruments may offer companies an alternative route to go public.