It is always a wonder when a besmirched and ridiculed financial product becomes mainstream. We remember how, with the artful guidance of Michael Milken, junk bonds, once known as “fallen angels” made the transition to new issue high yield securities. Pointing out that a triple-A rated bond had only one way to go, Milken convinced issuers that their ratings did not have as much strategic value as they thought. Mix that notion with massive fees for Wall Street underwriters and a new capital markets tool is born.
A Special Purpose Acquisition Company or SPAC (previously, “blank-check company”) is organized to raise money in a public offering to make an acquisition within the next two years. Because the potential target must be unknown at the IPO, the SPAC has no operating history or assets so the disclosures in the S-1 are minimal. As the attorneys at Winston & Strawn put it, “the financial statements and the Management’s Discussion and Analysis of Financial Condition and Results of Operations section is not significant”.
What is significant? Management.
Investing in a SPAC is akin to that old saw from the venture capital world, “bet on the jockey not the horse”. Except in this case, we are also betting that the jockey will be able to find a horse to ride in the next 24 months. A SPAC S-1 will typically have elaborate and lengthy descriptions of the M&A magic and strategic acumen of the sponsors.
The sponsors are handsomely compensated for their efforts typically receiving 20% of the company in founder’s shares for a few thousand dollars as the “promote” fee – a significant dilution to the other shareholders. The sponsors also buy warrants to purchase shares at a 15% premium to the IPO price. So in addition to their reputations, the modest warrant proceeds represent the sponsor’s only real skin in the game.
Complexity Equals Value?
When a SPAC goes public they sell “units” of one share plus a detachable warrant to buy some portion of a share. All of the cash proceeds are put in a trust until the future merger is complete. The new shareholders have the option to redeem their shares for cash if they don’t like the merger and most actually take that route. A recent study*, found that mean redemptions were 58% of the cash and more than a third suffered 90% redemptions. The sponsors then sell PIPEs at the closing of the merger to replenish some of the cash. Thus, the post merger shareholders are mostly different than the original investors in the SPAC.
In a simplification that seems out of place in a structure fraught with complexity, all SPACs go public for $10 per share. Pershing Square’s $5 billion SPAC, Tontine Holdings, broke this mold with a $20 IPO price.
More importantly, Pershing Square created an incentive for original investors to stay in the deal. Some of Tontine’s IPO warrants are not detachable and are lost to those investors at redemption. Those returned warrants are then given to the remaining shareholders increasing their value – hence the “tontine” name.
Of course, with no business or assets to tout, it is important that the SPAC have a catchy name along with the some reputable sponsors. A company I invested in just merged with a SPAC called Subversive Capital. (I hope owning that stock doesn’t put me on the government’s ever expanding list of domestic “terrorists”.) Recently, celebrities have turned up to help brand SPACs and get some name recognition. Subversive Capital recruited Jay-Z to support the merger.
The S.E.C. has helpfully pointed out that it “is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it.”
Who Gets What?
In sum, the SPAC carries risks that have been regulated away in the traditional IPO process. It divides these risks among various investor classes. The returns diverge as well.
Thanks to some sleuthing in a JP Morgan report, Hydraulic Spacking, we learned that, for the 90 SPACs covered in the report, the interests of these various groups diverged dramatically along with their returns. At the top of the food chain are the sponsors who have captured an average return of 648%, next are the PIPE investors with 63%, and last are any buy-and-hold investors at around 44%. Note that these buy-and-hold returns were 34% below a comparable IPO index performance.
Bankers will point out the lack of a post-IPO “pop” in share price indicates a lower cost to the company of a SPAC IPO. In reality, that cost is absorbed by shareholders due to the dilution from the sponsors shares. So the missing IPO pop has been effectively transferred to the sponsors.
For bankers, the SPAC is the gift that keeps on giving with IPO fees, PIPE fees, M&A fees and some lively activity for the trading desk.
Given these potential returns, it is not surprising that the SPAC structure has been on a roll. In 2020, fully 45% of all new equity issue proceeds went to SPACs in 228 deals totaling $77 billion. This year, in February alone, they raised $32 billion.
Some are beginning to question the SPAC mania. Short positions have risen from $724 million to $2.7 billion in the last few months – perhaps an indication that deal quality has declined. Inevitably, Wall Street will drive this feeding frenzy until investors discover they’ve had too much of a good thing.
* A Sober Look at SPACs, Harvard Law School Forum on Corporate Governance, November 19, 2020.