Some Concerns About SPACs

Special Purpose Acquisition Companies (SPACs) were popular in 2020 and they are still hot. 2020 saw more than double the number of IPOs than 2019.1 Because many of these companies have 18-24 month timelines to close their acquisitions, we have not reached the end of this mania.

Prior to the start of the SPAC boom there was serious concern about the number of unicorns and their future prospects. SPACs offer these companies a method to tap into public markets. And the public markets need for these companies to be brought to market since they have seen a decline in overall volume in recent years.2 Given the declines in trading volume, share repurchases, and the widening of bid-ask prices, the stock markets can use all the listings, shares and excitement that SPACs bring.

SPACs are a risky bet for the average person since they do not know what they are buying. For this reason it is more truthful to say that SPACs are a gamble for an individual than it is to say that they are an investment. The valuation of a SPAC is difficult since the expected future value is such a broad range. SPACs valuations have also risen because of excess liquidity in the market and the willingness of people to assume risk.

There are three structural issues with SPACs that make them poor investments.

First, SPAC sponsors typically receive 20% of the final merged company. This is sometimes referred to as the “promote”. Contrast this with the 3.5% – 7.0% underwriting fees for underwriters of IPOs. There is some evidence that the “promote” has been declining recently, though undoubtably it remains higher than underwriting fees or more expensive than a direct listing.3

Secondly, SPACs also often use Private Investment in Public Equity (PIPE) financing.4 This investment is used to provide immediate liquidity to the target, but it is also dilutive to SPAC shareholders and the price of that equity is often lower than what SPAC shareholders receive.

Thirdly, SPAC sponsors are not incentivized to act in the shareholder’s best interest. The sponsors have two years to find a target or risk absorbing the legal and administrative fees incurred for the SPAC. Given that choice, the sponsors will overpay for a target or worse, acquire an immature company.

It is unclear how this will end. There is over a $100B in SPAC capital seeking targets.5 In the next year or two this money could be an accelerant to M&A. Alternatively, there could be a slow wind down of operations and the return of capital. Given the incentives and motivations of those involved in this boom, a risk-averse person would bet on the former.

References:
1 https://www.statista.com/statistics/270290/number-of-ipos-in-the-us-since-1999/
2 https://www.marketwatch.com/story/as-stock-market-trading-volumes-decline-liquidity-concerns-rise-2019-10-21
3 https://www.reuters.com/article/us-spac-compensation-idUKKBN28J1I9 
4 https://www.investopedia.com/terms/p/pipe.asp
5 https://finance.yahoo.com/news/spacs-700-billion-market-2021-goldman-sachs-morning-brief-110126053.html

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