SPAC Shares Return to Earth

To the moon...and back

Warren Buffett famously said that “it is only when the tide goes out that we see who has been swimming naked”. In a “risk on” market environment, every investment seems to go up and stay afloat no matter how questionable its fundamentals. But when market sentiment turns to “risk off”, investors quickly reverse course and start paying attention again to things like earnings, cash flow and valuation. If the first few weeks of January are any indication, the tide has turned and we are soon going to see quite a few naked swimmers stranded offshore. And this is already happening in the market for SPACs.

The WSJ recently published an article the title of which pretty well sums up the current situation with SPACs: “The SPAC Ship is Sinking. Investors Want Their Money Back”. According to the WSJ, over half of SPACs which have completed mergers in the past two years have seen their share price fall by 40% or more from their pre-merger IPO price (and more from their peak price). And according to a September report published by CNBC, 97% of all pre-merger SPACS (that is 291 of 300 companies) were then trading below their IPO price, which equals the per share amount of cash initially raised by the SPAC and is the price at which IPO investors can redeem their shares before a merger is approved. So neither pre nor post-merger SPACs are doing well, and things are worse now than they were in September. This does not reflect well on the current health of the SPAC market, to say the least.

I have written at length before about the complexity and controversy inherent in SPACs— for example in this July post on the PSTH/UMG deal—and I don’t propose to do so again today. But I do think we should perhaps take just a few minutes to review some of the reasons SPACs have been so controversial in the past and why so many of them are doing so poorly today:

SPACs are “blind pool” investments. “Blind” is not generally a word one likes to see (pun intended) in descriptions of prudent investments. Most investors want to know exactly what they are investing in, which is decidedly not the case with pre-merger SPACs. When you buy shares in a SPAC IPO, you are writing a check for the SPAC sponsor to invest as he/she sees fit over the next two years. Prior to merger, the SPAC itself will have no business to operate and no assets other than the cash raised in the IPO, which it intends use to fund a merger with an operating company down the road. SPAC IPO investors are making a bet on the ability of the SPAC sponsor to identify an attractive merger target, negotiate a good price for the deal, arrange additional financing if needed and govern the combined company going forward. At each stage of the process, something can (and often does) go wrong. If this seems to you more like “speculation” then “investing”, you are correct. At least when we bet on the Super Bowl we know what teams will be on the field and what game they are supposed to be playing. This is not always the case with SPACs.

Before we trash all blind pool investments, however, we should acknowledge that private equity, venture capital and hedge funds are also blind pool investment structures. In these cases, investors (the limited partners) also write checks for someone else (the fund general partner) to invest on their behalf, often with no more guidance on how the money will be invested than is the case in a SPAC and without some of the same investor protections.

Some SPAC sponsors are flakes. I won’t name names, but you know the sorts of people I am talking about—sports stars, TV celebrities and ex-politicians—many of whom have little or no real investment experience and some of whom are acting merely as fronts for the people actually managing the SPAC. These are not generally the sorts of people who should be managing the public’s money, but until recently it seemed like all one had to do was launch a SPAC and watch the money roll in. Well we are now watching the money roll out, and investors who end up losing money with the flakiest of SPAC sponsors will have only themselves to blame.

Conflicts of Interest and Fees. SPACs are rife with conflicts of interest and exorbitantly high fees. The conflicts occur between the SPAC’s sponsor and its investors, between and among various classes of SPAC investors, and between the SPAC and its eventual merger counter-party. SPAC transactions are also loaded with fees of various sorts—IPO fees, merger fees, PIPE fees and of course the sponsor promote—which substantially dilute the economics for passive investors. And while these conflicts and fees are fully disclosed in the SPAC transaction documents (IPO prospectus and merger proxy statement), the transactions themselves can be quite complex and opaque, understood only by the most sophisticated of investors.

Let’s start with the SPAC sponsor. In exchange for a few million dollars of start-up capital and a bit of “sweat equity”, the SPAC sponsor receives a valuable “sponsor promote” in the form of free or nearly-free SPAC shares, often amounting to 20% or more of the total outstanding shares. This sponsor promote can generate very large returns for the sponsor even when the SPAC share price performs poorly. And because the sponsor promote only vests upon completion of a merger, the sponsor is heavily incentivized to get a deal done within the agreed time window for doing so (typically two years). But as time on the clock runs out, the sponsor becomes increasingly incentivized to get just about any deal done, even a questionable one, so long as he thinks SPAC investors will approve it and not too many will elect to redeem their shares.

Additional dilution to the SPAC investors comes in the form of warrants issued to the PIPE investors, who are often called upon to finance the SPAC merger transaction, as well as from the generous valuation and acquisition terms agreed with the merger counter-party (which likely has its choice of SPACs with which to combine). In the M&A business, sellers generally do better than acquirers because of asymmetrical information and control premiums paid and this is almost certainly the case also with SPACs (although for somewhat different reasons perhaps). Even if post-merger SPAC shares end up trading at a discount to the IPO price, leaving passive investors with losses, it is still possible that both the SPAC sponsor and the shareholders of the SPAC merger counter-party will have done quite well for themselves financially.

Who pays the price? So who pays for all of this largess doled out to the various SPAC insiders? Well you might think the IPO investors do, but I’m not so sure. Casual readers of the financial press might believe that most SPAC IPO shares are bought by “dumb money” retail investors, who don’t understand what they are buying, but this is not quite how Wall Street works. Before most individual investors can get in on the really juicy IPOs, whether SPACs or traditional IPOs, institutional investors and hedge funds will likely have already been allocated most of the available shares by the IPO managers (bankers). And because these institutional investors are generally quite sophisticated and powerful, they will have protected themselves from many of the costs and conflicts inherent in the IPO, in the case of SPACs by negotiating cash redemption rights (which lapse after a merger is agreed) and detachable warrants (which survive the sale of shares purchased in the IPO). In the event of a bad merger proposal, these folks will vote against the deal and ask for their money back. In the event they are out-voted on the merger, they can sell their shares and keep or sell the warrants, which will retain option value even if they are out of the money. And of course if all goes swimmingly, they will ride the rocket ship up until the valuations become really silly at which point they will sell (to retail investors most likely).

But still there is no such thing as a free lunch here and so someone must absorb the losses when things go wrong. So who is it? Well the most obvious candidate would seem to be those investors, disproportionately retail, who buy SPAC shares in the after-market at ridiculously high share prices, perhaps after seeing them hyped on social media. These are the folks who really get hammered when the SPAC’s rocket-like shares come plummeting back to Earth, as they generally do.

We can think of retail investors punting on SPACS as a bit like Charlie Brown kicking the football. He knows Lucy is probably going to pull the ball away at the last moment, and he will again fall on his bum, but he does it anyway. I can’t explain why this happens, but happen it does, all the time and not just with SPACs. All I can really say about this phenomenon is “good grief!”

Valuation. I am not an expert on SPACs and there is a lot about them I still don’t understand. But what I really don’t understand about SPACs is their valuation, particularly the valuation of pre-merger shares. SPAC IPO shares are typically priced at $10 and the implied market value of the company at that price equals the amount of cash raised in the IPO. But many pre-merger SPAC shares have in the past traded at prices well above their IPO price for reasons I cannot explain. How can the market value of the SPAC shares be higher than the market value of the company’s total assets, all of which is initially cash sitting in a bank escrow account pending the merger and the possibility of shareholder redemptions. OK, perhaps there is market speculation about a particularly interesting merger candidate the SPAC sponsor is pursuing (say a company with “EV” or “crypto” in its name), which could add some further speculative option value to the SPAC share price. But keep in mind that once a merger is approved the sponsor promote also kicks in, immediately diluting the per share value of the SPAC IPO shares by 20% or so. Recall also that the merger price paid to the shareholders of the target operating company will likely be quite generous, probably higher than any other SPAC was willing to pay, suggesting a potentially large transfer of value from the SPAC to the shareholders of its merger counter-party. And when it comes time to negotiate the detailed merger terms, the owners of the target operating company are likely to value the SPAC shares to be issued as merger consideration quite realistically, pricing into the exchange ratio appropriate discounts for the dilution attributable to the sponsor promote and the various warrants issued by the SPAC.

Where is the SEC? Why isn’t the SEC all over this? Well, they are. The SEC has been monitoring SPACs for some time now, and in April 2021 issued this helpful guide to the legal liability issues associated with SPACs. And as you would expect, the SEC is paying particular attention to the largest and most controversial SPAC transactions, including this notorious SPAC deal involving our former President. In thinking about the SEC and SPACs, keep in mind that the relevant US securities laws are primarily “disclosure” laws, not “investor protection” laws per se. The SEC reviews the disclosure documents prepared in connection with IPOs and public company mergers, but it does so with a view to confirming that the SEC’s disclosure rules have been complied with and not with any intention to opine on the investment merits of the underlying transaction (and in fact expressly declining to do so).

My bottom line on SPACs? I am a cynic by nature, and I also try to be a bit provocative in this newsletter (to get you all thinking), and so I have consistently come down pretty hard on SPACs. Having said that, I would concede that SPACs are a rather clever transaction structure which may well have some future place in the corporate finance toolkit. But I think SPACs have been grossly abused by greedy sponsors and bankers, and unsophisticated retail investors should generally avoid them at least pre-merger. After that, I suppose SPACs are fair game in a “buyer beware” marketplace like ours.

And for retail investors who still want to take a punt on SPACS, despite all the well-publicized dangers, I say “Good luck Charlie Brown.”

Links:

The SPAC Ship is Sinking, WSJ, January 21, 2022

Higher Quality Sponsors Needed to Turn Around SPACs, CNBC, September 28, 2021

The House Always Wins with SPACs, Breaking Views, Reuters, February 26, 2021

SPACs, IPOs and Liability Risk under the Securities Laws, SEC, April 8, 2021

The SEC Turns Up the Heat on Trump’s SPAC Deal, NYTimes, December 7, 2021