Sign of investment euphoria? Get out your copies of Malkiel’s “Random Walk Down Wall Street” and refresh memories on this quote how an enterprising person raised many during the South Sea Bubble mania “For carrying-on an undertaking of great advantage but no-one to know what it is!!” Sounds like a SPAC to me…..there is nothing new under the sun.
SPACs, or special purpose acquisition companies, have been around for decades, but they became more popular during the trading boom of 2020-21. They are often referred to as blank-check companies because they have no operations, but raise money by going public with the goal of using the funds to acquire another company within a specific timeframe. This allows private companies to go public without going through a traditional IPO, which can be a lengthy and costly process.
What is a SPAC?
SPAC stands for special-purpose acquisition company, which is Wall Street jargon for a publicly traded company that holds nothing but cash. Also known as blank-check companies, SPACs exist to buy private companies, and effectively take them public while avoiding the pitfalls of a traditional initial public offering.
SPACs have taken popular companies like sports-betting firm DraftKings Inc. and space-tourism company Virgin Galactic Holdings Inc. public.
The SPAC Explosion
Starting the summer of 2020, SPACs began surging onto the stock market and the momentum continued 2021. Hundreds of SPACs were doing deals or are on the hunt for companies to buy. Technology, electric vehicles and green energy have been especially hot areas.
SPACs have been around for decades but are taking off now because the biggest players from Wall Street and Silicon Valley are using them to raise money and take companies public. They have raised nearly $95 billion in 2021.
Give me money.
Why should I?
‘Cause I’m gonna make you a bucket load of money. (And me ever so much more).
How?
Trust me.
-SPAC.
The SPAC Mechanism: A Closer Look
The bubble was, and still is, unfortunately quite remarkable. In simple terms, the scheme involves a group of clever individuals—mostly men—who come together to “sponsor” a new shell company known as a Special Purpose Acquisition Company (SPAC). This entity essentially commits to utilizing the funds raised from external sources in a profitable manner. They initiate an initial public offering (IPO) and then seek a private company to merge with, ultimately taking that company public through the merger. Following so far?
The sponsors of the SPAC bear the responsibility for covering legal, accounting, and underwriting fees, which can amount to millions of dollars depending on the funds raised for the investment vehicle. In exchange for establishing the SPAC and securing its capital, sponsors receive essentially free equity, anticipating its future value. Their compensation is secured, assuming a merger occurs at some point.
Once the SPAC is established, the sponsors have a two-year window to identify a merger partner and finalize a deal. If they are unsuccessful, they must absorb the fees themselves and return the raised funds to investors with interest. It’s not surprising that the incentive for SPAC sponsors leans heavily toward completing the IPO and finding a merger partner, of almost any nature, before the two-year deadline lapses.
This scheme is successful largely because it operates as a confidence game. As actor Joe Mantegna explains in the 1987 David Mamet film “House of Games,” it’s called a confidence game not because you give them your confidence, but because they give you theirs.
Who wouldn’t want to invest alongside seemingly intelligent and wealthy individuals such as Richard Branson, Bill Ackman, Masayoshi Son, Chamath Palihapitiya, Michael Klein, Jay Z, Shaquille O’Neal, and Alex Rodriguez? All of these figures have either sponsored SPACs or lent their names to them. It’s the timeless art of seduction magnified and thrust into the public equity markets.
Who wouldn’t want to invest alongside seemingly intelligent and wealthy individuals such as Richard Branson, Bill Ackman, Masayoshi Son, Chamath Palihapitiya, Michael Klein, Jay Z, Shaquille O’Neal, and Alex Rodriguez? All of these figures have either sponsored SPACs or lent their names to them. It’s the timeless art of seduction magnified and thrust into the public equity markets.
But How do SPACs Work in Practice?
A SPAC’s “special purpose” is to use the pile of cash it raises in its initial public offering and other funds it takes in to merge with a private company. The private company then gets the SPAC’s place in the stock market. SPACs typically have two years to complete a deal or they must return money to investors. Lately, many have only needed a few months to announce mergers.
The appeal of going public through a SPAC lies in the fact that it allows private firms to promote their business and fix their valuation through a limited group of investors behind closed doors before making a deal public. In contrast, with a traditional IPO, pricing can fluctuate up until the night before the shares begin trading.
After a SPAC has revealed its target company, both parties have the freedom to present ambitious projections to potential investors, a practice that would not be permitted prior to a conventional IPO. As a result, this can drive up the price of the SPAC’s shares prior to the public release of regulatory documents associated with the merger. In general, SPAC sponsors are permitted to purchase 20% of the target company at a significant discount, while SPAC bankers usually delay a portion of their fee until the SPAC secures a deal. These financial arrangements may contribute to the trend of multiple SPACs competing to take the same private companies public, resulting in higher valuations.
Within the stock market, a SPAC has three distinct phases. The initial phase occurs post-IPO, during which the sole asset of the company is typically $10 cash per share. At this stage, the stock typically trades around $10, providing shrewd investors with the opportunity to make a profit when the share price drops too low by purchasing cash at a reduced rate.
The second phase of a SPAC’s life cycle occurs following the announcement of a merger, during which the stock’s value can fluctuate significantly based on how the deal is perceived by investors.
The final phase of a SPAC’s existence takes place after the merger has been completed. At this stage, the stock price is influenced by the outlook of the new company, much like any other publicly traded stock. Since the private company assumes the SPAC’s position on the stock exchange, the name of the stock and its ticker symbol usually change to reflect the name of the newly formed public company. For instance, DraftKings is now traded under the ticker symbol DKNG.
“It’s easy to understand why executives at the companies went with this option,” said New York University Law School professor Michael Ohlrogge, who studies SPACs. “It wasn’t because it was a better financial technology – it was because it was just better for them.” I remember the first time I had a SPAC explained to me. It was explained by someone who has spent their life investing. They seemed to see nothing wrong with a vehicle where everyone is pretty much guaranteed to make money except the guy who buys and holds. The vehicles were obviously rigged in favour of the promoters, hedge funds initial funders, and target companies. While retail got crushed, the guys who set the SPAC up made a fortune, so that’s not really a failure (from their perspective).
How SPAC Sponsors Earned Money
There was a widespread view that SPACs were a faster, easier way to take cutting-edge companies public, sidestepping some of the legal and regulatory hurdles traditional IPOs face.
SPAC sponsors have the potential to earn significant profits because they receive a portion of the stock in the newly established public company if they are successful in finalizing a deal. On the other hand, early investors, frequently hedge funds and other institutions, can secure a secure and profitable return for a certain period of time. This is due to the fact that each $10 share of a SPAC can be redeemed, with interest typically around 1.5%, prior to the merger. Moreover, investors are also provided with a bonus in the form of a “warrant” that enables them to purchase additional shares at a discounted price if the company performs well.
However, it wasn’t the low-risk deal that hedge funds received that attracted retail investors to SPACs. Instead, the companies that SPACs targeted for acquisition frequently presented overly optimistic revenue and earnings growth projections. In the hopes of getting in early on potentially lucrative new businesses, individual investors would purchase SPAC stocks prior to or shortly after an anticipated merger, frequently paying prices well above the $10 per share value. SPACs have merged with and taken public a variety of companies, including money-losing electric vehicle startups, early-stage drug developers, and other businesses that promised to revolutionize their respective industries.
On occasion, retail investors were able to profit from SPAC investments if they made shrewd moves. For instance, Diamond Eagle Acquisition Corp., a SPAC, saw its share price soar above $17 prior to merging with DraftKings Inc., an online sports betting company, in early 2020. Following the merger, the stock was renamed DraftKings, and it skyrocketed to a high of $74 over the ensuing year.
As enthusiasm surrounding SPACs continued to mount, more and more money piled in. Prominent fund managers, ex-politicians, and celebrities were among those who established new blank-check entities. Between 2020 and 2021, over 850 SPACs raised approximately $245 billion to use for identifying potential deals. However, the quality of newly issued offerings quickly deteriorated. Sponsors chose more speculative acquisitions or had difficulty finding suitable deals at all. This was followed by a rise in interest rates and the bear market of 2022.
Investor Frenzy: SPAC Mergers and Stock Market Excitement
Special Purpose Acquisition Companies (SPACs) are not a recent development. According to Spac Insider, an industry tracking entity, the inaugural SPAC surfaced in 2009 in the aftermath of the financial crisis, managing to raise a modest $36 million through an initial public offering (IPO). However, the SPAC phenomenon witnessed a significant upswing at the turn of the decade. In 2020 alone, there were nearly 250 SPAC IPOs, accumulating around $83 billion from investors. The subsequent year saw a staggering increase, with 613 SPACs completing deals and raising an impressive $162 billion.
The mention of a potential merger between a SPAC and an ostensibly exciting private company has, at times, ignited fervor among investors, leading to soaring stock values. A notable example is the announcement by Anglophile investment banker Michael Klein in February 2021. He revealed that Churchill Capital IV Corp, one of the numerous SPACs he launched, would acquire the privately held electric car manufacturer, Lucid Motors. This news propelled the SPAC’s stock to surge by approximately 500 percent. The $43 million investment made by Klein and his fellow sponsors in the SPAC suddenly translated to a paper value of around $3.3 billion, as reported by Reuters.
The implied valuation of Lucid at that time was $56 billion, even though the deal’s closure was five months away. Fast forward to the present day, Lucid is currently valued at $10 billion, experiencing a 92 percent decline from its peak stock value.
Troubled SPACs are usually one of two types: totally speculative businesses or reasonable ones that were grossly overvalued. It’s just a cautionary tale. When something is too good to be true, it’s too good to be true. In hindsight it is obvious when you look at the valuations some of these companies were getting from SPAC sponsors that it wasn’t sustainable
How Many SPACs Crashed and Burned
A number of businesses that went public through mergers with “blank-check” companies have sought protection from creditors.
Quanergy Systems Inc., which produces sophisticated sensors and software, went from making its debut on the stock market to filing for bankruptcy in only ten months. Fast Radius Inc., a company specializing in 3D printing, managed to stay afloat for nine months, while online retail start-up Enjoy Technology Inc. lasted eight-and-a-half months before filing for bankruptcy.
The common factor linking these companies is the method by which they entered the market. Rather than conducting a traditional initial public offering, each of these companies merged with a special purpose acquisition company. A SPAC is an empty corporate entity that is publicly traded and exists solely to locate a company to merge with, allowing the merged entity to take over the shell’s listing. These deals were a popular trend on Wall Street during the pandemic era. However, the increasing number of companies that went public using SPACs and have since gone bankrupt has drawn attention to the speculative nature of the SPAC game.
One of the most notorious Special Purpose Acquisition Companies (SPACs) involved an attempt to rescue WeWork, which has recently filed for bankruptcy. This situation has added to the embarrassment of Masayoshi Son, the founder of SoftBank, the financial backer of the company.
The current trend of SPAC mergers resulting in bankruptcies shows no sign of slowing down. Nearly 100 companies that went public through SPAC mergers do not have enough cash reserves to sustain their current spending for the next year. This is in addition to the 73 companies whose share prices have dropped below $1, putting them at risk of being delisted from major stock exchanges like NYSE and Nasdaq. As most SPACs have a baseline share price of $10, a share price below $1 indicates that an investor who bought into the SPAC in anticipation of a merger and held on has lost at least 90% of their investment.
I am genuinely surprised there have not been more consequences for the banks who facilitated turbo charging this bubble. Certain of the firms ran around chasing this craze finding anyone they could to raise a SPAC – pocketing fees on the way in and then pushing to find almost any target to merge – taking back end fees on the capital raise and enormous advisory fees from the target companies. Banks marketed this as a way to get around US IPO disclosure limitations allowing forecasts to be put in the public domain – regulators were late to the game to stop it. The banks are to some degree paying the price now with a dismal IPO environment but it was really shameful behaviour by some banks and suggests the GFC consequences had little impact
Never forget those con artists that put their names to them and created huge losses for their followers. – WShak, Full-Time Private Investor
