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SPACulation!

Kunal Mashruwala

While SPACs are all the rage nowadays, they are hardly new. After all, human behavior is hardly new, right?



Turns out, SPACs (Special Purpose Acquisition Company, also known as Blank Check or Shell company) have been around for more than a decade or two.


Throughout their (checkered) history, SPACs have essentially remained a vehicle for private companies to seek public financing. In other words, SPACs are formed to raise money through an IPO to buy another (unknown) company. Think of it as a loaded hunting gun waiting for a target in sight.


Between 2013 and 2019, the hunting guns were loaded with $43 billion of dry powder, an average of over $6 billion per year. In 2020 alone, this number shot up to $83 billion. And during 1Q 2021, SPACs raised another $97 billion.


But before we drown ourselves in numbers, let’s step back and understand how and why SPACs work.



How SPACs work.


A group of investors, ranging from private equity funds and investment banks to family offices and (semi-retired) corporate executives form a company and list it on the public markets via an IPO. These investors – who typically (i) specialize in an industry and (ii) have credibility to eventually make a deal – are collectively called Sponsors.


At the time of their IPOs, SPACs have no existing business operations and hence are called a “shell company”. SPACs may not even have stated targets for acquisition and hence are called a “blank check company” because you don’t know what you’re exactly buying into.


Once publicly listed, investors in the SPAC range from well-known institutional investors to the general public. The money SPACs raise in their IPO is put in an escrow account, an interest-bearing trust. Sponsors typically have 24 months to complete an acquisition or they must liquidate and return the funds raised to their investors.


That’s pretty much the SPAC setup in a nutshell. At this point, I can almost visualize you going: “all this is great but if the idea is to simply go public, why not use a traditional IPO?”


Let’s look at the pros and cons of SPACs relative to IPOs. There are three advantages that SPACs offer relative to traditional IPOs as well as one huge disadvantage.



SPACs vs. IPOs (the pros).


First, the traditional IPO process is cumbersome and lengthy. There are investment banking meetings, pitchbook preparations, and roadshows with institutional investors. Multiple layers of the-dog-and-pony-show, which typically takes anywhere between 12 to 15 months.


Contrast that to a SPAC, where the process bypasses most of these steps and therefore, in general, offers a quicker turnaround of 3 to 6 months.


Second, the traditional IPO process involves a price discovery. There are promoters, multiple investment banks, and qualified institutional investors to take care of. Add to that a pressure to potentially underprice the offering, which in turn drives the first-day-pop (how else do you attract retail investors for quick gains, and keep them hooked over decades?).


Contrast that to a SPAC, where the price is certain. There is no price discovery process to go through. Therefore, the dilution of original shareholders remains known upfront. And that too with certainty.


And third, the U.S. Securities and Exchange Commission (SEC) disallows traditional IPOs to issue forward looking statements.


You guessed it! Contrast that to a SPAC, where the regulator (at least till date) doesn’t mind forward looking statements. In other words, please share your story. Need I say more?


Now put the (i) faster speed to market, (ii) efficient pricing, and (iii) relaxed regulations together – seems there’s a lot to like about SPACs relative to IPOs.



SPACs vs. IPOs (the con).


So, what about the huge con, or perhaps to be politically correct, disadvantage you say? Well, let’s get straight to it.


There’s an outrageous, perhaps obscene, cost to this fundraising that hardly anyone talks about. At least not as openly as they talk about the positives of SPACs! And perhaps understandably so – whose bread I eat, his song I sing.


A recent publication by Stanford University and New York University, based on the study of 47 SPACs that merged between January 2019 and June 2020, indicates that 50.4% of the cash raised by a median SPAC was used simply to cover fundraising costs!


Yes, read that again. 50.4% friction cost of fundraising.


Nearly half of this cost – roughly 25% pre-IPO – is solely attributable to what is called “Promote” – a term indicating fees charged by the SPAC Sponsor as Founder’s shares to offer the fundraising services. Perhaps that explains why I used words like “outrageous” and “obscene” a few lines back.


The same study suggests that the equivalent number for a traditional IPO is 20 to 22% of the cash raised (5 to 7% underwriting fee plus 15 to 17% first-day-pop-loss).


Regardless of whether you believe the research or not, you have to agree that there is a friction cost for private companies to raise public money, whether via SPACs or IPOs, right?


Guess who’s paying for this friction cost of buying a gun (the SPAC), hiring a hunter (the Sponsor), and waiting for the hunt (the acquisition target)?


You, the retail subscriber to the SPAC. And why are you still sucked into this game? Allow me to add more colour to this.



The psychology driving SPACs.


Your typical SPAC target is a high-growth, free-cash-negative entity that has burnt through several rounds of private financing (think angel investing, follow-on VC rounds). Why else would you need external financing, right? Remember WeWork?


Then Covid hits. We’re locked down. Business freezes. Economy stalls. Fed brings interest rates down to virtually nil overnight. Throws a lifeline to businesses and a stimulus to individuals working from home. Essentially, free money and free time, along with perhaps plenty of idle minds.


Now add to that mix the on-the-ground political environment in the US, the birthplace of the SPAC boom. Republicans versus Democrats. Wall Street versus Silicon Valley. Finance versus Technology.


Amidst this charged undercurrent, the rhetoric of democratization of finance from Silicon Valley works its charm.


In reality, that’s another delusional mechanism for risk transfer from the Silicon Valley investor base (read venture capital) to the retail investor.


Now that’s real “crowdsourcing”!


Under the guise of liberty and democratization, and armed with free money and free time, your unsophisticated investor is ready to bet.


Nice groundwork for SPACulation, right? You bet (pun intended!).



Now keep 2020 and the pandemic aftershocks in mind. For the typical SPAC target company that is now desperate to raise cash for survival and that too fast, this is your golden opportunity. Suddenly, the SPAC concoction of speed, price certainty and story-telling to a broader unsophisticated investor base feels like Pooh swimming in honey.


It’s a lifeline you want to grab. At any cost.


And so parting with 25% of your company’s ownership seems better than any other option (chances are you’ve run out of private financing alternatives since after all).


For the typical SPAC sponsor, who is a (semi-retired) corporate executive, investment bank or private equity fund, the term sheet with the “Promote” is extremely favorable. You will own 25% of the company pre-IPO (20% post-IPO) regardless of what happens to the deal.


If you raise $100 million SPAC and list it, you now own $20 million worth. If you find a good target, that’s a bonus. If you find a loser, who cares. Even if the valuation collapses by 50%, your stake will still be worth $10 million. Not a bad pay day, right?


Allow me to use a July 2020 case study from CNBC and make this more real for you.


Goldman Sachs sponsored a SPAC, raised $700 million at $10/share. They paid $16 million on warrants to acquire 8 million shares at $11.50/share and received Founder’s shares for 20% of the company by paying $5,000. Yep, not a typo, that’s five thousand. On the day of the closing, the $5,000 turned in $140 million. What a nice pop!


And finally, some more data. Between 2015 through September 2020, the 89 SPACs that have completed mergers have an average loss of 18.8 percent and a median loss of 36.1 percent. Think of the “Promote” cost and these numbers will make sense. Either ways, these are not exactly comforting statistics for an investor.


Trust this helps you develop a richer feel for the environment and the subsequent psychology that has catapulted SPACs to all the rage they are nowadays.


 

To conclude, what’s next for SPACs? No one knows. I certainly don't. What I do know is that SPACs are an alternate vehicle to an IPO (Initial Public Offering).


What I do believe is that IPO stands for Insider’s Private Opportunity. Or It’s Probably Overpriced. Take your pick. What I suspect is that SPACs, at least in their current form, will be no different than an Insider’s Private Opportunity.


What I do believe is that trees don’t grow to the sky. What I suspect is that once the environment that allowed SPACs to boom is out of season (free money, free time, and SEC leeway), the SPAC boom will cool off too.


Does that mean all SPACs are bad? No. But in their current form, most are.


Does that mean you should not invest in SPACs? No. But remember, when you enter a casino, the house already has a huge edge. It ain't much different here!


As with most things in life, pay attention to what’s being said and more attention to what's not being said. And then think. Independently. Be careful, stay safe.

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