thinking about Special Purpose Acquisition Companies (SPACs)

Over my years working on Wall Street, it was invariably a sign of ultra-frothy markets when equity offerings called “blind pools” or “blank check companies” began to pop up. The pitch was typically: so-and-so is a great investor; give him (Wall Street has been one of the most anti-woman places in the US) and he’ll do magic (but unspecified) things that will make us all rich.

These were part of the underbelly of the market, a cut above Wolf of Wall Street brokers and their “pump and dump” schemes, but not by a whole lot. I can’t recall one that worked out well.

In today’s world, the functional equivalent is the SPAC. Lots of law firms have online articles outlining the nuts and bolts of how SPACs work. My version is below. There’s also a good, and often referenced paper from the Social Science Research Network laying out the plusses and minuses.

The conceptual justification often given for the existence of SPACs is that they’re an innovative way to lower the cost for a company of going public, accomplished by disintermediating the expensive traditional broker IPO process. The SSRN paper argues, persuasively, in my view, that the cost savings claim is factually incorrect.

SPACs are faster to get SEC approval for listing than traditional IPOs, since at that point they’re shells rather than operating companies. As/when the SPAC finds a company to buy, the transaction is technically a merger, rather than an IPO of the target, so SEC involvement is minimal.

One clear characteristic of recent SPACs is that they involve mostly early stage companies, the kind that in the past would have marinated for several more years in the venture capital world before being considered close enough to profitability or business maturity to appeal to the public market.

For me, the backdrop for today’s SPAC world resembles the bubbly market of 1999. At that time, the IPO calendar was filled with early-stage companies. These were hyped by Wall Street star analysts like Henry Blodget and Mary Meeker, and aggressively bid for by institutional investors based on their reports. At the time, I had thought (one of my dumber ideas, as it turned out) that I might be witnessing an evolution of the public markets that would replace private venture capitalists much earlier in companies’ development (the implications I saw were that PEs wouldn’t count for as much and original research would count for more). Back then, it wasn’t the market evolving, however. It was mostly hype in a frothy market. In fact, Blodget was ultimately barred from the securities business for his role in stoking the speculative fires with ultra-favorable recommendations that his private emails showed he didn’t believe.

how SPACs work

Hang onto your hat! This is a really convoluted process.

the pitch

The starting pitch is the same as with traditional blind pools: the sponsors, a luminary of some sort, together with a financial backer like a hedge fund, create the SPAC to raise funds in the public market and then find an operating company to buy and merge with.

step one: sponsors take a big cut

At startup, the sponsors get to buy 20% of the SPAC for a nominal sum.

step two: conventional IPO

The sponsors take the SPAC, which at this point is basically a shell, public through a conventional IPO. Units, which consist of one share plus a warrant, typically sell for $10 each. Each warrant gives the holder the right to buy some fraction (this varies) of a share of stock for $11.50. Sometimes, the sponsors also toss in a right–like a warrant only no payment required–for a fraction of a share.

In addition to the warrants/rights, IPO shares have another important perk. Holders are able to redeem their shares and get their $10 back (keeping their warrants and rights) at any time before a merger is completed. In SPACs that have been launched so far, most initial holders either redeem or sell their shares in the open market, meaning that there’s a big difference between the shareholder base pre-merger and post-merger.

step three: two years to look

The SPAC is required to find a partner to merge with within two years. If it doesn’t, the SPAC is dissolved and any remaining money returned to shareholders. The sponsors get nothing–implying that sponsors have an enormous incentive to complete a deal.

step four: more financing, using PIPE investors

PIPE stands for private investments in public equity. Because IPO investors can redeem their shares, and many do, the typical SPAC ends up having only about 2/3 of its initial funds on hand when it finds a merger partner. So it ends up doing private placements to institutional investors to get the money needed to complete the deal. PIPE investors buy new shares, but don’t get warrants or the ability to redeem. They do get to know the identity of the merger partner and see its financials. Since the combination is technically a merger and the private placement transaction is not an IPO, the SEC has no problem with this.

recent history

SPACs made up about half of the US IPO market in 2020. So far in 2021, SPACs are a lot bigger chunk of the IPO scene than that. 90%?

One consequence of the popularity of SPACs is that there are a lot of them looking for merger partners, maybe $100 billion in their collective pockets upon debut, even without PIPE money. As a rough rule of thumb, sponsors can earn, say, 15x their money from making aa top-quartile acquisition and 3x from a bottom quartile one. So sponsors have a strong incentive to close any deal within the two-year window rather than walk away with nothing.

Buy and hold investors in SPACs, in contrast, have tended to make some money, although generally less than they would from holding a growth-oriented index funds. A mad rush to buy at any price wouldn’t do you or me much good at all.

Because of the potential imbalance between the number of sponsors with money burning a hole in their pockets, the relative lack of potential targets and the dire consequences for sponsors for coming up empty. I’d much prefer to be holding potential merger targets. However, these tend to be early stage companies still in private hands, so that option isn’t open.

canaries in the coal mine?

Yes is my short answer. The SPAC market really does have the feel of the IPO market of 1999.

implications for us

What the implications are for us as investors today, if that’s right, are less clear to me.

2000 opened to Y2K as a non-event, a collapse in orders for internet and cellphone equipment (followed by a more general downturn)–and a massive rotation into very defensive stocks, particularly utilities, consumer staples and housing-related, all of which had been serious laggards over the prior several years. (An aside: many now-famous hedge fund managers were value investors fired during the epic value drought of the late 1990s. 2000-2002, in contrast, was perhaps value’s last hurrah. To my mind, sticking with this vintage-1935 investing school explains a good deal about hedge funds’ poor record since then.)

Of course, if Wall Street form holds true, the least likely thing to happen in 2021 is a repeat of 2000.

For what it’s worth, I think reopening stocks will continue to be good performers, especially non-mall specialty retail and restaurants. My guess is that this area will continue to be top of mind for investors for a while, as well as the main focus of the market rotation toward business cycle sensitives that’s now underway. On the other hand, I expect stocks whose main attraction is their appeal to quarantined consumers will continue to fizzle. Here, I’d try to make a distinction between pure (pure=bad, in the way I’m looking at things) covid stocks and those where the pandemic has given a company an introduction to consumers who will continue to pay for products/services even when things get back to normal. I have no particular insight into winners vs. losers in this arena.

In any event, I think two big differences between now and 2000 are that; we likely have cyclical recovery ahead of us rather than recession; and the 10-year Treasury is yielding about 1.75% now vs. 6.3% this time 21 years ago. In the most simplistic terms, a yield of 1.75% supports a PE of 57 and 6.3% supports a PE of 16. I conclude from the current level of yield support that, absent a steady rise in interest rates (which I think is unlikely), chances of a 2000-style market meltdown aren’t high. If I had to prioritize, rising rates, as always, are the #1 threat to the overall market.

something I have less confidence in, but still…

Just a minute ago (Sunday night), I looked at a chart of the Russell 2000 vs AARK, the Ark Innovation ETF, that latter as a proxy for the capital flight market of the Trump years and the pandemic defense of 2000. Since the November election, the R200 has been on fire, gaining 45%+ through last Friday. Until a month or so ago, AARK was more than keeping pace. Then the yield on long Treasuries began to rise. Since then, AARK has dropped by 22%, while the R2000 is flat. That’s significant. But it’s not the whole story, in my view. Over the past 12 months–from the depths of the market’s pandemic swoon, the R2000 is up by 110% but the AARK has risen by 220%. I find it hard to work up conviction for the idea that a 20% relative decline makes up for the previous 120% relative gain. To me the numbers say that R2000 is going to outpace AARK for some time to come. (In addition, from what little I’ve read about the ARK funds, they don’t believe in playing defense to try to mitigate short-term declines.) To be clear, I’m not advocating trying to time short-term shifts in markets. That’s a recipe for disaster. But for me it would make a lot more sense to try to upgrade the secular growth portion of my holdings rather than to increase their overall weighting in my portfolio.

Since I’m writing about SPACs in a negative light, I think I should note that I own a small position in DraftKings–a case of consistency and hobgoblins.

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