By now, you may have heard of a new bubble that has taken its place among the pantheon of bubbles we call the global economy: special purpose acquisition companies, also known as SPACs. If you haven’t, well, you should sit down for this: In 2020, SPACs raised $83 billion across the United States. In January 2021, they raised $26 billion.But what, exactly, is a SPAC? Simply put, a SPAC is an empty shell of a company (often spun up by a larger conglomerate) with the sole purpose of acquiring or merging with an unlisted company to take it public via a shortcut. The result, ideally, is a big payday for everyone involved.
Because of this promise—which experts say often doesn’t pan out—the trend has taken off.Former House Speaker Paul Ryan has a SPAC. Colin Kaepernick has a SPAC. Jay-Z, Shaq, Ciara Wilson, Serena Williams, Alex Rodriguez, and Steph Curry all have SPACs. SoftBank, of course, has a SPAC. Venture capitalist Chamath Palihapitiya is famous for his flurry of SPACs, including one used to acquire a 49 percent stake in Virgin Galactic—whose parent company, Virgin Group, has its own SPAC which it recently used to merge with 23andMe. On Monday, Elon Musk made a viral tweet about SPACs.
It’s hard not to see the SPAC euphoria as yet another speculative bubble at a time when risk, speculation, and desperation are the general vibe. The $83 billion raised last year was six times what was raised in 2019 via SPACs, but also about the same size of all the capital raised by IPOs in 2020. David Solomon, CEO of Goldman Sachs—itself underwriting countless SPACs—warned in January that the situation was "not sustainable in the medium term." The Financial Times was less sanguine, with one headline reading "SPACs are oven-ready deals you should leave on the shelf." This is everything you need to know about SPACs, the latest finance trend eating the world and spitting it out.
A “sponsor” (which could be a business executive, a corporation, a private investor, or investment fund) gets together some capital, then asks investors for more—a “blank check”—to take a shell company public. These companies, despite having no actual business, are listed on a stock exchange after going public via an IPO. That company will then have 24 months to do only one thing: find and merge with a private firm, called a “target,” then take that firm public quickly and cheaply. Sponsors get SPAC shares at a steeply discounted rate, typically $25,000 for 20-25 percent of the company. During this process, most shares are redeemed and most SPACs then turn to private placement (PIPE) investors to replenish their capital. Once the merger is completed, a small piece of the company is held by public and private investors, as well as the sponsor.
How does a SPAC work?
As Michael Klausner and Emily Raun wrote in a Wall Street Journal op-ed examining the SPAC bubble, most SPAC investment comes from sponsors offering hedge funds the following pitch: investors buy ‘units’ that contain a share and one or two additional securities calls a “right” and a “warrant.” If you cash out your shares because you don’t want to see the merger through, you keep the rights and warrants for free. This means that sponsors and investors can sell all of their actual shares and still be left with an ownership stake, essentially for free. Post-merger, rights typically offer one-tenth of a SPAC share for every unit bought. Warrants can typically be optioned into buying anywhere from 0.5 to 1 share at $11.50 for the next five years post-merger. Klausner and Ruan write that for those savvy enough to redeem shares but keep (or even sell) warrants and rights, "the investor's annualized return is more than 10 percent with no downside risk."
This is all a pretty sweet deal for investors and for sponsors, who tend to take 20-25 percent of a SPAC’s shares at essentially zero cost if they redeem their shares before a merger—their fee to promote the deal.Beyond the obvious lure of big profits, another often-repeated reason for their popularity is that SPACs are cheap for a variety of reasons. One frequently cited reason is that they are cheaper than IPOs because they avoid a "pop,” which is when shares close above the listing price, arguably leaving money on the table that might have been captured by a higher price.
Why are SPACs so popular?
In this telling, the problem is that IPOs not only take so long and cost so much, but that the company raises sub-optimal amounts of capital because investment banks underwriters will underprice a company’s IPO to generate large returns on fees thanks to higher demand generated by undervalued shares. Even some critical analysis from the Financial Times in August 2020 repeated this claim, offering that SPACs "can skip over the expensive and time-consuming IPO process" but also quoting venture capitalist Bill Gurley who adds that "clearly, the rampant and worsening underpricing of IPOs has created a huge arbitrage opportunity for SPACs."In other words, seeing the traditional IPO process as too stuffy and expensive (and even unfair), and lured by huge profits, financial-types see a big opportunity; at least for now.
SPACs are a great deal for sponsors and for investors who get out early. But for non-redeeming shareholders that hang on past a merger, SPACs are an increasingly popular but unsustainable vehicle for taking companies public that consistently burns investor capital and generates negative returns. An analysis by The Financial Times in August 2020, for example, found that the vast majority of SPACs organized from 2015 to 2019 sat below $10 per share—the IPO price for SPACs. "The poor investment record of many SPACs," the authors write, "is a reminder that when Wall Street pushes a new product, clever financiers invariably find a way to shift the most risk on to ordinary investors."
Are SPACs good for investors?
The SPAC structure is a deeply flawed one, because of how much the shares of investors that hold on post-merger are diluted. Remember those rights and warrants? Consider this: I invest in a hypothetical SPAC with 100 shares and buy 10 for myself. Those 10 shares are 10 percent of the company. But after the sponsor and other investors cash in their shares and use their rights and warrants (which ultimately convert to shares), suddenly there are a lot more shares in play, a lot less cash behind each share, and thus mine are actually worth less. Essentially, investors that hold on are paying for the sweet deal offered to those that redeem their shares. So, SPACs have a cost. A November 2020 study by Klauser, Raun, and NYU Law professor Michael Ohlrogge found the median cost of warrants and rights alone to be $1.66 for every $10 delivered in a merger.
If you look at it as a percentage of cash delivered—that means the IPO proceeds minus redemptions but plus new money from private investors—then the median cost is 50.4 percent. Another way to understand it is as a percentage of post-merger equity, so we can understand how much value a SPAC must add to justify itself. By this metric, a SPAC’s median costs sit around 14.1 percent of the post-merger equity. This means that the company's value must increase by 14.1 percent or the cost of the SPAC and its dilution will be eaten by shareholders or the target company. Of course, some investors will drink the Kool-Aid and believe that the company will increase in value by at least that much and hopefully more. But as we’ve already seen, most SPACs don’t do so well.
“SPAC shareholders were bearing the cost inherent in the SPAC structure”
There are a few problems with the assertion that SPACs are “cheaper” than IPOs, Klausner told Motherboard in an interview about his research. "A better way to put that is that the SPAC shareholders were bearing the cost inherent in the SPAC structure, which includes the sponsor's promote and the warrants primarily,” he said. “If SPAC shareholders are happily volunteering to take those losses, of course a target will get a very nice deal by going public by merging with a SPAC. But the total costs are higher than the total cost of an IPO."While the infamous IPO “pop” is often accused of leaving money on the table, a similar cost emerges in a SPAC merger: shares are sold at $10 each but sponsors receive shares for free; a sponsor's shares can be seen as "money left on the table" even though there would likely be less demand for the shares without the sponsor's involvement. The research team used these overlapping assumptions—that the SPAC or the IPO would have sold more shares without sponsor dilution or underwriter underpricing—to compare dilution costs to IPO pop costs. Their data suggests that 20 percent is a reasonable representative figure for a given IPO pop, and after adding on an average IPO underwriting fee of 7 percent, and arrive at a 27 percent IPO cost. Compare this to the median SPAC dilution cost of 50.4 percent."The biggest misunderstanding that I see persisting is the notion that SPACs justify their high costs by giving companies going public great certainty that the deal will go through at a certain point. It all really comes down to redemptions,” Ohlrogge told Motherboard. “Sometimes the redemptions are too high that the deal just falls through completely and the company doesn't go public. Even when they don't fail, though, you can end up with a situation where redemptions are so high, that the company is getting a very small amount of cash—something like 15 percent of the SPACs we looked at ended up only delivering $10 million or less in cash."
Are SPACs cheaper than IPOs?
One particularly illuminating example of the unpredictability of SPACs in Klauser, Raun, and Ohlrogge’s study centers on the Twelve Seas Investment Company, which initially raised $207 million by selling 20.7 million units to the public. It saw 82 percent redemptions, raised no new money at the merger, and its sponsor held over 4 million shares (essentially for free) while there were only 3.7 million shares available publicly. The merger company received $37 million in cash, but its sponsor had 4 million shares for free, the underwriter was paid $15 million for shares that were almost entirely redeemed, and some $36 million in warrants and rights promising free shares were circling around. The team calculated the total dilution cost was 254 percent of the cash Twelve Seas delivered, putting it just below the 75th percentile of SPACs they examined in terms of costs."People say SPACs are great because you lock in a price and you know what it's going to be, but actually you don't really know the price,” Ohlrogge told Motherboard. “If you're giving away a set number of shares for free and you don't know how many shares you're going to sell, then you're not certain about what the real price per share you're going to get is. If you sell 10 shares for 10 bucks each and then give away 10 shares for free, you're effectively selling shares for five bucks each.”
Are SPACs reliable?
All of these are problems surrounding the claims that SPACs are cheaper and offer more certainty. If there is any reliable trend to be found, it’s a negative one. Even when sponsors were "high-quality"—defined as a Fortune 500 CEO or a fund with more than $1 billion in assets—the research team found only a slight improvement in performance that turned into losses after twelve months.
In the months since Klausner, Raun, and Ohlrogge’s study was published, more signs have emerged that SPACs are not only poorly designed vehicles destroying investor capital but also within a bubble that could burst soon. As Ivana Naumovska writes for the Harvard Business Review, some 300 SPACs this year are coming up on a deadline where they must find a target to merge with or risk being liquidated. "What is the impact of having so many SPACs bidding for a company? Let's say they're bidding for an absolutely fabulous company. If they overpay for it, that's not good for their shareholders,” said Klausner. “And if the sponsors are getting towards the end of the line, the sponsor is going to be very tempted to overpay and the targets are going to have all the bargaining power. If I was a SPAC investor, I'd worry about the bargaining power of the target when they've got eight SPACs bidding for them and a sponsor worried the music is going to stop soon."Ohlrogge was similarly dour, warning that these "SPAC-offs'' where multiple shell companies are desperately bidding for a target before liquidation have created exuberant markets where shares jump at unconfirmed rumors of a merger deal. "There's a lot of risk for big, big losses for investors. It used to be that most of the investors in SPACs were institutions and there was very little retail investor involvement, but that's starting to change,” Ohlrogge said. “In the past three or four months, that's changed a lot actually and retail investors have started to become involved. For our analysis, we looked at 13F filings made by institutional investors and were finding about 90 percent of both pre- and post-merger SPAC holdings were by institutional investors. Now, we're seeing SPACs like Churchill, where there are only 34 percent 13F holders as of the most recent filing." It’s clear that, for now at least, SPACs aren’t going anywhere. Bank of America reported that on its platform, retail investors represented 46 percent of trading volume in SPACs in January, up from 30 percent two months earlier. "The speculative nature of SPACs seems to be particularly appealing to retail," analysts wrote. "We definitely don't need to remind anyone what can happen when something speculative comes on the retail radar (ahem, GameStop).""The rush for the door will start with redemptions. Then we've got 300 SPACs that are already out the door or through the first gate—but they're doomed, I think, when music stops. But if the bubble continues, maybe that 300 will make it through,” said Klausner. “If it doesn't, then performance will be shown to be bad, valuations will come down, redemptions will go up, PIPEs dry up, then the existing stock of SPACs is in trouble. And then, the new SPACs will have trouble in even having the SPAC mafia invest."