SPAC to the Future

Among the countless adaptations that businesses made in 2020 was the seismic shift in how many privately-owned companies chose to go public. In lieu of following the traditional initial public offering (IPO) process, which is marred by regulatory hurdles and uncertain pricing, many firms opted to enter the public market via special purpose acquisition companies. As the name suggests, special purpose acquisition companies, SPACs for short, are publicly traded companies that are created with the sole purpose of acquiring an existing company, thus taking the company public while sidestepping many of the complications inherent to the traditional IPO process. In juxtaposition to most other companies, SPACs do not produce any goods or services, generate any profits or losses, or have any clients or suppliers, and as such are aptly referred to as blank-check companies. Before we explore the history, recent widespread adoption, and potential pitfalls of investing in SPACs, let us first take a closer look at what SPACs are and how they operate.

As mentioned above, SPACs are publicly listed companies created with the sole intention of acquiring another firm. Prior to attaining a firm, or in most cases even having a target company in mind, SPACs must raise capital through an initial public offering. In order to do so, assurance must be given to investors that the funds raised will be used to acquire a firm within a predetermined window of time – typically two years. Individuals wanting to buy shares of a SPAC are able to purchase a common share, typically adjoined with an out of the money warrant, on the public exchanges for around ten dollars. The industry standard IPO price per share is set at ten dollars for most issuances, because there is no way to assign a fair value to the stock using traditional valuation methods. Finally, the proceeds of the stock issuance are placed in trust and invested in short term government securities until a target company is identified and the business combination is completed. Once a target company is identified, the management team shares the terms of the proposed transaction with investors, giving all shareholders of the SPAC an opportunity to review the combination. Any shareholders that do not wish to participate are able to redeem their shares for the pro rata amount held in escrow. Typically, the redemption value is equal to the investor’s initial investment amount plus interest. Now that we have a common understanding of what a SPAC is, we can turn our attention to the past and present market environment.

From Humble Beginnings

The history of SPACs dates back to the early 1990s, however a different form of blank-check companies was first introduced in the 1980’s. After rampant fraud and abuse plagued the blank-check companies of the 1980’s, Congress stepped in and imposed new regulations greatly reducing the viability of blank-check companies in their prior form. As a way to get around this legislation, a new form of blank-check company, considered exempt from the controls imposed by Congress, was introduced in the form of a SPAC. Much like its predecessor, SPACs were often abused and in need of regulatory reform. From the 1990s to today, regulations have greatly improved leading to more robust investor protection and added confidence in SPACs as a viable alternative to traditional IPOs. Having undergone years of regulatory refinement, SPACs had set the stage for rapid market adoption by the mid-2000s, however it was not until 2020 that any real interest was shown to this investment structure.

2020 was a landmark year for SPACs both in absolute terms and in their share of total IPOs. According to SPAC Analytics, in 2020 a total of 248 SPACs had IPOs, accounting for 55% of all IPOs, and raising just over $83 billion. To put this into perspective over the ten years prior to 2020 (i.e. calendar years 2010-2019) there were a total of 225 SPAC IPOs, with total gross proceeds of $47 billion. This bears repeating – both the number of SPACs launched and the amount raised in 2020 were greater than the prior ten years combined. Clearly there has been an extraordinary surge of interest in SPACs, the root causes of which are examined below.

Three notable factors contributing to the uptick in SPACs include investors’ heightened demand for uncorrelated returns, the effect that the broad-based market volatility of 2020 had on businesses, and the innovative marketing tactics adopted by SPACs. First, because SPACs invest in private businesses, retail investors tend to view them as an alternative to Private Equity. However, the portfolio diversification benefits of SPACs, in relation to Private Equity, have yet to be proven. Next, the stress that COVID-19 induced on many businesses led to an abundance of companies seeking capital. These companies faced outsized uncertainty about how much money they could expect to raise using a traditional IPO, making SPACs’ use of a more-or-less fixed valuation more enticing. Finally, as competition for investor capital has risen, SPAC management teams, also referred to as sponsors, have become more innovative in how they attract investors. One such approach commonly deployed by SPACs is to include renowned investors and public figures on their management teams, regardless of the individual’s industry expertise or investment acumen. A few examples include baseball executive and subject of Moneyball Billy Beane, legendary hedge fund investor Bill Ackman, multi-time NBA All-Star Shaquille O’Neal, and the former US House of Representatives speaker Paul Ryan. While a logical case could be made for some of these individuals being included on a SPAC’s management team, it is more likely than not that this is done as a marketing ploy – a very successful one at that.

Looking to the future there is no doubt that SPACs will play a larger role in bringing private companies to market in the short-term. SPAC IPOs in 2021, at the time of this writing, are on track to surpass the record breaking 2020 issuances by a multiple of four. The long-term prospects are harder to project; however, if we look to the past we can get a clearer picture of what might be in store. In general, the number of IPOs in a given period tends to ebb and flow with the business cycle, reaching a peak in the latter stages of the cycle and dropping precipitously during recessions. This correlation to the broader market is unsurprising. When the stock market is at or near peak levels investor confidence is high and there is an abundance of capital in the market, signaling to private companies that it would be a good time to raise capital via a public offering. There were just over four hundred IPOs in 2020, a number not seen since the dotcom bubble of 1999 and 2000. In 2001, however, as the stock market retracted, so did the number of IPOs. A similar degree of IPO reduction occurred during the great recession of 2008 and 2009, indicating that as long as investor confidence remains high the current trend is likely to continue.

Weighing the Costs & Benefits

One of the advantages of investing in a SPAC is that it provides common retail investors access to private companies, a segment of the market largely available only to large institutions and wealthy investors. In addition, investors are given the option, but not obligation, to participate in proposed transactions. This allows investors more optionality than provided by private equity funds, which do not allow investors this choice. As we will discuss later in this article, the long-term investment performance of SPACs has been underwhelming. However, there are many SPACs, often hyped by news pundits, that have greatly exceeded the broad market return. There are, however, downsides to investing in SPACs, primarily outsized fees and a clear misalignment of interests between investors and sponsors. The payoff structure of a SPAC incentivizes sponsors to complete an acquisition even if the investment is unlikely to be profitable for shareholders. Founders of a SPAC are in a unique position in that they typically put up around 5% of the total IPO proceeds, but are entitled to 20% of the SPAC’s common equity. The significance of this is illustrated in the following example.

Suppose a given SPAC raises the 2020 average $300 million at IPO. The sponsor then invests around $15 million of his or her own money which, if they are able to successfully structure a deal, equates to $60 million in founder shares (i.e. 20% of $300 million). Now let us assume the price of the stock, once the acquisition is completed, drops by 50%. Common shareholders of the SPAC will lose 50% of their investment; however, the sponsor’s 20% ownership would still be worth $30 million (i.e. 50% of $60 million). In other words, the sponsor would make a 100% return on what would prove to be a terrible investment for common shareholders. Alternatively, suppose the sponsor does not enter the deal previously described, perhaps they are outbid by another SPAC or altruistic, and because of this the SPAC does not close on a deal during the allotted time. In this case, investors receive their money back, plus interest, and the sponsor is left more-or-less empty handed. The beforementioned incentive misalignment is compounded by the fact that there are over 300 SPACs with assets in trust of over $92 billion that are currently seeking a target. The microeconomic theory of price, which describes the relationship of the price of a good or service to its supply and demand, would suggest that SPACs will have to pay ever-higher prices to complete transactions in the coming years, further jeopardizing common shareholder’s expected return.

Interestingly, the long-term performance of SPACs seems to contradict the enthusiasm surrounding them. According to Renaissance Capital, a firm that tracks IPO activity, of the 93 SPACs that completed mergers from 2015 through the third quarter of 2020, common shares had an average return of -9.6% and a median return of -29.1%. Moreover, less than one third of these SPACs generated positive returns. Comparatively, the US equity market, as measured by the Russell 3000 Index, generated an annualized return of 10.72% from January 2015 through September 2020. Given the performance record of SPACs relative to the broader market it seems irrational that this much credence has been paid to them. In some ways, the SPAC investment landscape is eerily similar to the IPO craze of the late 1990s, a market environment so memorably described by then Federal Reserve Board chairman Alan Greenspan as exhibiting “irrational exuberance.”

The Verdict:

With little fanfare, SPACs entered the investment landscape in the early 1990s as an obscure and often overlooked segment of the market; however, improved regulations and a conducive market environment led SPACs to new highs in 2020. Clearly, SPACs have earned their place as an acceptable alternative to traditional IPOs for many investors and businesses. Although momentum is on the side of SPACs, the widely debated question of whether the burgeoning interest in blank-check companies is justified or simply another case of irrational exuberance will not be known for some time. For the time being, SPACs’ known and unknown risks, combined with the flagrant conflict of interests between sponsors and investors, make them unlikely to be included in client portfolios any time soon. However, we will continue to monitor developments within the space to see how this saga unfolds.