For those who invest in equity markets, early 2021 might mark "feel good" times as market values in the U.S. continue to creep higher and higher, especially now there is a realistic chance the pandemic will recede into history by 2022.
But like any moment, when investors are hopeful and optimistic while still cautious, there is always unrest, something else rumbling in the backwaters: The flurry of trading activity in some products, the unexplained fluctuations in long-term bond yields, the crowded trades in some securities or investments, and the rise of herd trading, where investors are not making decisions based on fundamentals, but are doing so because of the "fear of missing out."
We are one quarter into 2021, and underneath headlines of vaccines, stimulus programs, and equity markets eclipsing 34,000 in the Dow Index, we observe scattered unrestful activity: A hedge fund loses billions shorting GameStop. Another hedge fund, Archegos, gets wiped by investments complex derivatives trades involving ViacomCBS. Economists hustle to explain why U.S. Treasury 10-year bonds have plummeted in value.
Years ago or quarters ago, we pondered the risks and extraordinary volatility of the cryptocurrency. We followed trends in BitCoin, tried to understand why it exists and why traders flocked to it, and struggled to rationalize its purpose or predict its usefulness years down the road. Now cryptocurrency trading and investing (and its just-as-popular BlockChain platform) are everyday occurrences for now (although 2020 brings a flurry of interests in NFT--non-fungible tokens).
For now, there are sports stars, entertainers and civil rights activists, with little background or historical interest in corporate finance, joining the SPAC bandwagon, a fashionable trend that surged in 2020.
So for now, let's contemplate this favorite financial product of the 2020s: SPACs. They weren't invented last year, but they onto the top of the pages in financial media even while the pandemic was roaring around the globe.
Special-purpose acquisition corporations ("SPACs") have been around several years. They are public companies with public shares, but with no current business model or ownership of a business. Not yet at least.
They must find a business to acquire. The acquired business will likely be a new-venture private company that gets to become a public company without having to go through the laborious steps of an initial public offering ("IPO") via the normal regulatory path.
The SPAC has two years to find a business; otherwise, it must plan to liquidate. The clock runs quickly.
In the past year, SPACs have been created at record-breaking, sometimes alarming levels. By late 2020, they had become the latest, hippest structure in corporate finance. The creation of numerous SPACs last year explains the near-record-levels of IPOs among U.S. investment banks last year. JPMorgan Chase, for example, earned about $10 billion in investment-banking fees, much of that arising from IPOs (and much of that coming from issuing new SPAC equity).
In 2020, 237 SPACs were formed by issuing shares to the public.
Alarming and peculiar are how those with little attachment to finance and banking are joining the SPAC bankwagon: entertainers, athletes, and others prominently known for anything other than being investors, asset managers, bankers or venture-capital or private-equity fund managers.
Historically in finance, when the "gimmick" of the moment attracts hordes who had not built track records in finance, then it's time to figure out whether a bubble is about to burst. That's not to suggest there is anything illegal with SPACs formed in the past few years or whether regulators and legislators should dash quickly to change some of the rules.
But it might be time to examine the "get rich as fast as possible" lure that might have attracted those with little background in finance to the scheme. The SEC's new commissioner Gary Gensler this week said the SEC is watching.
Many who have gotten involved in SPACs have done so by becoming sponsors, not necessarily as investors looking for new ideas. Think of sponsors as managers of a fund that has raised the funding via public markets and was able to do so rather easily because there is no up-front business to vet and analyze.
Sponsors with prominent or known names might be able to attact investors more easily--the better for the investor to be associated with that name. An investor might be more interested in a SPAC with Alex Rodriguez or JayZee as a sponsor for no other reason than the lure to be within their financial circles.
Familiar names in finance have sprinted down the SPAC path: Virgin's Richard Branson and basketball's Michael Jordan were involved. Hedge fund manager Bill Ackman of Pershing started one last year.
The SPAC IPO process unfurls in straightforward fashion (and is done with the approve in the U.S. of the SEC). But the same process doesn't require poring through years of financial data, ensuring the financial data is accurate, outlining pages and pages of the risks in the operating business, and working with investment bankers to determine an intrinsic value and a market value to sell new shares. In the U.S., all SPAC offerings are priced conveniently at $10/share. IPO proceeds sit in a trust or are invested in safe Government securities until sponsors find a company or two to buy.
After the SPAC has been launched, the search process starts. Sponsors must find a private business to acquire within two years or must determine what business is worth "taking public" through these convenient financial back doors.
Sponsors earn managemenst fees for the effort, in many cases as much as 20% of the value of the SPAC without so much as having to invest in the SPAC itself to help fund the acquisition. They may also earn additional fees when the SPAC actually does an acquisition.
Let's understand that carefully. The SPAC raises $500 million and is initially valued at $500 million. The sponsorship agreement permits sponsors to be allocated 20% of the value of the SPAC (or $100 millions up front). The SPAC entity invests the $500 million in Government securities and then conducts the search. Some SPACs will pay sponsors other ancillary fees. Investors tacitly acknowledge sponsors are providing $100 million of "value." But do they?
Sponsors with associated prominent names (the entertainers, athletes, and former politicians) garner attention, help make easy to raise the initial round of funding ($10/share) and likely don't rely on the "names" to do the heavy lifting or some of the the laborious analysis to determine what business should be acquired. But all sponsors enjoy the benefits of receiving the hefty fee.
Investors in SPACs must be aware, hence, that 20% of the future value of the target is skimmed or shared with sponsors, or (viewed another way) the target company must rise at least 20% in value before investors will achieve any increase in value of their original investment.
Some criticize how a SPAC approach to taking companies public doesn't permit investors and regulators to analyze, vet and study a target company in adequate depth--in the way the SEC requires via due diligence in normal IPOs. When the investor pays $10/share, he or she will not likely know at all what the target will be, what industry it be associated with, who will run the target company, how the target has fared in the past, or even what product or service the target sells.
A SPAC is already a public company, one that is making an internal strategic decision to do an acquisition, not subject to the scrutiny that comes with issuing new securities. SPAC managers/sponsors need not traverse the country in arranged ball-room meetings with potential investors to explain growth prospects of the business.
Of course, SPAC manager/sponsors have some responsibility to investors to do a fair amount of analysis and due diligence. They just get to bypass the arduous step of interacting with the SEC and the extended "road show" to convince investors who haven't yet committed funds. An easier, more efficient and less costly process, say those complain about the more difficult SEC process.
Company founders for decades have complained about the traditional SEC route and the requirement to work closely with investment bankers to establish a market value (and, of course, the expectation of paying investment bankers 4-7% in underwriting fees). Many have searched for or found less-onerous ways. A SPAC is a more recent solution.
Still, for SPACs, because there is a timeline (two years) and the clock runs out, is there a risk of sponsors acting too hastily or too irrationally? Will they rush to do any acquisition to justify their roles as sponsors? And will sponsors act in the best interests of investors?
(If there is no acquisition after deadline, the SPAC must liquidate and return the cash to investors.)
Time will tell some of this story, as it tends to do so for any kind of fashionable finance product that one day spirals out of control or one where less astute investors are left holding the detritus or "financial crap" after the product crashes or becomes wrecked by bad structuring or regulatory infractions.
(Think of the long list of complex mortgage-backed products of the 2000s or the exploding dot-com stocks of the late 1990s. Think of the flood of investors into funds of hedge funds in the late 2000s, where many ended up with holdings in a phamtom Bernard Madoff fund. This list can go on and on.)
Revert back to squares one or two:
Do sponsors really provide such value (20% stakes)? Why would sponsors be permitted to sell out their stakes and run (shortly after an acquisition)?
Will they do their homework properly? Will the scrutiny and the determination of "value" in the acquired company be as rigorous as that of a traditional SEC-approved IPO? Is the goal for sponsors to channel the funds into the right investment or any investment that meets the qualifications of a SPAC deadline?
Or consider the route WeWork might have taken when it planned an IPO in 2019, but questions and concerns by potential investors during the "road show" led to its cancelation. The SEC's timetable, the requirements to present financial details, investors' push to explain a route to profitability, enduring questions about its founder Adam Neumann, and loopholes and gaps in the company's efforts to explain the business model resulted in the cancelation. The process led to the right decision.
In a SPAC setting, investors would not have been able to slow down the process and analyze the problems and the risks in the model. A SPAC approach would have been more of an invest-first, investigate-later way for WeWork to go public.
As with all finance fads, let's hope the less-informed retail investors with fewer resources and contact don't get caught holding value-less SPAC stock while sponsors will have run away with millions.
Tracy Williams
See also:
CFN: WeWork: What Happened and Why? 2019
CFN: BitCoins: Embrace or Beware? 2014
CFN: Flash Boys: Slowing Down High-Frequency Traders, 2014
CFN: Snap Emerges from the IPO Gates, 2017
CFN: Is Uber Ready for an IPO? 2018
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