SPACs – Treat Them Like Themed Ponzi Schemes

Special-purpose acquisition companies (SPACs) are all the rage both on Wall Street and in international financial centres. SPACs are being formed in Cayman and BVI, with the Channel Islands having an amicable atmosphere with The International Stock Exchange (TISE). The rules of the TISE in 2017 were already nativity friendly, but recently TISE has made moves to make SPAC listings  even more attractive, such as not having a suspension of trading requirement when a merger candidate has been selected. 

The London Stock Exchange (LSE) is looking to craft or modify its listing rules so the LSE can be more competitive with EU and US exchanges for the listing of SPACs. Concurrently, the UK Financial Conduct Authority (FCA) is exploring certain modifications to its regulations, such as the presumption that SPAC shares will suspend trading when it has identified a target and replacing it with rules tied to disclosures to investors and clearly identifying their rights on approving acquisitions and redeeming their investment.

Private Equity firms are also getting into the mode of raising money through the use of SPACs. Many are incorporating the SPAC into their private equity tools kits. SPACs serve as co-investment vehicles, allowing private equity sponsors to execute side-by-side transactions with lower leverage and increased equity. The SPACs tool permits the opportunity for more significant acquisitions in industries that the private equity fund documents prohibit.

Most US-listed SPACs are incorporated in Delaware. For non-US SPAC founders seeking targets outside the US, a SPAC incorporated elsewhere is an alternative with advantages. Most IFCs permit more efficient post-acquisition structures and remove the US tax, legal, and/or regulatory implications of using the US-domiciled SPAC.

US law and exchange requirements permit some concessions for non-US issuers who qualify as "Foreign Private Issuers".  The foreign entities usually follow the more flexible "home country rules". This addresses the overseas concerns about access to the US markets being able to be listed on a US exchange, but without being subject to the full weight, complexity, and cost of compliance with US legal and regulatory requirements.

Old Tricks But More Sophisticated

These types of transactions are nothing new, just more sophisticated. During the 1980s and 1990s, this type of transaction  was called a reverse public merger or reverse takeover with a blank  cheque company. A company desiring to finance its operations was convinced that being public was precisely the key needed to get the money  it needed.  The public shell[ii] would have audited financial statements, a symbol, and would be trading publicly. Mind you, they may have been trading by appointment, but trading they were. As soon as the companies were merged, the private company shareholders would have 80 per cent of the shares outstanding and the public company 20 per cent. A minnow swallowing a whale – a nice trick if you can do it.

The whole deal may have cost US$50,000 to US$125,000.  Common problems  were the over-valuation of the private company, the repeated failure of the promised private investment in public entity (PIPE) financing, and a mere whiff of due diligence. Another common problem is that many of the shell's shares were reportedly held by "persons" that were controlled by a promoter.  Sometimes, as much as 20 per cent of the public float was directly controlled by the shell promoter.

The combination of a perennial over-valuation of the private company accompanied  by the promoter just itching to sell their shares yields a predictable result. A company was launched with much fanfare only to see the stock price go down every day as the promoter dumped the shares they controlled into the market.  The crashing stock killed the hope of any PIPE investments.

In the late 1990s and early 2000s, over 150 Chinese companies got instant US listing by merging into a US SPAC company. The fad saw some US$50 billion worth of these deals launch before investors learned that many of the China reverse-takeover firms and shells were frauds. They were factory-made fakes. The problem  with a reverse takeover is that the apparent information asymmetry gives private companies a vast space to commit mischief, deceive themselves, or defraud the public. There was no 3^rd party due diligence – period. That's right, US$50 billion was lost – fleeced from investors in SPAC transactions.

Around 2015, SPACs began to offer IPO investors 100 per cent money-back guarantees with interest; the holder would also be entitled to keep any warrants or special rights, even if they voted against the merger and tendered their shares. Even more significantly, they could vote yes to the union and still redeem their shares. In effect, this gave sponsors the green light on any merger partner they chose. It also made SPAC initial public offerings (IPOs) appear as a no-lose proposition, effectively giving buyers a free call option on rising equity prices. As the Fed's low-rate, easy-money policy propelled the stock market higher for over a decade, it was just a matter of time before SPACs came back into vogue. And so they have, with unprecedented force.

The Risks

Blank-cheque companies were created in the 1980s and were associated with fraudulent activity and penny stocks which gave them a bad reputation. Blank-cheque companies rebranded as SPACs now have stricter rules and regulation. The average size of a SPAC raised this year is more than US$230 million, compared with about US$180 million in 2016. To be sure, SPAC listings come with risks. Target companies often give up more control and economics when they sell to a SPAC, which has its operating team in place. They're also subject to a vote by the SPAC shareholders. Sometimes this can lead to deals being scrapped before they can close.

According to the research firm Deal Point Data, a record 247 SPAC IPOs were completed in 2020, raising total gross proceeds of approximately US$75 billion, or 53 per cent of the total number of offers and 48 per cent of the overall IPO market by value. It is further estimated that, all told, sponsors will net more than US$13 billion in free equity. Great for them, but is that good for the rest of the shareholders? In fact, by the time the average SPAC enters into a merger agreement, warrants afforded to hedge funds, underwriting fees, and the generous sponsor's promotion eat up more than 30 per cent of IPO proceeds. According to the study of recent SPACs by Ohlrogge and Klausner[iii], a typical SPAC holds just US$6.67 a share in cash of its original US$10 IPO price by the time it enters into a merger agreement with its target company.

The problem with the founder-shares arrangement is the outsized nature of the compensation and inherent misalignment of incentives. This is before the massively dilutive nature of founder stock and the enormous amount of options awarded to principals for completing the merger,  making it difficult to complete a deal like a sober adult.

With an adult IPO you have the honest matchmaker, the investment banking firm.  For all investments there is a tension between the desires of the opportunity and the desires of the investor. The investment banker’s role is to compress  the desires into a fair and balanced transaction. The regulations and dynamism of the opposing forces work. The investment bankers  are using their considerable skill as  matchmakers between opportunity and capital. If they get it wrong too often, there will be no more investor money for them to place. It is never riskless. Many errors have been made. But the dynamic keeps the process under adult supervision.

The dynamism of the opposing forces between the opportunity and capital is lost in a SPAC transaction. What you have in place of dynamism, the necessary tension between a willing buyer and seller, is two principals trying to make as much money for their small cabal as possible. We have reviewed many SPAC mergers and to say the cabals of principals are like a pig at a feeding  trough is an insult to pigs. But the principals are not stupid. They don’t really want the deal to crash but it is a predictable outcome of drunk deal making. Without regulatory supervision, there's a disjunction between the virtues of character and the virtues of intellect. 

According to the Ohlrogge and Klausner study, six months after a deal is announced, median returns for SPACs amount to a loss of 12.3 per cent. A year after the announcement, most SPACs are down 35 per cent.  This was assessed during the same time period the NASDAQ gained over 20 per cent! The returns will get worse as the hundreds of SPACs begin trying to find and compete with each other for viable opportunities.

Has litigation begun? Yes. 

According to Bloomberg Law - ANALYSIS: SPAC Plaintiffs Are Filing Early But Not Too Early:

“With SPAC initial public offerings on the rise, and litigation nipping at their heels, it’s a good time to look for trends and commonalities among special purpose acquisition companies that end up in litigation, as well as when that litigation is likely to occur. This, the first in a series discussing those trends, highlights when plaintiffs are most likely to initiate SPAC litigation.

“Combined research of Bloomberg Terminal data on completed SPAC mergers and Bloomberg Law Dockets data on SPAC-targeted lawsuits has revealed 36 lawsuits involving SPAC deals that were announced and closed in 2020 through Q1 2021. These cases were filed from approximately one to 10 months after the merger announcement, with the majority of cases filed in the first four months.

“Despite the quick turnaround, plaintiffs filed only 11 of the 36 complaints ahead of the merger’s completion date—typically around the three-month mark—while 25 were filed after that date. Comparing these two trends suggests that most plaintiffs are suing right around the completion date—seeking either to stop the impending merger from happening or to contest something about it immediately after the deal is done.”[iv]

So should one invest in a SPAC? Sure, but treat all SPACs like a themed Ponzi scheme.  Avoid being the liquidity provided for by the dumb money rushing in after the merger. Get in at the ground floor and dump half of your position when the stock doubles. Dump the second half a) with a trailing stop loss order, or b) the moment you think you should have not sold the first half.

SPACs could be a useful tool to reduce the costs and risk of a traditional IPO. However, without the honest tension of a buyer and seller, the compensation bar siren’s call of the greedy to sip of warrants and fees becomes irresistible.

We see no stepping stones in the marsh, only landmines.

 

Footnotes:

[i]Apologies to Max Plowman, “Keyserling’s Challenge”. The enhanced sentence should read “Life is just one damned fact after another.”

^[ii]A Public Shell is a company with little or no business, a bit of cash, but is a listed and trading public company.

^[iii]NYU Law and Economics Research Paper No. 20-48

^[iv]Thank You Bloomberg Law - ANALYSIS: SPAC Plaintiffs Are Filing Early—But Not Too Early April 21, 2021