investment insights
Spotlight on SPACs, or writing blank cheques for an IPO
Lombard Odier Private Bank
Key takeaways
- High profile, ‘blank cheque’ corporations saw a ten-fold rise in inflows since 2019
- ‘Special purpose acquisition corporations’ offer a way for investors to participate in private markets and companies to shorten the typical IPO timeline
- However, pre-merger, SPACs trade without fundamentals. Once invested, returns have been mixed and their structures may obscure costs to some investors
- The low yield environment continues to favour alternative sources of return, and unless they suffer a setback, SPACs appear here to stay.
‘Blank cheque’ companies are attracting billions of dollars from retail investors and hedge funds in search of capital gains and access to private market returns. These special purpose acquisition corporations, or SPACs, promise firms a simpler, cheaper and alternative path to a public listing. They also come with caveats that investors should carefully examine.
SPACs are shell companies with a two-year lifespan, created with a promise to buy another business within that time. When investors place USD 10 shares with the SPAC, which then searches for a firm to take public, they do not yet know what the target will be.
Every week sees dozens of SPACs launched. Over the last year, SPACs have raised more than USD 137 billion, according to Bloomberg, ten times more than in 2019. An estimated 40% of those investment volumes come from retail investors, around twice the retail share of participation in regular listed US equity markets. That has prompted a fishing frenzy for target companies, which are often start-up technology firms developing automotive or space technologies, sustainable energy, or older businesses in private equity portfolios.
High-profile sponsors in high-profile industries raising capital are helping to drive investor demand. The largest SPAC to date is the USD 4 billion raised last year by hedge fund Pershing Square Capital’s founder Bill Ackman. There are many other examples. Chamath Palihapitiya, the venture capitalist, used a SPAC in 2017 to take a 49% stake in Sir Richard Branson’s Virgin Galactic, and was reported last month to have created another seven special purpose corporations. Just last week one of Michael Klein’s SPACs bought e-vehicle company Lucid Motors Inc., a Tesla, Inc. rival. On 26 February, former Credit Suisse Group CEO Tidjane Thiam was reported to be looking for a financial services target for a pool of SPAC investments worth USD 300 million.
Another large share of the cash comes from hedge funds including Millennium Management, Magnetar Capital and Polar Asset Management, which are reportedly active in the SPAC market, and may also enjoy additional trading rights in the vehicles in the form of warrants. Institutional investors may be using SPACs as a substitute for low-yielding fixed income returns as they have the option to exit with some equity optionality before a deal is announced.
In this low-yield environment, one of the attractions is that SPACs allow investors to withdraw their money, plus interest, if they do not like the announced target. They are therefore buying optionality on potentially high-growth private companies that would otherwise be out of reach. If too many investors drop out of the proposed deal, the SPAC, which usually takes a 20% stake in the common stock for a nominal price, can also withdraw from the deal.
What’s wrong with IPOs?
Pricing is one of the most obvious shortcomings of traditional IPOs. Because many investors take a short-term perspective on the stock, investment bank advisors have an incentive to under-value the initial market price. That way, when trading starts, investors see an immediate gain. But the company’s founders and existing owners then find they earned too little and effectively paid for the listing from their own pockets. In 2020, data shows that IPOs jumped 40% on average in their first day of trading. That makes them unattractive to a private company’s board.
In contrast, a SPAC agrees the launch price with the target company’s owners and promises a simpler and cheaper listing process. As Sir Richard Branson explained last month when asked about his October 2019 SPAC launch of Virgin Galactic, the structure “gets through all of the rigmarole of public companies.”
If the case for SPACs sounds too good to be true, it is worth exploring the downsides. The investors’ cash pool has to pay advisory and banking fees, diluting their original speculation. Worse, a recent paper published by Stanford and New York University law schools1 found that at the time of a merger, the USD 10 per share investment is worth only a median USD 6.67 in cash. The study concluded that for “a large majority of SPACs,” share prices fall after a merger. Within three months of merging, the authors found SPACs had a median loss of -14.5% and a median -16.1% difference with the Russell 2000 small capitalisation index.
This means that “SPAC investors are bearing the cost of dilution built into the SPAC structure, and in effect subsidising the companies they bring public,” says the report. In contrast, a separate study2 in December 2020 calculated that the median return from all types of IPOs three months after listing was a positive 1.6%.
Before completing an IPO however, SPACs are posting gains. The IPOX SPAC index of common stock held in publicly traded SPACs has been live since the end of July 2020. It reports a rise of 64.2% since then. Traditional equity markets have posted returns of 48.2% for the Russell 2000, 24.6% for the NASDAQ and 17.6%, including dividends, for the S&P500 over the same period.
Investing in success?
Critics also point out that even SPACs that make acquisitions are not necessarily backing successful companies. The question for many investors is then whether private companies that raise liquidity through a SPAC are doing so because they have no other option. And whether they are comfortable with the dislocation between their own investment interests and the SPAC sponsor’s eventual goal of inheriting a one-fifth stake in a listed firm.
Virgin Galactic, often cited as an early example of the current appetite for SPACs, has slipped on its original 2007 deadline for delivering commercial space flight. Last week it announced a new chief financial officer hours before reporting a fourth quarter loss of 31 cents per share on zero revenue. That has not prevented its share price from rising four-fold in 16 months of public trading, nor singer Justin Bieber and actor Leonardo DiCaprio from booking seats3. Two other space-related companies have announced plans to go public using SPACs: Astra, which develops launch vehicles may be worth USD 2 billion in an IPO, and Momentus Space, whose Russian CEO cannot legally scrutinise his own company’s designs under US national security laws.
As more SPAC cash chases fewer opportunities, there is a danger of merger values and SPACs’ shares becoming inflated as they approach deals. Shares in Mr Klein’s Churchill Capital Corp. IV more than halved in value over two days after the 22 February announcement of a deal with Lucid. For months, investors bought shares based on rumours, and then sold their holdings when they saw the details of the deal.
Much of the capital looking for opportunities may not find targets, and so could end up returned to investors. Enough disappointments may eventually tip the market as investors grow frustrated with too few acquisitions and possibly unfounded forward financial projections.
Opaque performance
The new market for SPACs also lacks aggregate benchmarks and an easily available track record. As a result, a high-profile success story tends to inflate flows into the vehicles. In these early days of SPACs’ broad adoption, there are also clear signs of the potential for investors to talk up stocks in these shell companies, since they trade without any fundamentals.
A second threat may eventually materialise from a sustained increase in interest rates on the back of a resurgence in inflation, reducing the relative attractiveness of these growth-biased vehicles. That looks unlikely for this year.
As long as the low-interest rate, low-yield environment persists, markets will continue to look for increasingly sophisticated sources of return. And as long as the SPAC market does not develop into a bubble, run out of credible companies to target, or become mired in lawsuits4, these vehicles may offer an alternative route for companies to float on public markets.
1 https://poseidon01.ssrn.com/delivery.php?ID=873102088082121001096021087092091071063022072087058011076074009078082008067087100014062000018022024047055080000015028116078102107069090006054114107117086066015029098000069094112122001029000006111079124090090117000067020019083107092093112098065113089121&EXT=pdf&INDEX=TRUE
2 https://www.schaeffersresearch.com/content/analysis/2020/12/16/what-to-expect-after-landing-a-huge-ipo-return
3 https://www.forbes.com/sites/jamesasquith/2020/02/26/tourists-in-space-justin-bieber-and-leonardo-dicaprio-have-already-purchased-tickets-as-demand-skyrockets/
4 https://www.bloomberg.com/news/articles/2021-02-16/spac-flop-is-test-case-for-disgruntled-investor-lawsuits?sref=vmuh8Rud
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