From the desk of John Arnesen,
Consulting Lead, Pierpoint Financial
I don't know whether I should be embarrassed or feel in good company to confess that it wasn't until 2019 that I knew what a Special Purpose Acquisition Company (SPAC) is. I know about the Special purpose Vehicle (SPV) and Special Investment Vehicle (SIV) as I invested cash collateral into these before it all went wrong during the Global Credit Crisis when liquidity dried up, but a SPAC was new to me.
My ten-year-old schoolboy self, on hearing the acronym SPAC, would have had me and my unruly peers giggle, but no one claimed that ten-year-old boys are the epitome of sensitivity or political correctness. Thankfully they grow up. Given this confessed lack of knowledge, I thought it would be useful to me, and hopefully those in a similar position to dive deeper into SPACs and their structure, why they are so popular, their pitfalls and to examine the securities finance data as to why they were so heavily shorted in 2020.
Background and structure
SPACs are not as new as I thought. They have been around for at least thirty years, and since their early days in the 1990s and 2000s, regulators in the US have increased scrutiny, oversight and procedural elements. Most importantly, investor protection has improved too.
Essentially a SPAC has no assets and doesn't make or build anything, but it does buy. In a genuine sense, it's an empty shell. All of this is by design. They have been labelled as 'blank cheque' companies because their primary goal is to attract investors to give them money in order for the SPAC to become a publicly-traded company through an Initial Public Offering (IPO) with a fixed share issuance, priced typically at $10.00 per share plus interest allocated to the investors. An added incentive is the issuance of warrants at a fixed-price that gives investors the option to increase their holding if performance is strong. Naturally, investors are not going to give money to any Tom, Dick or Harry, the founding members of the SPAC will need to have impeccable credentials, a proven track record of investments in a specific field and a solid reputation that attracts investors to them. Think Warren Buffet, not Bernie Madoff. The SPAC founding members goal is to identify a target entity with a promising growth outlook and then merge, thereby taking the joint company public. If successful, the investors will receive equity commensurate with their capital contribution while the founders will typically receive 20 per cent of the newly acquired company. That is a massive incentive in selecting the right company.
Governance and risks
SPACs do not sit around drinking Starbucks while hoping something will drop into their collective laps, and they are under strict time-frames not only to identify a suitable company but to complete the acquisition within two years, sometimes shorter. The market value of the target company must be 80 per cent of the funds held in trust. The targeted companies use the SPAC structure as an alternative to going through the heavy process of launching their own IPO with its endless roadshows to investors, something made virtually impossible during the pandemic and the avoidance of investment bank fees which a traditional IPO would incur. The targeted company has to convince a group of seasoned experts from the SPAC of the value on offer, and the SPAC has all the authority it needs to make a decision. This reduces the time to market, another attractive feature. Even once the deal is announced, if investors aren't persuaded by it, they can redeem their shares.
And if none of this happens? The IPO trust proceeds are returned to the investors with interest, and the SPAC dissolved. Investors have the time value of money to consider as they will only receive the yield on a T-bill should the SPAC fail to invest, but the potential upside likely makes this an acceptable risk.
So, what can go wrong? Several things. The risk that the SPAC doesn't find a suitable company within the allotted time-frame could lead to anxiety to find something quickly and the potential to value an opportunity poorly. Investors can reject the deal, but I imagine that the founders would view this as an abject failure.
Litigation is a real risk, and several SPACs are being sued currently over a range of issues such as failure to honour redemption rights, the payment of fees, and breach of duty. In 2019 Modern Media Acquisition Corp was to merge with Akazoo, a music streaming service. It transpired that the management had tinkered with the accounts and exaggerated the customer base. The deal didn't go through, and the SPAC failed.
Target companies may be wary of going through all of the due diligence effort and costs, only for the deal not to happen, or that investors pull their money out of the SPAC. In many ways, the target company has to be equally selective in choosing a partner.
The popularity of SPACs can result in an oversupply of them searching for too few opportunities. That will inevitably tighten the terms, favouring the target company that can be pickier but may reduce investors' upside potential.
The target company may appear attractive, but due diligence can expose some gaps in the requisite compliance and controls or weak governance requiring attention before a public offer can occur.
The market
2020 was a stellar year for SPACs breaking records for the amount of capital raised with more than 240 SPAC IPOs executed. High-profile companies such as Virgin Galactic chose a SPAC structure in 2019 to raise capital, which fed potential investors' interest. There is plenty of cash in trust that is hunting for suitable targets; over $80bn at the start of 2021 as the chart below shows.
Securities finance & SPACs
While SPACs gained in popularity in 2020, it appears that they also attract the attention of Hedge Funds. They like to short them. In many ways, this makes sense because SPACS, unlike other company share issuance, is limited by time, and there should be a correlation between high levels of capital, time to expiry and the prevailing share price. Pre-deal there isn't much incentive for the shares to trade above $10, but expectations, rumours and indeed duration to expiry can cause this to happen. Imagine if Jeff Bezos announced he was starting a SPAC as he has 'a couple of ideas'. Not only would he likely attract a vast amount of investors, but the pre-merger SPAC will likely trade well north of $10.00. However, this is not where the action lies. The merged SPAC and targeted company, once the deal is complete is where the short-sellers get busy. The chart below describes the shift in revenue generation from traditional IPOs in 2019 to SPAC-related companies in 2020. I can see why this interest in selling short occurs. A SPAC is trying to be visionary. It's looking for the next disruptor with a compelling story and significant upside potential. The deals they enter into tend to be with companies that are hugely popular with some investors while viewed with scepticism by others. The demand to borrow the SPAC-related stocks has seen balances shoot up significantly.
The most borrowed stocks are in Virgin Galactic which has seen a doubling of share price this year, and DraftKings, a sports betting company whose share traded at $19.00 the day after it went public rising to $63.00 as of 4th February 2021. Conversely, Nikola's share price rose to a high of $80.00 after its public launch in June 2020 but now trades at $24.00. QuantumScape, a battery maker for electric vehicles, faces litigation, charged with misleading investors over its battery technology being insufficient for electric vehicles and is no better than existing batteries. Ouch! Its' share price reached a high of $131.00 in December 2020 but now trades at $47.00
The market has a healthy mix of investors, including those that can see the day when we take holidays in space, and when every vehicle in the world will be electric. I want to think so too, but equally, you have a broad range of investors that don't buy it or, at least remain sceptical that these particular companies will be the pioneers that make the breakthrough. So they short them. Securities finance is supporting their view by lending them stock and making a pretty penny while doing so.
SPACs seem to me to be an elegant way of bringing small companies with good ideas to market. There may be some misalignment of incentives, but that is for the investors to work out, and they do have their detractors who think they are overhyped and oversupplied.
There is evidence that post-merger SPACs don't trade much above the IPO price of $10 as the chart below depicts. In the meantime, long and short investors express their sentiments and one, if not both stand to make handsome returns.
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