The rise of SPACs

Every few years efforts to redefine the IPO emerge, and as night follows day, investors get hurt and calls for tighter regulatory reform echo in legislative chambers and cable TV studios. The last significant “re-invention” emerged in the height of the dot-com boom when online brokers started selling newly issued shares directly to retail customers. We all know how that ended.

Flash forward one generation: a newly formed company called Social Capital Hedosophia Holdings recently sold $600 million of stock to a trusting public and heralded their achievement, which it trademarked no less, as “IPO 2.0.” Their pitch is that young companies — even the current class of “unicorns” valued over $1 billion — have a very difficult time going public. Instead, the argument goes, it is easier for them to become public by merging into an entity that is already public and, voila, the young company has become a public company without the headache of actually engaging in an IPO. Perhaps a better moniker would have been “IPO 2.0-No.”

Social Capital Hedosophia is a “blank-check company.” That is, a corporation that has no specific business plan or purpose — other than to find a business and acquire it. Given the press around the offering (and the “2.0” branding), one would have thought there was actually something new here. Hardly.

Blank-check companies have been around for decades. They have been called “clean shell companies,” “blind pools,” “public shells” and, since the 1990s, the somewhat classier “special purpose acquisition companies” — SPACs. The basic model has remained the same: investors advance cash to the sponsors of the blind pool who look for something for the public shell company to acquire.

There are some modest protections for the investor. The funds are put in an escrow account, the target has to be valued at least 80 percent of the cash in the SPAC and the acquisition has to be completed within two years or the money is returned to the investors. Beyond that, there are not really any substantive limitations on what the SPAC can acquire. One might reasonably speculate that target acquisitions that do not look very attractive in month one start to look much better by month 24, as no sponsor wants to actually return the cash to the investors.

But the proponents of SPACs as an antidote to the IPO famine have it backwards: Historically, SPACs have been the avenue of last resort for companies that want to go public but can’t — either because underwriters won’t take them public or the public markets won’t embrace them.

Indeed, the relative scarcity of IPOs over the past several years has much less to do with the hassle of going public than it does with the (larger) hassle of actually being public. Many unicorns could go public today if they wanted to; indeed, I know many Wall Street bankers that are calling on them regularly to pitch the idea. But being public is a hassle and it is expensive: quarterly financial reports, daily gyrations of the share price, meetings with Wall Street analysts and public investors and greater legal liability for misstatements to the public.

Moreover, the private equity markets — both here and abroad — have been only too willing to finance many of these companies — often at valuations greater than the public markets would afford — so there has been no need to go public.

 

In that sense, the SPAC is a solution looking for a problem. And, as it caters to those companies who can’t go public the conventional way, there is a tremendous adverse selection problem for the targets and an economic problem for the investors. For the target companies, an inability to go public “the regular way” is meaningful, and if you ignore the market when the market is speaking, you do so at your own peril.

As a conduit for weaker public companies, SPACs have an unparalleled record: they consistently underperform the broader equity markets and there is scholarly research that proves it (since 2003 SPACs have returned, on average, a negative 19.7 percent). That shouldn’t be surprising, because the quality of the acquired businesses — by definition — is lower than those that have been vetted by underwriters and the market. Historically, the companies that SPACs acquire make lousy public market investments, and that is because those companies are not mature enough for the pubic markets, and the public markets make lousy venture capitalists.

And if a company is ready for the public markets, there are substantial advantages to going public “the regular way.” First, a company in a traditional IPO gets to select its investors; the SPAC has already done that, and they may not be the supportive investors the company would prefer.

Then there is the process itself. The sponsors of Hedosophia would have us believe that merging with a SPAC is easier than filing for an IPO, but that simply is not true. As with an IPO, the merger with a SPAC requires all of the same business preparation, due diligence, prospectus-drafting, SEC engagement and regulatory oversight; even the paperwork is substantially similar (only it is called a merger proxy statement instead of an IPO prospectus).

After the acquisition, of course, the target is a public company, subject to the same hassles as any company that went public via a traditional IPO. But the biggest advantage to the traditional IPO over the SPAC is cost.

And therein lies the real motivation behind IPO 2.0. In the Hedosophia prospectus, under the innocuous caption “Founder Shares,” we learn that the sponsors of the SPAC have granted themselves 20 percent of the equity of the company. At the time of the deal, that was worth $120 million. You read that correctly. For the investors who capitalized the SPAC, that is a pretty substantial haircut to net asset value, and for a target company seeking a route to the public markets and for the investors who bank-rolled it, the SPAC sponsors will charge it a nine-figure toll to get there. In that context, the traditional investment banking fee of 5-7 percent of proceeds raised looks like quite a bargain.

So we are back to the adverse selection problem: Even if it cannot go public the traditional way, what target company is willing to take a $120 million discount on its fair market value to swap into a public shell? It should come as no surprise that the same scholarly work that showed the typical returns for SPAC investors to be a negative annual return of 3 percent also showed that the typical returns to SPAC sponsors were a positive 1,900 percent.

The conflict-of-interest is palpable: One might reasonably speculate that target acquisitions that do not look very attractive in month one start to look much better by month 18, as no sponsor wants to actually return the cash to investors and forgo the substantial value of the “founder shares.”

Companies in merger discussions with SPACs should tread carefully. If being public is the goal and the business is not substantial enough to pursue an IPO in the traditional fashion, the SPAC is an alternative, albeit a difficult one. If you are not ready to be a public company, merging with a SPAC won’t make you ready. And the discount to your fair market value that you will have to suffer will be substantial.

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