SPACS: the current bubble, & SPACS 101

26 April 2021

Spacs are “Special Purpose Acquisition Companies”, which are essentially stock market listed cash shells, or “blank cheque companies”, looking for a company to buy. Their creation has been booming for a number of good reasons, and this bubble might well burst in the not too distant future, with a number of sponsors and others getting burned ie losing money. So if you wish to play in this space, some caution is warranted.

This brief note sets out

1) What a SPAC is and the current state of the market;

2) Who the key players are and why;

3) Key Risks for players in the market;

4) What might happen…

1) What a SPAC is and the current State of the Market:

The way it works is that a sponsor (someone with at least a modicum of credibility) generally raises say $200m to $400m (Bill Ackman has a $4bn Spac, Pershing Square Tontine) from a range of financial institutions, such as hedge funds, family offices or long only institutions eg Wellington; Fidelity, Templeton etc etc.

This money raised goes in to a trust, and the cash shell is quoted on the stock market (most are USA listed). The sponsor generally has 24 months to find a company to buy, worth say >$1bn if they have a $200m cash trust. (For the math to work a $200m SPAC needs a company valued at $1bn or more.)

Once they find the target and agree a deal, they go back to the investors and say this is what they have found and why it is such a great deal, and if they need more money than is in their cash trust they bring in others, “PIPE” investors,(Private Investment in Public Entities) to add cash, and also replace any existing investors that ask for their money back (their investment in shares is redeemable).

Once the deal completes then the sponsors can get their rights to 20% of the cash- their “promote” ie 20% reward for presenting a deal to the investors that is completed, so a great deal for the sponsors. Not like in Private Equity, where the sponsors keep 20% of the profit made- over a preferred return to investors of say 6% or 8% compounding, in SPACS they get 20% just for doing a deal. The big problem is that interests are not aligned- the sponsors get 20% irrespective of the performance of the investment, the de-spac investors are left holding the baby if the deal underperforms, which they largely have been.

Many spacs are trading below cash value, see www.spachero.com

2) Who are the key players and why?

The Sponsors:

Do it for the potential of great returns, multiples of money- maybe 5x to 10x in under 2 years, at fairly low risk, and they can keep creating a string of new ones.

Their risk capital is

1) to pay for the IPO documents / process, and

2) pay an investment bank 2% for some phone calls / zooms to the usual suspects to fund the cash shell / Trust. So maybe a $5m to $8m cash is at risk on $200m cash shell / Trust

3) provide working capital- expenses to find the target, negotiate the deal eg lawyers, and DD expenses etc- this comes out of the sponsors risk capital

So on $200m cash shell maybe $5m to $8m in expenses is at risk- but they get 20% of the cash as a “promote”. So the sponsor might get $40m to $50m of value, or more, in their de-spac for their $5m to $8m, eg 5x to 10x within 2 years.

So in a $1bn deal, the stock price can plummet and they still make a great return.

Some sponsors can further de-risk their position by selling off part or all of their “fees commitment” on a deal that keeps them in for profits without the risks of the cash invested.

Ideally the people backed ie the sponsors, should have good deal evaluation skills and a good deal track record and dealflow, but even celebrities, politicians and sports people have launched them. This says something about what is happening, it is unclear how good some of these peoples teams are at the above skills. However there are many deal junkies and experienced M&A professionals as sponsors eg Michael Klein, a former Citigroup CEO / M&A Head- with many vehicles under the name of Churchill Capital, and family Offices, industrialists, Venture Capitalists, Buyout funds, Family Offices, and so on. “SPAC Jesus” Chamath Palihapitiya, ex VC, who has done multiple SPACS and made himself hugely wealthy, has promoted SPACS and is a high profile commentator. He was behind Virgin Galatica, whose stock “went to the moon” and has recently been descending to earth… (he was selling closer to the peak..)

Bottom line, it seems to be, or was, “pretty easy” to raise a $200m to $300m SPAC- reasons are given below, and there is a great financial return for the sponsors. And some see it as a cash cow, doing multiple SPACs eg Klein/ Churchill, Chamath etc. A great cash register!

Some larger Spacs are listed below:

Source: WSJ, 26 April 2021

The Bankers:

Do it for lots of easy and fast money: 2% for some phone calls/ zooms to get the $200m to $400m ++, plus de-spac fees of maybe another 3% to 4%. (The lawyers also get lots of money preparing the IPO documents). They might also get lots of follow on M&A fees and investment banking business.

The League tables are as below:

The cash shell / Trust original investors in a SPAC (Hedge funds, Family Offices, Institutional investors etc):

Do it for the great arbitrage and substantial upside option.

They generally get

1) warrants in the company, that they can trade or sell separately from their investment in the spac ;

2) the right to ask for ALL of their money back when a de-spac / target is announced- they can vote to approve the deal so keep the warrants they got, and still get their money back ($10 was in a trust). But if they like the deal they can get a decent share of the IPO/ acquisition, without being scaled back as would commonly happen in a hot IPO; if they do not like it they can keep the money from the warrants, and some shares have traded up crazily before acquisitions were announced- the $10 shares trading above $50 on rumours eg Churchill Capital / Michael Klein buying a EV company

3) Forecasts: In an IPO forecasts are not given. In this “acquisition” / merger, forecasts are given, to hype everything up. Watch for lots of lawsuits in the coming 5 or so years…

4) More new deals to look at: many private companies have been staying private for longer, so this brings many more companies to market.

The free lunch for the original investors looks pretty good, great for arbitrageurs, with interest rates at zero then there is a very low opportunity cost. The “option returns” can be pretty good, at least a lot better than many bonds.

The De-SPAC target / the “Acquired” / Merged companies

De-Spac companies / the targets can love doing a SPAC as

1) They may get a much higher price than they get in an IPO- and the deal is “firm” (subject to redemptions) and a “guaranteed” large pot of cash;

2) They can negotiate a great deal (the SPACs can be desperate to do a deal and do not have much downside from a bad deal) with certainty of terms;

3) It can happen faster and maybe cheaper and easier than the long drawn out IPO process with fewer hoops to jump through;

4) They may be able to IPO much sooner and quicker than they could in a traditional process- and they have a supposedly market credible sponsor, who likely knows the markets better and how to best “sell the deal”, and they appear to be making huge forecast of great futures, in many cases apparently crazy forecasts

5) Maybe the spac brings a great Board member and / or strategic relationships

3) The key risks for the players in the SPAC market

-Sponsors:

=> could lose their money, their $5m to $8m or more “stake money”, (lawyers fees for IPO document; any diligence costs for a deal; 2% fund raising fee to the initial bank for funds raised) if they do not de-spac in the required 2 years to find a deal. But historically under c. 15% of deals have not de-spacced, but that was before this current huge wave. It could be that the failed de-spacc numbers will rise substantially, with more “busted de-spacs”.

=> could not make as much money ie not make 5x to 10x, as they can be locked up for perhaps one year, but is not maybe 2x for 2 years is still pretty good..?

=> potential lawsuits from over-optimistic forecasts, accusations of poor Due Diligence. (How many artists, sportsmen, politicians, and even some M&A bankers are good at DD..?!)

And there are a lot of companies looking for deals:

And historically, the liquidations risk (but this was a way different market):

-Banks

=> when the market shrinks, loss of easy money huge fees, maybe some reputational damage for the spac dogs (will be many); maybe some lawsuits

- de-Spac- the companies acquired

=> maybe lawsuits down the road when many forecasts are missed? Look at Multiplan: A class-action lawsuit was filed earlier in 2021 by an investor alleging that the SPAC’s board didn’t sufficiently evaluate the deal and that inadequate disclosures led to an overvalued transaction.

=> risk of a substantially lower stock price

-Investors in the original SPACs

=> only the opportunity cost of the money invested? A good arbitrage

-Investors in the De-Spac (stand to lose the most, at least initially)

=> potential huge losses as many companies fail to meet forecasts; offset by a smaller number that will outperform, some strongly. Look at Multiplan…

=> dilution impact- the sponsor promote, the warrants, fees, (fees of 7% for an IPO may end up being higher for a de-spac if there are many redemptions..) and if there is a high level of redemptions, then even more dilution…

The key issue in all of this is that interests are not aligned, the sponsors make a great return if they do a deal, any deal. So the incentives are huge to overhype and overpromise things, they can get a great return even if the stock price plummets. Several banks have put in structures that more align returns, where the sponsors only make their 20% of gains- not as a reward for doing a deal, but these are still a small proportion of Spacs.

4) What might happen

With over 400 spacs and >$150bn in cash desperate to do a deal within 2 years and a limited pool of potential IPO candidates, things are very frothy, where there are “spac-offs”, ie auctions amongst spacs, and VCs and LBO firms are getting numerous calls, or calling SPACS to sell. So crazily high prices will get paid. I turned down 3 deals in mid 2020 valued at under $100m that then de-spacced for values between $1bn to $2bn , 6 to 12 months later.

10x to 20x uplifts in 6 to 12 months in many companies smacks of a bubble to me, and lots of pain to come.

If interest rates go up then the opportunity cost will rise making them less attractive.

But what will really kill / shrink the spac bubble will be that investors no longer back the de-spacs, as they realise that interests are not aligned and have lost too much money, as so many of the de-spacced vehicles prices plunge. There could be a regulatory backlash as well. As there are more “busted” de-spacs ie the de-spac does not get funded, then more sponsors will start to run shy, and less sponsors will start the process given that they could now lose their grub stake. There could well be a wave of lawsuits further down the track given the sometimes hugely aggressive forecasts of the de-spac targets, but this could take time to emerge- or not, witness the Multiplan deal.

Maybe some money might be made from buying up spacs trading below the $10 price, (there are quite a few.. , see spachero.com) where investors can request the return of $10 if they do not like the de-spac target.

However as some spacs may obtain extensions beyond the 2 year limit to get their deals down, warrants are often detached, then the returns may be meagre unless of number of the chosen de-spacs trade up strongly prior to the de-spac. However the effort involved to check the IPO docs and the thin market may not justify the effort.

So caveat emptor for all de-spac investors. A short fund for de-spacced companies could also do well, and some hedge funds are targeting de-spacs as shorts, but wary of the Reddit crowd. Just ask Muddy Waters. But like in the 1999 internet boom insanity, a few will become the next google or facebook. The hard part is knowing which ones these are.