National Post (National Edition)
SPACS the 2020 breakout U.S. investment vehicle
That should make you nervous
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” Thus wrote Charles Mackay in 1841, describing the madness that overtakes crowds captured by a popular delusion of which investors are often prone.
When I hear about innovations that promise to democratize investing, I foresee madness ahead.
This time, Wall Street has been publicly bemoaning the decline in the number of IPOs because that change has limited the opportunity of the average investor to tap into emerging companies. As more and more companies stay private for longer, the riches accrue to professionals able to access private equity, so the story goes.
Not fair, say the ever-charitable Wall Street types.
Ah, but, Wall Street has a solution: the special purpose acquisition company, better known as a SPAC, a cureall for the ills plaguing the ever-shrinking U.S. public market. A SPAC is a publicly-listed shell company seeking to merge usually with a private company, thereby taking it public.
Similar vehicles have been around in Canada for a long time and have had a good track record in facilitating entry into public markets. But, as with any good idea that is taken to extremes, it's buyer beware.
How do SPACs work? After a sponsor raises the required minimum US$30 million, the SPAC is publicly listed and will seek to merge with an operating company within 36 months. If a successful merger is executed, the operating company will take over the listing under a new name and ticker. Once the deal closes, investors who owned the SPAC now own shares in the operating company. If a merger is not done within the time limit, the vehicle is liquidated and investors get their money back, plus accrued interest, less the sponsor's fee.
This year alone in the U.S., 140 SPACs have raised a record US$50-billion-plus, more than was raised in the past 10 years. SPACs are usually owned by corporate leaders and private-equity firms; individual investors typically make up a small part of the overall ownership.
SPACs have some unique features. Unlike traditional IPOs that have a lengthy time to market and can get derailed when markets wobble, a SPAC provides certainty of execution. In this year's extreme market volatility, SPACs have provided reassurance to investors that the deal will get done.
Since investors buy in before the target is identified, essentially just contributing cash to the pool, typically at US$10 per share, they have a better shot at the upside, something that the typical first-day pop in an IPO denies those who do not have direct access to private markets or who are not coveted clients of a dealer underwriting the issue. That IPOs are typically underpriced to benefit customers of investment banks irks Silicon Valley.
In the case of the IPO vs. the SPAC, it might be best to stick with the devil you know. SPAC sponsors typically get 10 to 20 per cent of the equity at very favourable prices. Former Goldman Sachs banker Michael Klein, active in bringing SPACs to market, reportedly reaped US$60 million on a US$25,000 investment in less than two years when his company brought Clarivate public.
Even if the SPAC does not complete a merger within the allotted time limit, the sponsor will often walk away with a sizable fee. However, the big win for sponsors is in completing a merger. The limited time in which to complete a merger, coupled with the fact that sponsors do not pay much for their stake, is an incentive to get a deal done.
Sponsors become less picky as the deadline nears because of the asymmetry in the structure. Exercise the warrants, grab the fee and run, as it were. Critics claim that the companies going public through SPACs are not getting as much scrutiny as a traditional IPO, which allows more time for due diligence.
The risk for the individual investor is the unknown — will it succeed? Are you willing to have your money sit idle for more than two years, missing opportunities and having it returned to you (minus fees, of course)? Historically, this sort of trend usually indicates a market top.
Many well-known financial personalities, including Bill Ackman of the hedge fund Pershing Square Capital Management and Gary Cohn, the former Goldman Sachs president and economic adviser to U.S. President Donald Trump, have sponsored these vehicles.
What's disconcerting is that celebrities and pro athletes have hopped on the bandwagon, too, among them Billy Bean, the Oakland A's executive of Moneyball fame, basketball great Shaquille O'Neal and former house speaker Paul Ryan. Their involvement in an endeavour largely outside their areas of expertise should prompt potential investors to ask: Would I take investment advice from this person?
Not all SPACs are created equal, but like any investment, know what you are buying. Ackman, for one, has foregone the 20-per-cent deeply discounted equity stake or the so-called “promote.” He purchased shares at the SPAC IPO price and holds warrants — which typically cause massive dilution when a merger is done — that do not vest for three years and can only be exercised after the merged entity appreciates by 20 per cent.
Ackman claims that the structure of his SPAC better aligns the interests of sponsors and investors and we have no reason to doubt him. But even if you dig through the minutiae of the prospectus to verify these claims, you are essentially betting on the reputation of the sponsor to consummate a merger. By investing in a SPAC, you are taking it on faith that a deal will get done based on the sponsor's track record. That's all you have to go on.
What ill are SPACs intended to cure and have we diagnosed the ill accurately? Over the past few decades, the number of U.S. publicly listed securities has declined by more than a third, a period over which the total market capitalization of U.S. stocks tripled. That means the U.S. market now has fewer listings and more mega-stocks. The shrinking number of stocks is due to both de-listings as well as a reduction in the number of IPOs, with de-listings beginning to outstrip new listings in 1996, a year in which private-equity deals soared 40 per cent.
What occurred in the U.S. in 1996? The National Securities Markets Improvement Act (NSMIA) of 1996 made private capital formation a more attractive choice for companies than public finance. How? It facilitated access to a critical mass of private capital by lifting the burden on private companies of seeking an exemption under the so-called Blue Sky Laws in each of the states. NSMIA also expanded the number of permissible private investors, spearheading growth in the number and size of private companies, leading to the unicorns we have today.
Fast forward to the 2012 Jumpstart Our Business Startups Act (JOBS Act) which further tipped the scales away from public markets by expanding the number of permissible private company shareholders to 2,000 from 500, easing accredited investor qualifications and opening the door to crowdfunding.
To be sure, the JOBS Act also included provisions to boost public listings, chiefly by reducing financial and compensation disclosure requirements during the IPO. However, by 2018, private equity capital had increased to 48 per cent from 25 per cent. Clearly, the provisions that facilitated private-equity raising trumped those intended to boost public markets.
The SPAC may shift the landscape from private markets back to public ones. A vibrant public market is in itself a good thing if it contributes to the allocation of capital to worthwhile enterprises. But the complexity of the vehicle, the asymmetry of the payoff between sponsors and ordinary investors, as well as the limited life that skews the process away from careful due diligence, may upend the potential of a SPAC. Greater regulatory scrutiny, in place of faith in sponsors, may right the ship or sink it.
Absent the wherewithal for careful due diligence, it may be best to avoid the madness of crowds until sanity returns to investors, one by one.
THE RISK FOR THE INDIVIDUAL INVESTOR IS THE UNKNOWN
— WILL IT SUCCEED?