As 2021 began, during the fluctuation of GameStop stock and the emergence of the term Bored Ape Yacht Club, as well as the surge of Bitcoin beyond $50k, discussions about yet another investment vehicle were being held by celebrities and financiers.Thank you for reading this post, don't forget to subscribe!
Chamath Palihapitiya, a venture capitalist, promoted it as a way to establish a “fair and equal playing field”, enabling ordinary individuals to invest in high-growth companies. Hedge fund manager Bill Ackman had plans to utilize it in uniting with a ‘unicorn’. Even athletes like Shaquille O’neal became involved.
All of them were supporters of SPACs, remember them?
- SPACs, also known as blank-check companies, are public shell firms established by investors, intending to acquire and publicly list a different private company within two years after their IPO.
- The merged entity, also known as a deSPAC, becomes listed on the market – often quicker than a customary IPO.
SPACs were viewed as a revolution. In February 2021, when former New York Yankees baseball star Alex Rodriguez introduced his SPAC, he remarked, “This is just the beginning.”
(Photo: Alex Rodriguez – Michael Locicano/Getty Images)
More than two years later, the enthusiasm surrounding SPACs has dwindled, with the ambitious aspirations of numerous business veterans yielding to a stark reality:
- Rodriguez’s SPAC has yet to secure a company for a merger, and Ackman’s quest for a unicorn through SPAC was abandoned.
- O’Neill’s Forest Road Acquisition Corp SPAC merged with Beachbody, which was trading at 15 cents a share as of Nov. 15.
- Palihapitiya, widely regarded as the SPAC king, launched six SPACs, all of which merged into new stocks and lost a minimum of 70% of their value. He reportedly made $750 million by selling his shares – and was sued.
These are just a few instances, yet they are emblematic of the trend. Most of the hundreds of SPACs spawned at the zenith of 2021 did not finalize mergers, and most companies that underwent the merger process turned into nightmares for average investors.
What led to such a resounding failure of SPACs? And is there a chance that they will regain popularity?
Initiating a SPAC during the peak of the bubble
SPACs did not materialize overnight, although it certainly felt that way. In the 1980s, blank-check companies began pairing with penny stock companies, many of which were fraudulent. SEC reforms facilitated the establishment of a legitimate SPAC structure in the 1990s, yet SPACs continued to be a curiosity for hardcore traders who traded them outside mainstream stock exchanges.
This began to change in 2010 when major exchanges started to list SPACs. In 2019, 59 SPACs went public – the highest since 2007. The number increased to 248 the subsequent year.
And then came 2021, witnessing a staggering 613 SPACs going public.
This surge aligned with rock-bottom interest rates and a growing aspiration among early-stage private companies to go public during a record bull market.
“A lot of venture capitalists and entrepreneurs,” says Jay Ritter, a finance professor at the University of Florida, “were thinking, ‘Hey, this is a really opportune moment to go public. And perhaps we can accomplish it more swiftly before market conditions turn unfavorable.'”
They believed that the SPAC merger would achieve a faster public listing than a traditional IPO or direct listing.
In 2019, the number of completed mergers between a private company and a SPAC was 25, growing to 63 in 2020 and 198 in 2021.
To summarize, at the outset of 2021, two key developments transpired: a deluge of SPACs were formed, and a plethora of companies were engaging in SPAC mergers. Although it may have seemed logical for the upsurge in SPACs and SPAC mergers to align seamlessly, the actual outcome was quite the contrary:
- Companies seeking SPAC mergers in 2021 mainly merged with SPACs that had gone public during the preceding two years – not during the 2021 surge.
- Most of the SPACs acquired during the 2021 frenzy were overvalued.
These SPACs required the favorable conditions from 2022 and 2023 to persist. Anticipation spoiler: They did not. Changes in SEC regulations impeded the SPAC merger process, concurrent with a stumbling stock market.
In 2022, the number of SPAC mergers nearly halved to 101, and by early November this year, Ritter states that only 75 mergers took place.
In light of the downturn, Ritter estimates that around two-thirds of the 613 SPACs pursuing IPOs in 2021 will never complete the merger and “will end up losing everything.” Many have already been dissolved, thereby returning money to investors.
When a SPAC is dissolved, the heaviest losses are incurred by sponsors, who are executives and private equity firms initiating SPACs and predominantly contributing sponsor capital of 3%-7% of the estimated capital increase from the IPO. The upfront cost of sponsor capital for the average SPAC in 2021 was approximately ~$8 million, according to Ritter.
During the peak of the SPAC fervor, these sponsors were confident about amassing wealth. Yet, they will exit collectively, with approximately 400 of the 2021 SPACs projected to suffer losses of approximately ~$3.2B.
How much did average investors lose?
When a SPAC merger fails, the losses typically impact only the SPAC sponsors. Nevertheless, average individuals have suffered losses for another reason: their investment in a company that merged with a SPAC.
- During the peak of the SPAC frenzy in 2020 and 2021, retail investors were enticed by the prospect of buying shares in a company at an early stage and acquiring the same benefits as a venture capitalist.
- However, the average one-year return on a company that went public through a SPAC merger in 2021 was -64.2%, as per Ritter’s data. (The average one-year return for the entire market was -10.4%).
This was not a coincidence: Ritter’s data, tracing back to 2012, reveals that companies undergoing SPAC mergers have consistently underperformed the market every year.
(BuzzFeed went public via SPAC in December 2021 at $10.45 per share. Its stock is now trading at ~$0.32. – Spencer Platt/Getty Images)
Why did the outcomes fare so poorly? Analysts assert that many of the companies that went public through SPACs in 2020 and 2021 were riskier: unprofitable technology companies and biotech companies in the earlier stages of developing new drugs.
Nonetheless, the lackluster performance may also be attributed to the SPAC process.
Research conducted by New York University law professor Michael Ohlrogge, Stanford University law professor Michael Klausner, and management consultants Emily Ruan indicates that the poor returns for companies going public through SPACs result from inherent flaws that benefit SPAC sponsors and select hedge funds at the expense of average investors.
- Upon the IPO, SPACs typically offer shares at $10 to hedge funds and other institutional investors (referred to as the SPAC Mafia in the industry).
- These SPAC Mafia investors, in essence, engage in a virtually risk-free investment, as they can either redeem their shares for the same amount plus interest or sell them. They also receive warrants that allow them to purchase future stock at a predetermined price.
- Subsequently, average investors can acquire shares on the open market, typically at the same price of ~$10. These investors generally become involved only after the announcement of the merger target.
- Albeit that the share price at this stage typically hovers around $10, the actual value of the SPAC diminishes, as per Ohlrogge, due to various costs: merger fees and underwriting expenses paid to bankers, accountants, and lawyers; warrants allocated to initial institutional investors; and sponsor shares. (The sponsor, in return for establishing the SPAC, receives approximately ~20% of shares at the lowest price.)
“You have numerous entities entering the SPAC fray to extract value,” remarks Ohlrogh.
Consequently, when SPACs announce merger targets, Ohlrogge, Clausman, and Ruan ascertain that the real value of a share typically lies between ~$4-$6, even as the shares continue to trade at ~$10, or at times, even higher. During the zenith of the SPAC surge in late 2020 and early 2021, share prices soared an average of 1.5 percent to $15.77 on the day following the announcement of a merger, resulting in a more expensive purchase for average investors and an alluring selling price for the SPAC mafia.
As convoluted as it may sound, in essence, a portion of the merged entity becomes excessively costly. Average investors, while acquiring shares, bear the brunt of various fees and the advantages they provide to sponsors and early institutional investors, placing them on a more arduous path towards realizing a commendable return.
Some companies that merged with SPACs overcame obstacles to benefit investors. Shares of the gambling platform DraftKings were trading at ~$38 in mid-November, with the price of DraftKings nearly doubling since its debut on the stock market.
However, this is a rare exception. According to SPAC Research, as of April 2023, more companies going public via SPAC between 2020 and 2022 were trading at Below $1 per share as opposed to those trading at more than $10 per share.
(Early investors gained by selling early, while average investors encountered struggles. Note: BillTrust and Metromile are no longer public, and the current share price reflects the latest available price. – To struggle)
Ohlrogge remarks that for years, proponents of SPACs had dismissed their poor track record, insisting that things would be different with better sponsors and targeted companies.
“And it never materialized,” states Ohlrogge. “Hence, they continue to underperform. I believe it’s because they have significant structural flaws that very few people truly comprehend.”
Perishing due to lawsuits?
Ohlrogge, Klausner, and Ruan’s paper was published in the fall of 2020, at a time when SPAC exuberance was transforming into a frenzy. Although widely disseminated, it did little to diminish the SPAC bubble or rectify the structural aspects of SPACs.
Lawsuits may be on the horizon.
- Klausner, a co-author of the paper, has represented plaintiffs in three lawsuits against SPACs in Delaware Chancery Court, contending that SPACs concealed their genuine value from public investors due to early gains for sponsors and hedge funds.
- In 2023, a judge deliberated on Klausner’s arguments in a particular case and ruled that it could proceed to trial, causing concern among SPAC advocates regarding a potential onslaught of lawsuits against SPACs and a more challenging climate for SPACs in the future.
However, Ohlrogge estimates the probability of SPACs fizzling at approximately 33%. In one respect, the judicial precedent will solely hold sway in Delaware, where most SPACs were incorporated in 2021. Nonetheless, SPACs can work around any new regulations by incorporating in the Cayman Islands, as many have already done.
Ohlrogge suggests that a more likely scenario would be for SPACs to endure and retain a degree of popularity, possibly resurging to prominence in another bullish market.
To echo the sentiments of SPAC enthusiast Alex Rodriguez, the SPAC bubble of 2021 may only be the beginning.
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