SPAC - Red Alert

As a former CFO of multiple public companies and as someone who is interested in various financial instruments, I've been curious about SPACs ("Special Purpose Acquisition Company") as a potential solution for the arduous process of going public, which I’ve done always the traditional way. The SPAC (a publicly-traded company with lots of cash, with the sole purpose of acquiring another company) and the target company agree on a pre-money valuation for the target. A SPAC is just another financial instrument that can help a private company go public that takes less than a month to set up.

The cash sitting in the SPAC becomes the money raised “during the IPO” and often a PIPE (Private Investment in Public Equity) is simultaneously raised when a target is acquired. Typically, SPACs have two years to purchase a target company, otherwise the investors get their money back, less some expenses. As an example, a $500 million SPAC merges with a private company and values the private company at $1.5 billion, resulting in a $2 billion post-money valuation of the combined entity.

What’s the big deal? It’s only a big deal if you care about returns. According to a Stanford Law Study updated October 2020, the investment returns are not good. In the 2019 to 2020 Merger Cohort, the median 12-month return was negative 34.9%. That alone should tell you to stay away. On the other hand, sponsors of SPACs have a median 12-month return post merger of 32%. In my opinion, it’s a total bait and switch. My conclusion: do not invest in a SPAC post-merger.

“The median 12 month return was -34.9%”

- Stanford Law Study

While the Standard Law Study provides some great information, I'd like to dig into this from an operator perspective. Most SPAC management teams turn over the reins to the target company executives and take their winnings (management fees, stock and warrants) and leave. These SPAC management teams are usually higher profile names that people look up too (e.g., Shaquille O’Neal even has a SPAC) . They provide the spark that encourages big funds to invest. In general, the management teams of the target companies are impressive but have no public company experience and are not ready to take a company public. They are usually scrambling to make sure they achieve product market fit, hire the right team to forecast the business reliably, get a public company audit completed and put in the controls necessary to produce accurate numbers (need to potentially be SOX compliant the year of the merger). These relative novice management teams will undergo scrutiny like nothing they have ever experienced. They will be asked questions about comments they've made in the past and requested follow up on any current comments. This will be an eye-opening experience for those never exposed to public market scrutiny. It usually takes months, if not years, of preparation before management teams are adept at handling these savvy public investors. They may start making short term decisions that jeopardize the long-term viability of the company as they don't have the stomach to tell investors what they should: ”it will take years to obtain the margins expected”. Most companies will not meet expectations investors have for them resulting in a declining stock price. My ballpark number to executives looking to go public is $10 million annually, which includes additional legal and finance staff, directors insurance, audits, and internal controls to be a public company. And that doesn’t include the time navigating the public markets, which includes quarterly earnings, investor conferences, and visits by shareholders.

Let's discuss for a minute the SPAC process. In general, when a SPAC goes public, it raises money from a group of investors that are called 13F filers. You can think of 13F filers as sophisticated, large funds that deal in these SPAC markets and account for 70% of the total post-IPO shareholdings. Two key features of a SPAC are their redemption rights and the warrants that come along with their investment. When a SPAC is ready to merge with a target company, shareholders can choose to redeem their shares for the price they paid at the IPO (less some costs) but keep their warrants. Really? Yes, you read that right. If enough of the pre-merger shareholders exit prior to the merger, the SPAC may need to raise additional money. This gives initial investors the ability to essentially see what is being purchased and exit if they don't like the target company (and get most of their money back, plus keep their warrants). Meanwhile, the investment banks take approximately 5.5% of the IPO for their fee and take another fee for the money that is raised upon merger. Fun fact: of the 2019 to 2020 cohort, 77% of SPACs needed to raise additional money at the time of merger because so many investors redeemed.

Going back to our example, we can see how this plays out. Remember, a $500 million SPAC merges with a private company and values the private company at $1.5 billion, resulting in a $2 billion post-money valuation. The SPAC will own 25% of the combined entity. The SPAC investors review the terms of the deal and 70% decide they don’t want to participate so they redeem their shares, pulling $350 million out of the SPAC. However, they keep their warrants. The SPAC now needs to “make up” this shortfall, so they raise $350 million in a PIPE. Essentially, this allows new investors to come in at a discount, and they also (generally) obtain warrants too.

What do you think will happen when these SPACs start inching closer to end of their two-year life? There will be a flurry of SPACs buying companies that should not be going public. Think of this as a two-year ticking time bomb. In order to defuse it, the SPAC has to buy a target company or return the money. Another way to think about it is that the SPAC route is the poor man’s ability to go public. Most companies with strong management teams and solid prospects will either go public the old-fashioned way or through a direct listing. Those that can’t stand on their own will chose the SPAC path and thus a lower quality company will be acquired. A ton of money will be chasing subpar companies…and you know how that will end.

Those that know me are very aware that I am a proponent of companies going public. The scrutiny that comes with being public is positive as it holds management teams accountable for the actions they take. The maturity that comes with the preparation to go public is priceless and management teams usually both become better and grow closer as a result. That said, it cannot happen overnight. With a SPAC, the maturity and expertise must happen, essentially, overnight. For those executives that are considering a SPAC, I ask that you not look at this as an easy, quick way to go public. Look into the benefits as well as the drawbacks and make an informed decision. Don’t just do it because your venture capitalists or your bankers are telling you it is a good idea. People said to me how easy a direct listing would be to complete. If you ask those that have done it, it takes just as much time and hard work as a traditional IPO, if not more.

As a counter balance, there are a couple of SPACs that have been successful. QuantumScape and DraftKings come to mind. Looking deeper, the management teams of both are highly experienced and have either taken a company public or been exposed to public company scrutiny. So it can be done successfully and with positive returns for those with experience. 

My prediction: Most SPACs will be a disaster for post-merger investors. Therefore, I’m calling on the SEC and the financial industry to put in some guardrails. Remove the ability for SPAC mergers to be covered by safe harbor rules regarding forward-looking statements in their proxy statements. Also, remove the lower liability risk the SPACs and bankers currently enjoy under Section 11 and 12 of the Securities Act, which covers misstatements and omissions in disclosures made in connection with a public offering. I know the bankers out there will balk at these suggestions. Ask yourself why. Why are they taking advantage of these rules to peddle this scheme onto the unsuspecting retail investor? Even Chief Executive Officer David Solomon at Goldman Sachs Group warned last week on the company’s earnings call that the flurry of activity isn’t sustainable. “If it bursts, it could leave a few insiders as winners while saddling individual investors who got in late with big losses.” David, it is already starting to happen.

“I’m calling on the SEC and the financial industry to put in some guardrails”

-Rob Krolik

According to SPAC TRACK, there are currently 352 active SPACs with a total of $108.1 billion dollars in cash that have either filed for IPOs, are searching for targets, or have announced proposed mergers. Tick, tick, tick.