The folk legend Robin Hood was, as every child knows, the legendary outlaw who robbed from the rich to give to the poor. But in a reincarnation of a long-running Wall Street scheme, it is the wily financiers who rob from the ordinary folk holding investment accounts at Robinhood.
That scheme is the Special Purpose Acquisition Company, or SPAC for short. SPACs have been referred to as “blank check companies” where investors blindly fork over their money to a sponsor and purchase shares of an empty shell company. The investors buy with the hope that the financial acumen of the SPAC sponsor will lead to smart investments for the company and a windfall for them.
SPAC issuance has taken off this year with $61 billion in shares sold for over 165 SPACs. This already represents over four times the $13 billion last year.[i] Recent SPAC sponsors include venture capitalist Chamath Palihapitiya of Social Capital, Bill Ackman of hedge fund Pershing Square, the former Republican House Speaker Paul Ryan, former National Economic Council Director and Goldman Sachs partner Gary Cohn, and a handful of private equity firms.
SPAC promoters argue that they are a way for investors to buy early into growing private companies. At the same time, private companies can go public more quickly – by virtue of being acquired by a listed company – than through the traditional Initial Public Offering (IPO) process.
But there is a dark underside to SPACs. They typically charge investors incredibly high upfront fees, and are structured so that the sponsors, bank underwriters and big early investors – like hedge funds – make money from the transactions, while retail investors frequently get stuck with the losses.
Lifecycle of a SPAC
The issuer of a SPAC will start by filing a prospectus with the Securities and Exchange Commission (SEC). Unlike in a typical IPO however, the prospectus contains no financial information, such as revenue or profits, that might help an investor evaluate the company; there is nothing to report. The company is an empty shell, that after the initial offering holds the cash provided by investors until the SPAC finds an actual operating company to purchase.
What is in the prospectus, for those who bother to read it, are the huge fees the SPAC sponsor is entitled to receive, regardless of its performance. The sponsors get paid by receiving for free a separate class of “founder” shares entitling them up to 20 percent of the proceeds of the SPAC once the SPAC finds a company to merge with. This feature is also and has led hedge funder Bill Ackman to call SPACs a “compensation scheme” rather than a particular type of investment.[ii].
Next, prominent SPAC underwriters such as Goldman Sachs, Deutsche Bank, Credit Suisse, and Citigroup typically charge the SPAC 5.5% of the proceeds raised. Both the sponsors and the underwriters make money on the volume of transactions, which creates incentives to bring as many SPACs to market as possible, rather than to focus on the quality of the investment.
But it’s also the faulty incentives of the initial buyers of the SPACs that is allowing the market to balloon.
Typically, initial SPAC buyers are hedge funds who borrow money to purchase the shares, with market convention usually pricing them at $10 to start. As the initial buyers, they get additional upside if the stock price rises (usually above $11.50/share) because they also receive derivatives called warrants. The holders of the warrants have the right to purchase additional shares later at $11.50, allowing them to potentially purchase additional stock at a discount if the stock is trading higher than that price.
The initial buyers are often in a no-lose scenario as long as they can find subsequent buyers. The early investors can take the opportunity to offload their shares once the SPAC identifies a target company. The increased publicity surrounding the announcement usually leads the price of the shares to rise at least some, and the initial investors can sell their stakes for above the $10 price they paid to a new set of investors. Hedge funds often purchase SPAC shares with borrowed money, allowing them to magnify even small gains. In addition, as the initial investors, they keep the warrants enabling them to profit if the SPAC acquires a company that does very well.
It is the investors who buy from those initial hedge fund investors – typically small investors – who take most of the risk, and frequently end up faring poorly. An analysis by Renaissance Capital of 89 different SPACs issued since 2015 found that on average they have lost around 18.8%. The review found that only 29% of them had a positive return.
Why SPACs appeal to less sophisticated retail investors
Many retail investors find SPACs alluring because they can invest early in a highly coveted private company that would normally be unavailable to smaller players. Furthering that belief are the few recent instances of SPACs successfully merging with heavily companies. These include the Diamond Eagle Acquisition SPAC acquiring sports betting site DraftKings, Social Capital Hedosophia acquiring Richard Branson’s Virgin Galactic, and VectoIQ Acquisition Corp combining with electric vehicle producer Nikola Corp.
At their peaks, Nikola reached a price of nearly $68, while DraftKings hit $64, and Virgin Galactic $42 before prices came back down to earth. This handful of companies where prices soared (even if only temporarily) are the exception rather than the norm though, and even in these cases, prices have come well off these highs. DraftKings is now trading around $36/share and Virgin Galactic around $17. Nikola, meanwhile, has become a poster child of the excesses of the current SPAC boom. Nikola has yet to generate any significant revenue, and its stock fell below $20 a share after the company received notice of probes by the SEC and the Department of Justice regarding potential violations of securities laws. [iii] The sponsors of VectoIQ, P. Schoenfeld Asset Management and Cowen, now face questions about how much due diligence they conducted when acquiring the electric car maker.
Many of the retail investors who are the second-round buyers are coming specifically from the astronomical growth of commission-free brokerage Robinhood, launched in 2013. Robinhood has quickly grown to 13 million users, adding 3 million new investors in 2020 alone, driven by its addictive and gimmicky features similar to those seen in casinos and on social media platforms.
But the platform does not provide its customers – whose average age is 27 – with the tools to properly examine companies they are buying. [iv] Data from Robinhood in June showed that DraftKings and Nikola were both some of the most actively traded stocks by users.[v] Hoping to get in early on the next big deal, Robinhood investors are readily buying shares of SPACs that have not yet found a target.[vi]
As long as these “Robinhooders” continue chasing these SPACs, the sponsors and investment bank underwriters will happily produce more, generating greater stakes and fees for themselves, regardless of how the SPACs ultimately perform.
SPACs Have Had a Troubled History
Several of the early blank check companies were promoted by individuals who had committed criminal securities offenses who intended to use these vehicles to scam unsuspecting investors. A fraudulent blank check company promoter in those days would falsely claim a company would be acquired. Following the jump in stock prices that usually followed, the promoters would dump their shares and exercise their warrants.[viii]
The practice of promoting fraudulent blank check companies to unsuspecting smaller investors became so problematic that in 1993 the Securities and Exchange Commission put in place a rule (Rule 419) prohibiting trading in the shares of blank check companies until after they merged with another company. But in response, lawyers tweaked the structure of blank check companies, creating what became a SPAC to get around the rule and continue to allow for the active trading of the stock.[ix]
SPACs in the early 2000s sought to distinguish themselves from their blank check company predecessors of the 1980s, mainly by requiring that 90 percent of the fundraising proceeds be locked up in escrow and invested in Treasury bills until the SPAC found a company to purchase. SPACs have a two-year time limit to find a company to combine with; if they do not meet that deadline, they have to return the money they raised to their investors. (In practice now, that rule fortifies the incentives for sponsors to make any acquisition, even a bad one, in order to meet the deadline)
Those changes got investors comfortable with SPACs, even though many state attorneys general still eyed them with suspicion, and SPACs started going public in 2003. By 2007, SPACs made up a quarter of all IPOs. In total, 66 SPACs for $12 billion were issued in 2007.
All the money that had been raised by SPACs leading up to 2008 came at the same time as the private equity industry had been engaging in a debt-fueled buying frenzy of companies they were suddenly looking to sell. As trouble started brewing in the markets by 2007, the PE firms were finding fewer buyers to sell their companies to, especially as debt markets dried up and investors also stopped participating in traditional IPOs.[x]
Between PE firms needing to sell, and SPACs needing to put the money they raised to work, SPACs frequently became the buyers of last resort. Investors in the SPACs hoping to merge with promising companies instead found themselves purchasing companies private equity firms were trying to unload. As of April 2008, months before the worst of the financial crisis hit, SPACs had lost on average 6.9 percent since August 2003.[xi] The impact of the 2008 financial crisis halted the issuance of SPACs again for a few years, but the damage was done for investors. A 2012 analysis of 158 SPACs issued between 2003 and 2008 found their average half year return was -14 percent, one-year return -33 percent, and three-year return -54 percent.[xii]
In many ways, the rise of SPACs closely mirrors the rise of the private equity industry. A disreputable corner of the market that many established institutions refused to be involved in until it suddenly became a highly institutionalized asset class. As MGM CEO Harry Sloan recently told The Hollywood Reporter, “We are not surprised that the SPAC has become an asset class of its own, a little like the way private equity developed”.[xiii]
High upfront fee structure and crooked incentives of SPACs need to be examined
Regulators should re-examine the existing incentive structure compensating SPAC sponsors, underwriting banks, and initial investors that allow them to all profit regardless of the SPAC’s longer-term performance. Many retail investors are blindly buying into these SPACs and there is every reason to fear that they will lose out.
There are, however, unfortunately currently few signs that the appropriate regulatory bodies are stepping up to safeguard investors. SEC Chairman Jay Clayton has recently called for SPACs to issue more disclosures but stopped short of criticizing the structure or history of the vehicles merely calling them “healthy competition to traditional public offerings”.[xiv]
[i] SPAC IPO Statistics. SPAC Insider. “SPAC IPO Transactions – Summary by Year”. Accessed Oct 8, 2020. https://spacinsider.com/stats/
[ii] Celarier, Michelle. Institutional Investor. “Egregious Founder Shares. Free Money for Hedge Funds. A Cluster***k of Competing Interests. Welcome to the Great 2020 SPAC Boom”. Sep 21, 2020. https://bit.ly/2H4oCXu
[iii] McElroy, John. Wards Auto. “How Nikola Hit Jackpot with Zero Revenue”. Jul 17, 2020. https://www.wardsauto.com/powertrain/how-nikola-hit-jackpot-zero-revenue
[iv] Abdou, Jenna. 33 Voices. “Watch out E*Trade: The Millennials Are Coming For You”. https://bit.ly/3llmnOz
[v] Fitzgerald, Maggie. CNBC. “Robinhood traders cash in on the market comeback that billionaire investors missed”. Jun 9, 2020. https://www.cnbc.com/2020/06/09/robinhood-traders-cash-in-on-the-market-comeback-that-billionaire-investors-missed.html
[vi] Nanalyze. “How SPACs Reward Everyone Except Retail Investors”. Jul 3, 2020. https://www.nanalyze.com/2020/07/spacs-retail-investors/
[vii] Tse, Crystal and Baker, Liana. Bloomberg News. “One associated with fraud ‘SPAC’ deals are now rehabbed and swapped for failed IPOs”. Dec 29, 2019. https://www.latimes.com/business/story/2019-12-29/special-purpose-acquisition-companies-failed-ipos
[viii] Riemer, Daniel. “Special Purpose Acquisition Companies: SPAC and SPAN, or Blank Check Redux?”. 2007. https://bit.ly/35qimSJ
[ix] Heyman, Derek. “Entrepreneurial Business Law Journal. “From Blank Check to SPAC”. https://core.ac.uk/download/pdf/159610375.pdf
[x] Ehrenberg, Roger. Seeking Alpha. “Does SPAC Spell SCAM?”. May 18, 2008. https://seekingalpha.com/article/77687-does-spac-spell-scam
[xi] Holman, Kelly. Investment Dealers’ Digest. “The SPAC Market Takes a Breather”. Apr 14, 2008. https://www.sewkis.com/wp-content/uploads/20080414_JimAbbottSPAC.pdf
[xii] Howe, John and O’Brien, Scott. Advances in Financial Economics. “SPAC Performance, Ownership and Corporate Governance”. November 2012. https://bit.ly/3o9vS5H
[xiii] Weprin, Alex. The Hollywood Reporter. “’Blank Check’ Bonanza: SPACs Hit Media and Entertainment Market”. Oct 7, 2020. https://www.hollywoodreporter.com/news/blank-check-bonanza-spacs-hit-media-and-entertainment-market
[xiv] Johnson, Katanga. Reuters. “Top US markets watchdog says blank-check IPOs offer ‘healthy competition’. Sep 24, 2020. https://www.reuters.com/article/us-usa-sec-clayton-spac/top-u-s-markets-watchdog-says-blank-check-ipos-offer-healthy-competition-idUSKCN26F2II