In 2022 an astonishing three out of four companies going public in the US did so by means of a special purpose acquisition company, or “Spac”. While the boom was several years in the making, when the crash came it was swift and severe.
For more than a year, the US Spac scene was dominated by bankruptcies, restructurings, shelved offerings and muted activity.
At the end of last year confidence started returning. By the second quarter of this year there were 54 Spac initial public offerings (IPOs) in the US against 34 for the same period in 2023. The UK has so far seen few signs of a comeback, but if there is continued pick-up in the US, it can be expected to follow.
Then in July the US Securities and Exchange Commission (SEC) imposed changes to remove some opportunities for abuse in the Spac mechanism. While the new restrictions mean that activity may not immediately boom as it did in the peak times, many feel they have given the industry a new legitimacy.
So, if the Spac recovery builds, is it to be welcomed or, as I believe, treated with scepticism?
Spacs are formed when some well-known people (sponsors) raise a lot of money and set up a new public company with the intention of merging it with an already-operating private company.
At the merger, many of the original investors exercise their right to redeem the cash they contributed on the IPO, and other investors come in with a private placement to make up the shortfall. These investors typically receive sweeteners such as warrants.
At the end of the Spac process there is a public company with operations known as a De-Spac.
Before the SEC-mandated changes, Spac and De-Spac sponsors and issuers benefited from a couple of striking advantages.
Marketing of the financing of the De-Spac was helped by some protections against litigation. So the bankers were often able to paint a rather rosy picture of the company’s prospects without particular regard for the consequences.
There was also no requirement to set out many items that would need to be included in a public offering, including detail on the fees, which typically gave the sponsors an egregious 20 per cent interest in the merged company.
These features have now gone.
Some advantages remain, but I believe they are often partial or questionable. Meanwhile, the disadvantages, especially for investors, are still there ‒ and are often underestimated.
One of the supposed advantages is that many companies that would be ineligible for an IPO due to their small size or lower quality can still pull off a De-Spac. This is of dubious benefit to investors.
Another possible advantage is that the price at which a De-Spac merger is effected is agreed, unlike the case with an IPO. This is partly true, though the De-Spac’s merger terms are often heavily negotiated up to the last minute.
If a company needs to get to market fast then Spacs do have the edge. An IPO typically takes 12-18 months, while a De-Spac can come to market in six to nine months. Former president Donald Trump needed the owner of his social media platform Truth Social to go public this year — which it did.
More typically, the compressed timescale to a De-Spac offering might be needed to catch the window of a hot market in some particular sector. But hot markets are generally not the best time to invest. In the boom times, offerings in electric vehicle companies were popular, but according to Spac Insider, a specialist website, the median De-Spac EV share price since 2009 is down 96 per cent.
Now consider some concerns that face investors in De-Spac shares.
Because no Wall Street investment bank brought the De-Spac company public, there is likely to be no investment research on the shares, there may be few credible market-makers, and little liquidity.
There’s no lack, however, of an overhang of potential sellers, notably the holders of the pile of equity-linked instruments that were issued in the prior financings. This can impede the De-Spac shares’ performance even if the De-Spac company is successful.
And while the sponsors’ fees are now generally slightly lower, they’re still high — much higher than the 6-8 per cent cost of an IPO — and damage the risk-reward ratio.
It’s not surprising, then, that the performance of US De-Spac shares has generally been poor. According to Professor Jay Ritter of Florida University, the average one-year return of US De-Spacs in 2023 was down 59 per cent, with longer timeframes showing similar declines. Trump’s De-Spac is currently down 84 per cent from its peak.
To be fair to Spacs, the SEC’s partial clean-up of the mechanism should mean that performance in the future will be marginally better.
And over time, bankers will almost certainly find new angles to boost Spacs’ attractiveness. Wall Street’s ingenuity is never to be underestimated.
Nevertheless, investors would be well advised to tread warily as the Spac cycle picks up.
The author is CEO of Tail Wind Advisory & Management Ltd and was founder and manager of The Tail Wind Fund.
https://www.ft.com/content/712cfa06-ff8c-4fea-848c-eaf1c5965458
