The Capital Note

SPAC Issuance at Record Highs

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Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the SPAC craze continues, an ill-fated Softbank investment, the Carlos Ghosn plot thickens, and a closer look at the nuances of blank-check companies. To sign up for the Capital Note, follow this link.

The SPACtacle
The special-purpose acquisition company (SPAC) craze that started last year is showing no signs of abating, with sponsors of the so-called blank-check companies raising record sums of money so far this year. Investors put $32 billion in new SPACs in February, the largest month of issuance on record. The total of $123 billion raised by blank-check companies in the first two months of 2021 is just under $30 billion short of 2020’s full-year total, according to a recent Goldman Sachs Research note.

Source: Goldman Sachs Research

And SPAC sponsors are getting more ambitious, targeting larger companies to take public than usual. The amount of activity in the space has raised eyebrows among regulators, some of whom allege that the vehicles lack transparency. Others call it a bubble.

In reality, it’s more a way of reintroducing risks that regulators have taken off the table. The IPO process is long and arduous and requires reams of legal documents and fairness opinions. The laws surrounding IPOs mean that investment banks and lawyers tend to take public companies that have proven track records, while riskier companies are kept private. The much-derided “IPO pop” is partially a result of the risk aversion embedded into the IPO process. SPACs, on the other hand, segregate risks among different parties, and facilitate the public listing of earlier-stage companies.

When a SPAC gets listed, it sells shares for $10 and promises to use the proceeds to merge with a private company. The shareholders can then exchange their SPAC shares for shares in the new company, or ask for $10 back. Each share also carries a warrant that allows investors to buy an additional share at $11.50 after the merger.

For investors, this model is attractive because the downside is relatively limited, so long as you buy shares at close to the $10 issuance price. However, the potential for a massive post-merger pop means that SPAC shares have tended to be valued above the $10 listing price, even before the SPAC’s target is announced. SPAC deals themselves can be risky because they commit capital to private firms without a roadshow or some other price-discovery mechanism. On the other hand, they’re usually done alongside a sophisticated private investor, who extends PIPE financing to the SPAC target. And besides, IPOs themselves can be risky, too, which is why IPOs tend to “pop” when they go public.

For SPAC sponsors, it’s a win-win. They usually put up little of their own money, and if the SPAC’s shareholders like the deal, sponsors are rewarded with a significant chunk of the newly public company. Investors such as Chamath Palihapitiya, who took Virgin Galactic public last year, have made fortunes through the vehicles.

And if you’re a start-up in need of capital, a SPAC offers a quick and easy route. Not only can you circumvent the paperwork and roadshow process of a typical IPO, but you can secure a fixed amount of financing from the SPAC before going public, whereas the amount of capital raised in an IPO can vary depending on investor appetite.

SPACs also allow early-stage companies to market their shares based on projected future earnings, unlike the typical IPO process in which firms can only publish historical financials. For many early-stage companies, that can deliver a better valuation.

The general framework involves downside protection for all parties except those who trade SPAC shares after the listing. SPACs can get bid up substantially before a deal is announced, so the initial promise to take $10 and turn it into $13 or $14 or $18 can quickly become a promise to take $50 and turn it into $60 or $70, as was the case with Churchill Capital Corp IV, a SPAC that rallied close to 500 percent before announcing a merger with Lucid Motors, an electric-vehicle start-up.

After the deal was announced, shares of the SPAC lost close to half their value. Critics see these price movements as evidence of fraud on the part of sponsors, but Michael Klein, the sponsor of Churchill Capital Corp IV, followed through on his promise. The SPAC now trades around $30, a 200 percent gain for its initial investors just a few months after the listing.

Those who lost money on the deal were the most risk-hungry investors, the ones who bought the SPAC at an inflated valuation on the hope that the merger would create outsize value. They’re probably not happy about the Lucid merger, but the same kinds of investors have seen huge gains in other blank-check companies. The rise of SPACs provides risk-hungry investors with an asset class that sates their risk appetite, and that’s not a bad thing.

Around the Web
Investors in Softbank-backed Greensill Capital are freezing the company’s funds:

Pressure mounted on SoftBank Group Corp.-backed startup Greensill Capital after a second fund manager, GAM Holding AG, froze an investment fund connected to the embattled finance firm.

Switzerland’s GAM said it had barred investors from trading in and out of the fund “as a result of recent market developments” and media coverage related to them. It plans to wind down the fund and return the money to investors.

Americans accused of aiding Carlos Ghosn’s escape taken into Japanese custody:

Japanese authorities have accused the Taylors of leading an operation in December 2019 to smuggle Ghosn out of the country in a musical equipment case that had special air holes drilled into it. At the time, the former Nissan chairman was on bail in Japan awaiting trial on charges of financial misconduct. The plan involved whisking Ghosn on a bullet train from Tokyo to an airport with lighter security in Osaka before taking him by private jet to Turkey and then to Lebanon, which does not have an extradition treaty with Japan.

Random Walk
Jay Ritter, a finance professor at the University of Florida, gave a nuanced breakdown of the SPAC structure in a recent interview.

On costs:

SPACs, however, are by no means costless, in large part because their structure typically creates dilution for shareholders. For example, like a conventional IPO, SPACs involve a middleman—the “sponsor”—that launches the SPAC IPO and does the work of finding a company to merge with, negotiating the terms of the merger and raising sufficient funds to complete it. If the sponsor does not complete a merger within two years, the proceeds of the IPO are returned to the shareholders with interest. In exchange for this sweat equity, the sponsor takes a cut of the deal–typically 20% of the IPO shares for a nominal price—which ends up diluting the company and public shareholders once a merger goes through.

That said, shareholders have the right to redeem their shares once the proposed merger is announced. So, especially if redemptions are large, the sponsor often winds up giving up some of its 20%—either by putting in more of its own cash or providing inducements to others such as private investment in public equity (PIPE) investors—in order to make sure that there’s enough cash to complete the merger. But given the dilution risk from the sponsor promote as well as other aspects of the SPAC structure, it’s unclear whether SPACs are cheaper on average than a conventional IPO, and they’re certainly not cheaper for all IPOs.

On the two types of SPAC investors:

To answer this, it’s important to recognize that the lifecycle of a SPAC has two distinct periods: pre- and post-merger. In the period between the IPO and the completion of a merger, or, if no merger occurs, the liquidation of the SPAC, the average return for the SPAC IPO investor since 2010 has been 9.3% pa. This high return has also been very low risk given that SPAC IPOs are essentially analogous to default-free convertible bonds. They’re default-free because the money is put into an escrow account, and investors can always opt to redeem, and convertible because there’s upside if an attractive merger is executed. With these sort of returns and attributes, it’s no wonder that a core group of hedge fund investors—the so-called “SPAC mafia”—have been happy to buy them.

More recently, a much broader range of investors has caught on and has started to pile into the SPAC market. One of those investors is me! Until two months ago, I had never bought a SPAC IPO. Now, I own eight or nine. Such increased investor demand is apparent in the price of listed SPACs. Historically, SPACs went public at $10 a share and traded at that price or maybe 5 to 8 cents higher—about 0.6% above the listing price on average. But, in 2020, SPAC prices typically jumped immediately after the listing and averaged 1.6% higher than the $10 listing price. And in the first two weeks of 2021, 53 SPAC IPOs launched—more than in all but three years ever—and their listing prices jumped more than 6% on average.

— D.T.

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