Looking back on the short life of the SPAC
Legendary investor Bill Ackman is known across the investing world for his big, concentrated bets. As an activist investor, he will often buy a controlling stake in a company, install his own people on the board, and steer the ship in the direction he wants to go.
His most recent play resurrected a long-dormant financial structure in the height of the pandemic, a special purpose acquisition company (“SPAC”).
SPACs raise investor money before looking for a private company to take public. The arrangement, in theory, gives a wider number of investors a piece of the new public pie. However, SPACs are again dying out in 2021. Today, we dive into why.
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SPACs are the “new kid on the block” instrument. It’s a financial vehicle that allows companies to skip the traditional route of going public. But Ackman’s SPAC mania hit a few speed bumps.
Recently, he announced a complex deal to buy a stake in Universal Music Group, which ultimately failed. Those who bet with him have not been experiencing the returns expected of a manager like Ackman. They’ve been mostly seeing red.
The former SEC commissioner filed a lawsuit against Pershing Square earlier this month, claiming Ackman’s fund acted improperly. The case could redefine Pershing Square and other SPACs as a regulated investment company, so that these vehicles would become just like any other publicly trading asset manager.
This would be significant. Currently, SPACs are defined as operating companies… that happen to have no operations other than making a previously private company public without any initial public offering (“IPO”) red tape. If this sounds suspect, it’s because it can appear suspicious.
Although Pershing Square is taking the brunt of the guns-drawn newly empowered regulators, it isn’t alone in its suffering.
Many other SPACs that rushed into the market last year amid the seemingly infinite supply of liquidity have seen their share prices collapse. Newly formed SPACs are now finding it difficult to source deals.
After decades of hearing about them on the news and during “water cooler” conversations, IPOs are fairly well understood by the investing public. But SPACs are more mysterious, and there are many misconceptions.
The Pershing Square case is one candidate. But some investors are starting to see how SPACs may not be great financial instruments.
For instance, the process of getting acquired requires less due diligence than a traditional IPO. A SPAC can bring a company public, skipping rules designed to protect shareholders from underbaked investments or fraudulent schemes.
Another issue is that shareholder dilution is built into a SPAC’s warrant structure. So if the value appreciates, incremental bits of value (sometimes as high as 10%) are shaved off the top to benefit the dealmakers. Similarly, these vehicles are incentivized to become highly leveraged, similar to the risky leveraged buyout deals you see in the private equity world.
However, whereas private equity partners conduct entire research pipelines on their investments to determine if the debt is sustainable, most retail SPAC buyers do not.
This can create a set of potentially perverse incentives for management that many investors are beginning to come around on. Still, there is a simpler, overarching trend putting SPACs under pressure.
Above all else, SPACs are a play on cheap money. Because SPACs are so highly leveraged, a low cost of capital goes a long way to making a deal feasible.
SPACs tend to target early-life cycle companies that are still pre-revenue, like Virgin Galactic (SPCE), meaning these companies usually have yet to generate any sales.
If money remains cheap well into the future, growth for these companies becomes much easier, and valuations rise.
In 2020 and early 2021, money was historically cheap. Not only did the 3-month U.S. Treasury suddenly fall right to the floor, but the 10-Year U.S. Treasury remained at less than 1% levels for a 10-month run. This was long enough for entire SPACs to be formed and run deals, and why there were so many SPACs in 2020.
SPACs had existed long before last year as a niche tool.
Until borrowing money became inexpensive, it didn’t make financial sense. For decades, the model received little attention. This changed with the recent government-driven liquidity infusions and low interest rates, sending SPAC valuations soaring.
But the cost of borrowing has since risen. Although the risk-free rate is still shockingly low, the 10-year Treasury yield, a good approximation of the long-term cost of debt, is back above 1%.
SPACs are now finding it difficult to source new deals and make existing deals work. It reflects the model’s delicate nature. While the traditional IPO model may be tedious upfront, it works in a far wider range of economic conditions compared to SPACs.
Debt markets fuel so much of what goes on in the equity markets and the economy. This is why every Monday, when we give you a picture of the market, we often talk about debt and how it matters in an investor’s portfolio.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research