Three centuries have passed since the launch of “a company to carry out a company of great advantage, but no one knows what it is.” It’s easy to think that only fools would invest in a shell firm that doesn’t state its objective. But the investors in the most famous of the so-called bubble companies, which emerged in London in 1720, were not complete idiots. As its shares were issued partially paid, they were highly leveraged at a higher price. Some made 30 times their initial fee. Now, most of the participants in the craze for blank check vehicles, special purpose takeover companies, or SPACs, are rational. But even rational bubbles eventually explode.
The 1720 firms encompassed a wide variety of offerings, such as “settling in Terra Australis,” making starch from potatoes, the hair trade, as well as others for supplying funerals, extracting gold and silver from lead, and “for empty the necessary houses ”(public toilets). The goals of SPAC’s recent batch are even more ambitious: flying taxi startups, synthetic meat, recyclable plastic, and, of course, a cannabis producer. Many make electric vehicles, sensors and batteries, these are renamed “electrification solutions for commercial applications.”
This year, more than 300 have been launched, raising 93 billion dollars, more than in all of 2020. But not everyone is 100% committed. Investors in these IPOs can ask for their money back when it merges with their target. What’s more, they can keep the warrants of the merged entity. In effect, they are buying convertible bonds without risk. The prefusion SPACs are giving double digit returns. A group of hedge fundsKnown on Wall Street as the “SPAC Mafia,” they use leverage to get bigger profits.
The promoters have an even more lucrative business: in the IPO, they put some cash to cover the costs. In return, they receive warrants and a 20% stake. The odds are so great in their favor that they can even win from trades that destroy value for other shareholders. At the time of the merger, the SPAC raises more in a so-called “private investment in public capital,” or PIPE. New investors are offered lower-than-market stocks, warrants, and other sweeteners.
It is estimated that the listing through a SPAC is three times more expensive than a traditional IPO: it sounds strange that this is chosen. But it offers a faster way to go to market, and thus take advantage of the speculative euphoria. When Tesla soared into the stratosphere, many SPACs announced mergers with new industry firms.
The promoters of 1720 made impossible promises. Those from the SPACs also speak of fantastic prospects. Unlike conventional IPOs, firms that merge with SPAC have more freedom to forecast sales, earnings, and valuations. Silicon Valley is delighted to turn to this “lemon market” to shed its failures: WeWork plans to debut through a SPAC.
The big losers are those who buy shares at launch, but don’t trade them in the merger, and those who buy after the merger. Not only is this Monopoly money, but your investment is diluted by all those warrants and the huge participation of the promoters. Why do they do it? Theorist Bill Bernstein suggests that people who enjoy gambling are willing to pay more for shares than they are worth. His “investment entertainment price theory” (Inept) explains why investors stick to SPACs even though, on average, they are guaranteed to lose money.
It is no coincidence that the SPAC market slowed in late February, in tandem with the collapse of GameStop, traded by Inept investors at Robinhood. The SPACs have many fronts. Its all-you-can-eat buffet is disappearing, as the number of warrants issued on IPOs falls. The impending expiration of the 2020 trading locks could soon flood the market with more SPAC shares. It is feared that the hundreds of them looking for operations will have problems finding suitable partners, as well as obtaining PIPE financing. Promoters are on the tightrope.
Several are lowering their goals. For example, when electric car battery maker Romeo Power announced a SPAC in October, it was forecasting sales for 2021 of 140 million, with growth of 59% in five consecutive years. But at the end of the first quarter, he lowered his forecast for 2021 to 18 million. It has fallen more than 75% from the high.
The SEC says it is examining “some significant and yet undiscovered SPAC issues.” It suggests that they may not have properly accounted for their warrants. It will also clamp down on shell companies that make misleading statements during their mergers. If the “safe harbor” rule that protects SPACs from lawsuits is removed, as seems likely, their advantage over conventional IPOs disappears. There is also concern that some may have spoken to their merger partners before their IPOs: if true, it would be a blatant breach of market rules.
In June 1720, the English Government declared that companies that had not been officially endorsed by Parliament were a “public nuisance.” That regulation wiped out the firms in the bubble, and its collapse brought down the London Stock Exchange. Only two of those companies continued to operate. Historians will undoubtedly call the SPAC frenzy the most rational bubble the world has ever seen.
The authors are columnists for Reuters Breakingviews. Opinions are yours. The translation, of Carlos Gomez Down, it is the responsibility of Five days