Eager for action and hot for the game. The coming attraction, the drop of a name. Blowin' and burnin', blinded by thirst, they didn't see the stop sign…took a turn for the worst. – The Eagles, “Life i...
Eager for action and hot for the game. The coming attraction, the drop of a name.
Blowin' and burnin', blinded by thirst, they didn't see the stop sign…took a turn for the worst.
– The Eagles, “Life in the Fast Lane”
We are always on the lookout for what inning we are in in the investment cycle of a bull market. One tell-tale sign that the bull run is nearing the ninth inning is observing the products that somehow jump out of the “Adult Swim Only” section and pour into the “Children Under 12 Only” one. Special Purpose Acquisition Companies (SPACs), also known as “Blank Check Companies,” are such a case. The Wall Street Journal and The Financial Times both featured SPACs in articles Friday:
Moreover, last week, Bloomberg News quoted Olympia McNerney, Head of Goldman Sachs SPAC Group, who warned that the market was getting “perhaps too frenzied,” which says something considering how lucrative SPACs are for Goldman.
A SPAC or a “Blank Check” company has a sponsor, usually a private equity fund or hedge fund manager or investment banker. The sponsor for the SPAC raises funds through an Initial Public Offering (IPO). Both institutional and retail investors can participate. The sponsor is incentivized to form the company, as it gives them a flexible pool of money that they can put to work buying private companies, bringing them public and getting around some of the reporting and filing requirements of the regular IPOs they would have to do if they purchased the target companies and brought them public directly.
It is important to note, at the time of the SPAC IPO, investors may not know the specific details on what the sponsors will purchase. This should cause a potential investor to give some pause. Firstly, investors are not quite sure what the SPAC will invest in. While flexibility could be a good thing, uncertainty is usually not. Secondly, here is a great quote from the Wall Street Journal article, in which a law professor at Stanford and former SEC commissioner Joseph Grundfest stated about SPACs:
“It’s a perfectly legal regulatory arbitrage.”
In any “arbitrage” there are winners and losers, a zero-sum game if you will. Since SPACs get around certain guardrails of normal IPOs, that sounds like the SPAC sponsor is the winner of said arbitrage and the investor is the net loser. We do wonder if there should be such a thing as “regulatory arbitrage” and shouldn’t the SEC be a bit bothered that the goal is to get around some pesky disclosure rules that are normally incumbent for an IPO?
Moving on, after the SPAC sponsor has raised capital from investors in the IPO, the investors now own shares in the Blank Check Company. In addition, the investors get warrants on the Blank Check Company. At this point, the SPAC is just a pool of publicly traded capital looking to invest in a private company or a portfolio of private companies. The way many SPACs are structured makes it very lucrative for the sponsor.
For example, this summer, a recent SPAC sponsored by Goldman Sachs raised $700 million at $10 per share. They paid $16 million for warrants to acquire eight million shares at $11.50 per share and received Founders Shares for 20% of the company for $5,000. On the day of the closing, that $5,000 payment yielded them $140 million of stock, assuming a deal closes. You read that right, Goldman Sachs gets 20% of the SPAC—or $140 million of stock for $5,000—and they get this whether the SPAC appreciates, declines, or stays the same in value. With the $16 million outlay for the warrants and the $5,000 for the Founders Shares, this $700 million SPAC can lose more than half its value, and the sponsor—in this case Goldman—will still make a fantastic return.
The cautionary tale here is when the market is blistering hot and returns on relatively safe investments are less than paltry, investors start reaching and SPACs certainly seem like a reach too far, especially when it appears that the sponsor either makes a lot if you lose—or makes exponentially more than you if things go right. That is an arbitrage that the investor is clearly on the wrong side of.
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