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What do tennis great Serena Williams, NBA legend Shaquille O’Neal, former baseball superstar Alex Rodriguez, music icon Jay-Z and former House Speaker Paul Ryan have in common?
All are the celebrity faces of one of the hottest “new” Wall Street financial products around, the “special purpose acquisition company.”
SPACs, or “blank check companies,” are touted as a cheaper, quicker way for private companies to go public and have actually been around since the 1990s. SPACs have generally lived in obscurity, inhabiting the backwaters of Wall Street and flying under the radar of most investors.
The pandemic changed all that. The combination of a low $10 price tag and dreams of getting in on the ground floor of the “next Facebook” became catnip to the new army of individual investors, enticed further by “free trades” on online brokerage platforms like Robinhood and sending the SPAC sector “to the moon.”
SPACs generate humongous fees for the Wall Street firms that underwrite their initial public offerings. From 2003 to 2019, an average of 17 SPACs a year had IPOs, with a high of 66 in 2007. In 2020, 248 SPACs had IPOs, more than the previous 12 years combined. Incredibly, last year’s record was broken in just the first three months of 2021, with 297 SPAC IPOs (80% of the total IPOs) raising $97 billion (70% of the total IPOs), more than the amount raised from 2003-2019 combined.
Clearly, SPACs are on fire.
Unlike regular companies, SPACs are “shell companies” with no commercial operations at the time of their IPO. Instead, they raise a pool of money with the intent of merging with a privately owned operating business, usually within two years. When the merger transaction closes, the private company assumes the SPAC’s identity as a publicly owned company. Voila!
The management team, or “sponsor,” of the SPAC might have a demonstrated track record in a target industry or otherwise had success with mergers and acquisitions. In essence, investors are betting solely on the “jockey,” as even the identity of the “horse” is unknown. They raise money from investors in an IPO, typically at $10 per share.
The IPO proceeds are placed in an escrow account, where they earn interest. SPACs typically pay 5.5% of the proceeds as an underwriting commission, with 2% paid at the time of the IPO and the remaining 3.5% payable only upon completion of a merger. The sponsor typically purchases up to 20% of the post-IPO shares (with no access to the escrow account) for a nominal amount, which is used to pay the upfront underwriting commission and ongoing expenses of the SPAC.
When a SPAC proposes a merger, the SPAC shareholders have an option to redeem their shares rather than participate in the merger and get back their full, proportional investment, plus interest. Since the escrow account contains the original $10 per share from the IPO (plus some interest), redeeming shareholders are entitled to receive a little more than $10 per share, whether they paid $10 per share or $50 per share.
Similarly, if a SPAC is unable to consummate a transaction by the end of the two-year period, the escrow account is distributed to shareholders and the SPAC liquidates. The Wall Street underwriter doesn’t get its remaining commission. The sponsor’s 20% equity position expires worthless.
It’s pretty clear that, the closer the two-year deadline gets, the more the interests of the sponsor and shareholders diverge. From the sponsor’s point of view, even a bad deal is vastly superior to no deal (and liquidation).
At the recent Berkshire-Hathaway annual meeting, Warren Buffett bemoaned the tidal wave of SPACs as “a killer.” Indeed, there are currently 400 SPACs searching and competing for merger targets (and presumably willing to make bad deals), which makes it tough for Buffett to make acquisitions that make economic sense. Referring to the speculative fever apparent in certain sectors of the market, Buffett said, “nobody tells you when the clock is going to strike 12 and it all turns into pumpkins and mice.”
In the other corner is the Pied Piper of the SPAC craze and “King of SPACs,” Chamath Palihapitiya, a former Facebook executive and sponsor of six SPACs that have raised over $4 billion. Palihapitiya envisions himself creating a Berkshire-like conglomerate and said in a recent interview, “Nobody’s going to listen to Buffett, but there has to be other folks that take that mantle, take the baton and do it as well to this younger generation in the language they understand.”
I’m with Buffett.•
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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.
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