SPACs Are Sputtering. Desperate New Terms Could Send Them Into a Death Spiral.

When law professors Michael Ohlrogge and Michael Klausner first started studying special purpose acquisition companies four years ago, they were stunned by what they found. Looking at companies that had merged with SPACs in 2017 and 2018, the valuations were so terrible that the professors wondered why anyone would resort to going public via a SPAC.

But the professors were quickly disabused of their study’s conclusions. “Everybody told us, ‘Oh, no. The 2015 IPOs, the 2017, 2018 mergers — everybody knows those were the bad ones. Now they’re different,’” recalls Ohlrogge, an assistant professor at New York University School of Law.

So the professors threw out all their work and collected a whole new batch of data based on 2019 and 2020 SPACs — but their bottom-line conclusion wasn’t any different.

SPACs are a complicated, opaque investment structure in which sponsors raise money in an initial public offering — creating what’s known as a blank-check company — and then go out and find a company to buy with that box of cash. To accomplish this task, they offer the IPO investors an incredible deal: a money-back guarantee on their initial $10-per-unit investment, including shares and warrants plus interest. The sponsors themselves skim a lot off the top, taking 20 percent of the IPO units for a nominal fee.

Ohlrogge and Klausner, a professor at Stanford Law School, discovered that these costs quickly added up: The dilution from warrants issued in the IPO, along with virtually free shares for sponsors and banking fees for both the IPO and the merger that ended up being two to three times higher for a SPAC than for a traditional IPO, all ate into the amount of cash the companies had once the merger happened. Because the companies passed on these costs to the remaining shareholders, the companies ended up with about 40 percent less cash than they started with.

“And then they’re trying to turn a profit for their investors when they’re starting 40 percent in the hole,” Ohlrogge explains. “That’s just really hard to do, and there’s just very few sponsors who can surmount that on a regular basis.”

The stock prices bear out the analysis. More than 300 companies that have gone public via SPAC mergers since the start of 2018 have averaged a loss of about 33 percent from the IPO price of the SPAC, versus an average loss of 2 percent for the 1,000 other companies that chose to go public through a traditional IPO as of mid-April, according to Renaissance Capital, which tracks IPOs. Compared with the S&P 500, which gained more than 50 percent during that time, the SPAC numbers are little short of a disaster.

But in October 2020, when the professors published their study — “A Sober Look at SPACs” — the stocks of SPACs were soaring even before the sponsors found targets. Few would listen to the criticisms.

“People were like, ‘Oh, no. The ones you analyzed, everybody knows those were the bad ones. It was obvious. But now they’re good,’” Ohlrogge told Institutional Investor in a recent interview.

Investment bankers, investors, and SPAC sponsors all sang the same refrain: “It’s different this time.”

To be sure, SPACs had previously been a murky backwater of finance; they were known as the vehicles through which second-tier private equity companies dumped their dodgy holdings into the market by offering IPO investors — mostly hedge fund buyers known as the SPAC Mafia — free money in the form of easily redeemable shares and warrants. Following the financial crisis of 2008 — which halted SPAC issuance for a few years — the Securities and Exchange Commission decided to let IPO investors vote for the prospective merger even if they wanted to cash out, at which point they could get all their money back, with interest, and keep their warrants.

Ohlrogge and Klausner weren’t the only people trying to sound the alarm about the structural weaknesses of the SPAC model. Pershing Square Capital CEO Bill Ackman, who launched the world’s largest SPAC with $4 billion in July 2020, criticized SPACs’ free sponsor shares as “egregious” and said he would take none. He also changed the terms of his SPAC’s warrants to entice investors to stick around, limiting the warrants’ potential for dilution.

Short-sellers also recognized trouble was brewing. Hindenburg Research founder Nate Anderson became famous in September 2020 for his truck-rolling-down-a-hill video exposé of electric-truck maker Nikola — the first big SPAC short during the boom and one that was followed by criminal charges against founder Trevor Milton, who has pled not guilty.

“SPACs have always been an inferior way to go public. But they are a quick way to go public,” says Anderson, who went on to target five other so-called deSPACs — postmerger SPAC targets. They include Clover Health Investments, Lordstown Motors, DraftKings, Pure Cycle, and Tecnoglass. “There is still an extensive number of companies that are trading at multibillion-dollar valuations that are worth nothing at all,” Anderson notes.

But such warnings were largely ignored as the new crop of SPACs were sponsored by top-notch Wall Street players like hedge funds and venture capital and private equity mavens. The list of brand names is practically endless, including people like former Goldman Sachs CEO Gary Cohen and former Citigroup banker Michael Klein; investing pros Barry Sternlicht and Bill Foley; tech superstars Reid Hoffman and Chamath Palihapitiya; hedge funds Pershing Square, Starboard Value, Glenview Capital, and Third Point; and private equity funds Apollo Global Management, KKR, TPG Capital, and Fortress Investment Group.

Big banks like Citigroup, Credit Suisse, and Goldman Sachs were suddenly topping the SPAC underwriting league tables, while multibillion-dollar hedge funds Millennium Management, Magnetar, and Citadel became some of the biggest investors in SPAC IPOs. Institutional investors Fidelity, BlackRock, and T. Rowe Price were also moving heaven and earth to get allocations into PIPEs — private investments in public equities — which supplied the additional capital required for SPACs to consummate their merger deals, especially when many IPO investors redeemed.

Surely the combination of all this smart money would make SPACs better. But it didn’t. A few months after Ohlrogge and Klausner suggested taking a “sober look” at SPACs, the bubble began to burst. Instead of recognizing that the analysis was spot-on, however, SPAC participants had another answer. “Now I’ve had people tell me like, ‘Oh, everybody knows that the late-2020 and early-2021 SPACs are the bad ones. It was just too much optimism and too bubbly. Now they’re good,’” Ohlrogge recalls.

“There’s no limit to how many times people can make this claim,” he adds, sighing.

The SPAC model has always been an ingenious, if complicated, way to convince investors and companies alike to hop aboard the gravy train, and now sponsors (and their bankers) are coming up with creative ways to keep it chugging along. But Ohlrogge says some of the new features are only making things worse.

“They have the potential to turn into a death spiral for SPACs.”

You can read the rest of my story here:

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