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The IPO alternative reached a zenith and has now undergone a dramatic decline as the allure of easy money has given way to compliance-dodging reality. By Nuno Fernandes, professor of finance at IESE Business School.
Financial innovation can be useful, but, as in many other industries, there are innovations that serve no purpose. One such example of this – special purpose acquisition companies (SPACs) – were, for a short while, a new way to go public on Wall Street.
For young growth companies it became the norm, and SPAC volumes rose above that of traditional initial public offerings (IPOs). An appetite for novelty, financial illiteracy, and excessive liquidity helped fuel that market frenzy.
SPACs are blank cheque companies that go public, raise capital, have no actual commercial operations, and have a two-year lifespan. They are created by a sponsor to raise capital through an IPO, and later use it to acquire a privately held operating company.
This is the ultimate goal of SPACs: to find and acquire other companies, at which time more money will have to be raised from investors. The process of acquiring and listing the target private company is called a “de-SPAC”. If the management team fails to merge or acquire a company within two years, the SPAC will be liquidated, and the investors reimbursed (minus fees and transaction costs).
Looking back at the boom
SPACs raised hundreds of billions of dollars in 2020 and 2021. In 2020, SPACs reached 53% market share vs IPOs in terms of NASDAQ listings. In 2021, SPAC numbers more than doubled, and the amount raised ($162bn) surpassed that of 2020 ($83bn).
In Europe, SPACs were never as popular as in the US. During 2021, for instance, there were more than 600 SPAC IPOs in the US, whereas in Europe they numbered fewer than 50 (with Euronext and London responsible for the majority).
SPACs are created by proactive (and often very media-friendly) sponsors, raise significant cash at IPO, and then search for targets. Sponsors of SPACs typically receive hefty fees from the blank cheque companies they set up, regardless of actual investor returns. Indeed, for investors, the evidence reveals a pattern similar to prior research on traditional mergers: most destroy value for acquiring shareholders.
Many of these SPACs were sponsored by celebrities such as Shaquille O’Neal or Serena Williams, with the goal of generating publicity and buzz among uninformed retail investors. In March 2021, the SEC warned that celebrity involvement in a SPAC does not make it an appropriate investment for all, because “celebrities, like anyone else, can be lured into participating in a risky investment or may be better able to sustain the risk of loss”.
SPAC drawbacks
Compared with a SPAC, an IPO requires comprehensive preparation involving the whole organisation and a full SEC review process. Consequently, IPOs can take much longer. Related activities in SPACs are also different. Instead of a roadshow, which typically involves thorough due diligence on the company preparing for an IPO, investors in SPACs put money in a target industry segment and a management team.
A SPAC is a type of reverse merger. In a reverse merger, a private company merges with a listed company and thereby goes public. It saves the private company from having to go through most of the strict regulatory process of a traditional IPO. However, it exposes later stage investors to added risks.
There are, however, (good) reasons that the traditional initial IPO process takes some time and has associated costs. To start, in this process a number of checks are performed on the company, including its audited financial statements, compliance and other internal controls have to be developed.
scores of companies that went public using SPACs are reporting failures of internal controls, poor bookkeeping practices, and significant other weaknesses
Additionally, prior to an IPO, the underwriter is liable for misstatements in the companies’ documents and prospectus, which pushes them to improve the quality of accounting practices of companies that are about to go public.
Nothing like this exists in the SPAC world. It should be no surprise that scores of companies that went public using SPACs are reporting failures of internal controls, poor bookkeeping practices, and significant other weaknesses in their accounting practices. Often, even the revenue line is not correct under the Generally Accepted Accounting Principles.
Novel does not mean useful
Investment scams are everywhere, from crypto to coin collections. Investors looking for quick and easy returns should be careful.
As in prior bubbles, from the South Sea Bubble to subprime loans, when a great mania emerges, several new companies arise and everything appears rosy. Further, when there are lots of buyers with deep pockets looking for sellers, the price tends to go up.
Buying companies at high prices is a sure way to have low future returns and, eventually, losses. Similarly, in other areas of finance, bad incentives have also led to negative outcomes. As Warren Buffett once said, only when the tide goes out do you discover who has been swimming naked.
Private companies used SPACs to go public based on rosy growth projections at the same time as they were burning significant amounts of cash. The SPACs party is over. And the return to traditional IPOs should become the norm again.
Fundamentally, investors should beware of novelty, but above all, think about the fundamentals of value creation. Once again, acquiring shareholders, like in the traditional mergers and acquisitions world, are not those who capture most of the value from these deals.
Critical thinking, a focus on the levers of value and proper due diligence trumps celebrity involvement.
Nuno Fernandes is a professor of finance at IESE Business School, board member, and the author of Finance for Executives: A Practical Guide for Managers.
