SPACs Aren’t 2000 IPO Mania’s Second Coming

Editors’ note: MarketMinder doesn’t make individual security recommendations. Those mentioned herein simply represent a broader theme we wish to highlight.

What do a space travel company, orbital tugboat builder, electric truck maker, next-generation battery developer, self-driving bus startup, fantasy sports operator, “aspirational lifestyle” retailer and a century-old snack maker have in common? All recently went or plan to go public, but in an unconventional way: as buyout targets of special-purpose acquisition companies, aka SPACs or “blank check” companies. As initial public offering (IPO) booms—particularly niche ones—usually do, SPACs’ sudden proliferation has prompted many pundits to draw parallels with 2000, citing froth and fervor. We think this is a bridge too far, although it is wise to be aware of the risks you may be taking on if you choose to dive into this space.

SPACs are a way for private companies to go public without the traditional (and costly) rigmarole of an IPO. Essentially, they are shell companies with one purpose: to acquire existing, privately owned firms using funds raised on the public markets. If we were into analogies, we would probably call them “midwives for startups” or something similarly reductive, but then all analogies are bad analogies. To set that aside, here is how it works: First, a SPAC registers with the SEC to go public through an IPO. A SPAC usually starts with a few high-profile backers to give it gravitas and attract would-be investors, and it quickly IPOs the traditional way to raise more capital on the open market. Its initial “business model” is only to merge with one or more private companies that don’t want to go through the hassle themselves, and investors are buying the potential of that merger. But it is frequently a grab-bag, as SPACs generally don’t have a target in mind. Instead, the SPAC’s capital usually sits in a trust while the principals hunt for a company to buy within a predetermined window. If all goes according to plan, the SPAC finds a target, buys it and, essentially, becomes that company.

SPACs have been around a long time, predominantly in the life sciences realm. But more recently, they have gained headlines for snapping up Tech-like companies, particularly in alternative energy and next-generation vehicles. In one high-profile case drawing regulatory scrutiny recently, a SPAC named VectorIQ was under the gun to find a merger target before it had to return shareholders’ capital. It rushed to pick up electric truck maker Nikola. The company is now under investigation by the SEC and DoJ for allegedly fraudulent claims the truck maker’s recently departed founder and executive chairman made. It also faked a demo video of its semi-truck, which didn’t have a working engine. Those incidents, plus the sheer volume of SPAC deals, is what started all these dot-com comparisons.

We aren’t so sure those comparisons are warranted. According to one SPAC tracker, there have been 147 deals so far in 2020 for a total of $56 billion, more than the previous 10 years combined.^[i] In 2000, which remains IPOs’ peak fundraising year, there were 445 IPOs, raising $108 billion.^[ii] So yes, SPACs have boomed, but the numbers here are a shadow of the dot-com era. Plus, the stock market is a lot bigger now. The S&P 500’s market capitalization in 2000 was around $12 trillion, versus $29 trillion or so now.^[iii] There are also qualitative differences, as not all of these companies are startups. Many come from private equity portfolios and are returning to public markets after a turnaround, making them generally more mature and time-tested. And then there is Utz, the snack-maker, which went public via a SPAC merger after 99 years of private family ownership. Not everything in this sphere is operating on a wing and a prayer. We aren’t arguing the SPAC world is froth-free, but it seems more like niche euphoria along the lines of Biotech stocks or gold and silver in the early 2010s or bitcoin in 2017—isolated frenzies that didn’t spill over into broader markets.

We think it is also worth considering why companies may be going the SPAC route and whether it is a case of markets innovating around a sore spot. Not only has there been a relative dearth in IPOs over the last several years, but the number of publicly traded companies in the US has plunged as many returned to private ownership. According to the World Bank, America’s listed companies have almost halved from 8,090 in 1996 to 4,398 in 2018, the latest available figure.^[iv] More companies going public via SPACs may simply be a way of addressing what many commentators saw as a long-running structural decline in public companies.

In our view, the dearth of US IPOs over the last several years wasn’t just a dot-com hangover. 2002’s Sarbanes-Oxley Act added a lot of costs and red tape to the IPO process, making it prohibitively expensive for many fledgling startups. This is a well-known problem, which Congress and the SEC have tried to address for certain companies (e.g., “smaller reporting companies” with sales less than $100 million and “emerging growth companies” with revenues under $1.07 billion), but that didn’t clear the logjam. This has led promising early-stage companies to seek several rounds of venture capital funding before they achieve sufficient scale to set off on their own—and reward backers. The whole process doesn’t just take oodles of time—it also dilutes early investors’ (including founders and front-line employees) holdings, leading to mountains of frustration when the company eventually gets bought or goes public.

SPACs seem to us mostly like a solution to Sarbanes-Oxley’s compliance costs. For an acquisition target, the regulatory and disclosure requirements for a reverse merger with a publicly traded SPAC are far less onerous than an IPO. Note, however, that we are not cheerleading for this, and it isn’t necessarily a net benefit for all involved. The structure also shifts more of the due-diligence grunt work onto shareholders, who vote on its acquisitions. (This is both a plus and a minus, because a shareholder who rejects the move can get their capital back plus some small amount of interest, typically.) IPOs rely on underwriters to ensure companies they take public are up to snuff—and to assume liability if they aren’t. In either case, it is up to the investor to understand what they are buying and the risks associated with it. But in the SPAC universe, it can take a lot of time, effort and research to know what you are actually buying.

We aren’t inherently for or against any stock, but we have often found wisdom in the saying that IPO stands for “it’s probably overpriced,” and we suspect the same logic applies to SPACs. Most see only a limited number of good targets and may not be buying on the cheap—particularly if they are buying from private equity or hedge funds, which are trying to turn a hefty profit of their own. Some SPACs may not even find a company to buy before the clock runs out. We largely agree with those who find the whole arena to be rather speculative, with people seduced by the prospect of quick riches. But long-term investing isn’t about quick riches. Done successfully, it is about getting market-like returns over the long haul, relying on the magic of compound growth.