SPAC Frenzy!
Ecosystem
March 2, 2021

SPAC Frenzy!

Gaussian Team

Many private companies are going public through SPACs. In 2020, SPACs have raised as much cash as they did over the past decade. Two-thirds of this amount was raised just in the past three months. 

This reality has been subject to some contention. There are certain advantages in a SPAC, ranging from guaranteed price to speed, but the approach also has its challenges.

Are SPACs here to stay? History may have some answers. Let's explore.

What is a SPAC?

A special purpose acquisition company (SPAC) is a type of cash shell, a company with no operations but a lot of cash. The idea is that the SPAC goes public via an IPO, with nothing but a large bank account, with which it will acquire a private company and merge with it ("reverse merger"), thereby effectively taking the private company public without the private company having to jump through all the regulatory hoops of an IPO themselves.

SPACs have two years to look for a private company to merge with. The shares are redeemable at the time of the proposed merger, so if SPAC investors refuse the merger they can get back their full investment in addition to a high return.

SPACs became especially popular in the US before the 2008 financial crisis. Private firms use SPACs as an alternative route to get listed, particularly when the markets are volatile and IPO activity is weak. 

Standard reverse mergers versus SPACs

Also referred to as reverse takeovers, reverse mergers are a way for private companies to go public without going through an IPO.

As Ivana Naumovska explains, a standard reverse merger involves a private company merging with a listed empty shell to go public. In cases like these, the shell is usually a leftover of a previously operational public company. With SPACs, the only difference is that the shell company is a proactive party that "hunts for private targets."

Reverse mergers have existed for decades. They’ve surged in the 2000s and peaked in 2010, before bursting in 2011. 

Ivana suggests that this particular dynamic that was present during the bust of the reverse mergers almost ten years ago is re-emerging in current SPACs; this is demonstrated through the frenzied growth, as well as regulatory concerns over the quality of targets.

The challenge with reverse mergers

Reverse mergers are certainly a less costly and less time-consuming alternative. So what's the rub?

Reverse mergers (incl SPACs) are a way to avoid regulatory scrutiny and invites fraud, like we saw with Nikola.

Reverse mergers have also severely underperformed historically. Of 107 SPACs that have gone public since 2015, the return on the common stock has been a loss of 1.4%. (As a comparison, the average return of companies going public via IPO during the same period was 49%.) Similarly, the current SPAC boom could be detrimental, especially for those retail investors who don’t fully understand the risks. As Howard Schilit, head of accounting at Schilit Forensics puts it, SPACs are highly speculative and shouldn’t be sold to investors at an early stage.

SPAC burst? No so fast

Financial experts warn that the SPAC frenzy could end badly for the investing public. ASahm Adrangi, founder and CIO at Kerrisdale Capital Management, many people have made money with SPACs and they don’t realize it’s not sustainable.

With all that said, a $1.9T stimulus, low-interest rates, sky-high valuations, and $2T in additional consumer savings from the pandemic that will be unlocked as normalcy returns, the SPACs bubble won’t burst soon. The stock market reflects sentiment. (Increasingly, it is hard to say exactly whose sentiment.) And the sentiment is strong!

Final words

The SPAC boom is likely not sustainable in the long term. But with strong economic growth, powerful labor market, low interest rates, and high valuations, the markets will likely continue to overlook the negative outlooks, high risks, and poor historical returns.

But that's what's fun about our merry technology ecosystem—unpredictable, uncertain rollercoasters. Rather than guessing with SPACs will tank, we should likely investigate new ways to insulate ourselves, our businesses, and our funds from ever-pervasive uncertainty.

Photo by Gilly.

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