The SPAC Attack
While previously viewed as sleazy and shady, it seems that suddenly many people, including Shaq O'Neal and Paul Ryan, are involved with a SPAC. How have SPACs taken Wall Street by storm, and why are they suddenly so popular?
What are SPAC's?
A SPAC is a Special Purpose Acquisition Company, also known as a blank check company. What do SPAC’s sell? What services do they provide? What is this company about? Absolutely nothing.
SPAC’s are a clever way to circumvent the traditional IPO process, which can be a very long regulatory process. This is essentially how it works:
SPACs’ process of going public is the opposite of how the normal IPO process works. Instead of providing lots of business details so investors can make decisions, investors pool their money together before they know anything about the SPAC. Basically, investors pool their money for something that they have no information about. Usually what happens is that investors are willing to give money to a SPAC organizer that is highly reputable and experienced because they trust their management.
SPAC’s can then easily go public without having to go through the normal scrutiny of an IPO because they have no real operations to report in the first place. After going public, a SPAC then seeks out a real company that hasn’t gone public yet and buys it out. After merging, the SPAC now takes on the name of the real company, and the real company has successfully gone public without having to disclose all of their operations and numbers for scrutiny. The SPAC sponsors are now happy because they own stock in a real company, the SPAC organizer is happy because they get a large portion of equity as a reward, and most of all, the company is happy because they have successfully gone public.
What's the significance of the rise in SPAC's?
This recent uptick in SPACs raises several concerns.
The first issue is regarding the potential increase in fraud. Companies that use SPACs to go public don’t face as many regulations. Consequently, there is much less pressure to have accurate and transparent bookkeeping. Theoretically, any company that wants to go public just has to convince the SPAC organizer that they’re worth buying. One recent example that demonstrates this issue is Nikola, which merged with a SPAC and was later accused of fraud.
This leads to the next issue: transparency. What about the secondary market? Should you invest in SPAC’s, and how risky is it? As an investor on the secondary market, buying a SPAC that hasn’t merged yet is quite risky because you have no idea what the SPAC will buy out. Furthermore, even if a SPAC has already been merged, you often don’t have enough transparent information about the firm that has been bought out. This lack of transparency is a huge disadvantage to the investor.
One more point of concern is the reward that SPAC organizers receive. SPAC organizers are incentivized to merge with a company, sometimes even when the company doesn’t have good prospects because regardless, they will be rewarded with a large amount of equity. With these incentives, it is entirely possible that the SPAC manager merge with a mediocre company at the expense of investors. There needs to be a realignment of incentives between the SPAC sponsors and SPAC manager.
The SEC is aware of these points and have pointed more of their attention to SPAC’s recently.
The future outlook for SPAC's
In 2020, SPACs were red-hot. Will the bubble burst anytime soon? David Erickson, a Senior Fellow of Finance at the Wharton School, thinks so. Erickson is drawing parallels between the Dotcom bubble of the 2000s to this recent SPAC trend. The returns of SPAC’s post-merger are not very promising, and investors will eventually lose enthusiasm. It is only a matter of time before the market reflects this correction. But SPAC’s are becoming popular in other places too, now racing to Asia to find new targets, where the economy is booming.
It will definitely be interesting to see how SPAC’s evolve. Will the bubble burst? Will regulations be put in place? Only time can tell.