About this Episode

Special purpose acquisition companies are having a moment. But who is making the money and what is being lost when a company chooses to ride a SPAC to public markets? Ivana Naumovska of INSEAD joins the Essential Podcast to share her insights on SPACs, reverse mergers, and the dangers of regulatory arbitrage for retail investors and entrepreneurs.

The Essential Podcast from S&P Global is dedicated to sharing essential intelligence with those working in and affected by financial markets. Host Nathan Hunt focuses on those issues of immediate importance to global financial markets – macroeconomic trends, the credit cycle, climate risk, energy transition, and global trade – in interviews with subject matter experts from around the world.

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Show Notes

• Read Ivana Naumovska’s Harvard Business Review article on the SPAC bubble.

Transcript

Nathan Hunt: This is The Essential Podcast from S&P Global. My name is Nathan Hunt, special purpose acquisition companies or SPACs have been in the news lately. These shell companies are created for the purpose of taking a private company public without the effort and regulatory scrutiny of an IPO. The process is a kind of reverse merger. However, many market observers have criticized SPACs, believing that they prey on low-information retail investors with dubious promises of internet riches that rarely pan out. My guest today is an expert on both SPACs and reverse mergers. Ivana Naumovska is a professor at INSEAD, her research examines how social and economic forces jointly shape financial market dynamics. Among her recent publications is an article in the Harvard Business Review entitled 'The SPAC Bubble is About to Burst.’ Ivana, tell me about the market for SPACs at this point in time.

Ivana Naumovska: So, more than a hundred billion dollars have been raised in 2021, around 420 SPACs are searching for a target right now, which means that the competition is intense for good quality targets. The majority of those SPACs will not find a target just because of this intense competition. And what we are seeing also is that there are close to 300 SPACs that are awaiting to IPO. Interestingly enough in the past year, pretty much anybody who tried to raise a SPAC succeeded in that, but we are seeing some SPACs, or some SPAC attempts, being withdrawn, suggesting that the market is cooling. Also, if we just look at the SPAC activity in 2021, between January and March, in those three months, it was an average of 100 SPACs per month IPO'd. What we are seeing in the second quarter, April through June is that there are less than 20 SPACs per month. So, the market is cooling, investors seem to be a bit more selective, and these are all good signs of a correction and the SPAC vehicle reaching a state of equilibrium, where we are going to see better quality SPACs and potentially better quality targets.

Nathan Hunt: There seems to be a lot of froth in the SPAC space. Is the amount of noise in these markets itself an area for concern? 

Ivana Naumovska: SPACs are a new vehicle. There is a lot of experimentation there. Even people with a lot of experience are facing a lot of unknown unknowns. That being said, I agree with you that I would trust more, a person who has been in the private equity business or in the venture capital business, or has been a CEO of a publicly listed firm. The concerns with these celebrities are very legit. In fact, what we are seeing and what I have seen in my data is that people like Alex Rodriguez, Shaquille O'Neal, Ciara Wilson is a Grammy award-winning singer. These people attract and sway investors. So, if a SPAC that seeks to go public is endorsed or associated with or has as a sponsor a celebrity, then that SPAC has a greater likelihood of succeeding in its IPO than is going public, but it doesn't have a greater likelihood of finding a target or creating shareholder value but to the contrary. So yes, we see these celebrities that are riding this bandwagon and that are swaying investors to invest in given SPACs. We had hundreds of SPACs in 2020, and we've seen, we've seen hundreds in 2021. So, one way through which SPACs can attract attention in this very competitive market space is by being associated with people that attract attention - celebrities. So, they are in a way as marketing tools as they're endorsing a given view. I don't think that they are going to play any specific role in managing the SPAC itself or the post-acquisition. However, it is a concern from the perspective that they are individuals that are probably of high quality for what they're known for but do not have the necessary capabilities to run a SPAC vehicle or a publicly listed firm that is to be acquired. Not only investors and academics are increasingly concerned about celebrity endorsement in the context of SPACs, but so is the securities and exchange commission. In March they issued an alert saying to investors, "hey, investors. It's not a good idea to invest in a SPAC just because someone famous is associated with it." There are concerns from multiple fronts and I believe there'll be a correction when it comes to how investors react to celebrities and SPACs. 

Nathan Hunt: You're not alone in writing critically about SPACs. I saw an article this morning, actually in the financial times, it was an interview with Jim Chanos. He had some very critical things to say, partly that's not surprising. He is a short seller, and we would expect him to have critical things to say about investments in which he had taken a short position. But why do you think these investment vehicles continue to attract attention when so few market observers and investment experts seem to have much positive to say about them?

Ivana Naumovska: So, the jury is out, there are some people, some of the pipe investors, some of the sponsors that are very vocal in endorsing SPACs. On the contrary regulators, some academics, and investors are skeptical. Now, this skepticism is data-based. What we are seeing is that the returns of SPACs that have de-SPACed are negative. So, if you look at the SPACs between 2010 and 2020, what we're seeing is the annual return, depending on how you calculate it will be between minus 4% to minus 15%. Now, this is after this SPAC period once they acquire a target. If you look at the returns that happen during the SPAC stage, while the blank check is searching for a target, when investors have downside protection, those returns are positive. So, they are around 8 or 9%. They have been decreasing lately, but they're still in the positive. This data point in itself can be attractive to investors in the sense that one may think that they can make money throughout that shell stage or blank check stage phase. But here it's important to also consider who makes the money and it's typically the institutional investors that bought the shares or the units, when the IPO was taken place. The buy units at $10. What happens is that it's going to increase to 12 or 14 or 15? If they don't like the target, they get to redeem their shares. Instead, retail investors step in and buy it for $12, if they decide to redeem it, they will get only $10 on those $12. So, there are some misconceptions of who makes the money and from what we are seeing is that it's the sophisticated institutional investors that make the money. It's not the retail investors that joined as shareholders of the SPAC vehicle post IPO.

Nathan Hunt: Let's imagine I was an entrepreneur looking to take my company public? What is it about SPACs that might attract me despite their somewhat dodgy reputation?

Ivana Naumovska: First it's faster and it's more certain, there is no roadshow, there are no underwriters. The target, the private firm is negotiating basically a merger with a set of sponsors and a blank-check company that has all the incentives to acquire a target. Basically, the sponsors have incentives to acquire any target and that is the only way they get paid. And this is where the certainty comes in. So, it's faster and it's more certain. Another component, which is interesting and very controversial is the regulatory arbitrage that SPACs allow because what happens to us is that merger law applies throughout than securities issuance law and this law provides a safe harbor provision for forecasts, essentially allowing for regulatory arbitrage opportunity for these private operating companies. These targets can make very rosy forecasts because they fall under the safe harbor provision. They are being protected from investor's lawsuits. What has changed recently is that the SEC stated that they're looking into this safe harbor and that the SEC itself can certainly go after deals and individuals that make very rosy false promises. And I certainly expect more lawsuits and litigations against SPACs in the years to come. So, the first thing is faster and more uncertain. The second one is this regulatory arbitrage. And the third thing that is somewhat of a misconception that I have seen while I have talked to a few firms that have sought to go public through respect is that those private targets seem to believe that it's cheaper. So, they say it's cheaper to go public with a SPAC than an IPO. Now, this is a misconception because what we're seeing is the data is that the total cost of the median company goes public via SPAC merger between January 2019 and June 2020 was 14% of the post tissue market cap while it was only 4.8 for the traditional IPO's. So, there is this misconception that it's cheaper, but in fact, it's not, which suggests there is also selection in terms of who selects to go public through an IPO and who selects to go public through a SPAC. This means that typically risk your lower quality firms who will seek the SPAC route or the reverse merger route.

Nathan Hunt: SPAC boosters suggest that the process of raising money through an IPO is unnecessarily burdensome. As you say, from a legal and regulatory perspective. I guess the question is, are retail investors missing out on a chance to invest in say, a potential tech unicorn because of the rules around IPOs?

Ivana Naumovska: That is partly true. Typically, the firms that go public through IPO's are more mature, they have operating businesses, they're cashflow positive. A firm on average needs to have a history of good performance to qualify for an IPO. Proponents of SPACs have said that SPACs allow retail investors to take part in what have historically been reserved as investments by venture capitalists. And that argument is legit and many of us can see it as such. However, that does not mean that the SPAC vehicle, as it is today, allows for such positive returns and enables retail investors to take part in the upside of start-ups. SPAC vehicles have that potential, however, given the current structure and the way returns are distributed between retail, investors, pipes, and sponsors, retail investors don't really stand to make high returns on unicorns that go public through a SPAC.

Nathan Hunt: Okay, let's say I had a company that was popular with an audience of primarily male internet savvy investors. So, a potential meme stock in the media. Shouldn't my potential investors be given the opportunity to make money on the movement in my company's evaluation? Even if my balance sheet doesn't necessarily point towards an IPO, what is, what is wrong with taking a buyer-beware approach to public markets? 

Ivana Naumovska: Let me address this question by first, reflecting or addressing the issue of meme stocks. And what we're seeing with GameStop and others is it's an interesting phenomenon where some make money, but a lot of the trading that happens is moral attitudes, social movements, social statements against let's say, institutional investors, such as short-sellers. So, it is moral attitudes mixed with a profit motive that is influencing the trading really. Those that got their shares early in those meme stocks and are fueling this bandwagon or rational and stand to make money because they are basically betting on other's people's biases or rather moral attitudes. The majority of the investors who jump on those bandwagons later because of rebellion will have to lose those in the medium to long run. There will be market corrections, market corrections are inevitable. Financial markets are semi-efficient. This kind of bandwagons and herding behavior will revert and we'll go to the opposite direction where we will see those that jumped early on the bandwagon, jumping off the bandwagon. And then there will be an imitation and herding and those that joined later that were, as I said, motivated by rebellion and morality, stand the chance of actually losing money. Now, if we think about SPACs and giving investors or retail investors, the chance to invest in those vehicles, one should first consider the extent to which those investors understand what they're investing in. And I think a big problem with SPACs is that they are very opaque. So, there are contractual terms. There's great variation in how the returns are being allocated in terms of what happens to the dilution of shareholder value once the warrants are exercised. Investors are investing in vehicles that remain as of today to be opaque to them. And I think that's where the SEC is actually trying to bring some clarity, and first and foremost to tell investors, “hey folks, you're investing in something that's so opaque. It's important to get educated.” They are issuing alerts to investors, to retail investors, for them to have an educated decision. In terms of the investments, they're making. So yes, absolutely if people are informed they can make the investment they wish. However, it's important for those investors to make educated decisions, to be informed about the vehicle they are investing in, and SPACs have been opaque. As a result of which retail investors have lost money, they lagged the sophistication. Also, SPAC's are ever-changing. I mean, as it happens with most new practices or most new investment vehicles or asset classes, they emerge, and then there is market learning, sponsors learn, investors learn, the regulators learn. So, it's a very dynamic asset class as result of which more sophisticated and institutional investors can understand what is going on, but retail investors have this information and knowledge disadvantage, which necessarily leads to poor investment decisions.

Nathan Hunt: I want to talk a little bit about how a SPAC is structured and comes to market because you've talked a lot about the opaqueness of them and I want to understand this from the perspective of someone who is making the money because obviously, someone's making money here. So how are SPACs put together and how do they come to market and who makes the money through that process?

Ivana Naumovska: The way to think about SPACs is that they have these two life stages, right? One life stage is the one where they're a blank-check company. The other one is when they acquire a target—assuming they acquire a target. When a SPAC or an empty shell company goes public through an initial public offering what people are betting on are the characteristics of founders, the sponsors, their reputation. A typical SPAC will issue units. That unit will be a combination of a share and a warrant. It will typically be at $10 per unit. Now, what we have seen is that once the IPO takes place at $10 per unit, especially in 2020, we saw a pop. The next day's return would be about 6.5% -- the average return that will happen from the zero to day one the IPO. The investor base in that IPO stage are mostly institutional investors. Retail investors can buy later on and let's say a retail investor can buy the unit or the share at $12. Those individuals don't stand to make the money that institutional investors made in the very first pop post-IPO. Whoever holds that asset has the right to redeem their shares in the period prior to the target acquisition, assuming that the founders and the sponsors of the propose a target. So there's this downside protection that anyone who holds a SPAC assets has with the redemption. Now, what do we have seen is that in that period of the blank check phase, the returns are historically, at leasr in 2020 and 2019, quite positive, 8 tto 9%, which is essentially a fantastic return for what seems to be a risk-free asset class. Then we have the post-SPAC period, which is the deSPAC period where retail investors or any investors have been losing money. And what we're looking at is about minus 15% annually. One important data point is that those institutional investors that invested in the SPAC at the time of the IPO will typically not be found after the SPAC deSPACs. So they made the money during the blank check phase, but what we're seeing as investor composition is very different after the SPAC has acquired a target. So we have to consider these two stages. There are two life stages of SPACs and the return that investors make. And we see retail investors not making money in the post-SPAC or the deSPAC stage because what happens is that there is a significant amount of dilution. And that dilution has to do with the exercise of the warrants, among other things, but also the fact that the market updates and learns that those rosy forecasts that the target and the sponsors had when they were announcing the transaction were not actually fulfilled as a result of which today we see Lordstown, Nikola, Hall of Fame Resort & Entertainment, being subjected to lawsuits.

Nathan Hunt: In the last year we have seen some high-profile IPO's implode before launch. When company disclosures revealed areas of concern, would we have not known about, for example, the unusual aspects of the company We Work if they had chosen a SPAC route to the public market? 

Ivana Naumovska: The advantage that's SPACs have over IPOs have from the perspective of the target, is that ability to make rosy forecast without being held legally liable going forward. Now, another aspect is that the due diligence rests in the hands of the sponsors and the target of the sponsors and the blank check company, and they have incentives to close a deal faster. So, there are no strong incentives for due diligence. This may change if they're made legally liable and there are stronger incentives for due diligence, but potentially under the SPAC model, some of the things with We Work would not have been revealed. Again, the SPAC crowd is a faster route to going public, and that comes at the expense of due diligence, but also the sponsors have incentives to close the deal. So, revealing some of the negatives of a given target would run counter those incentives. That being said, they do run legal risks, and we are yet to see how those risk are going to play out once regulators and investors start suing, and we are seeing an increased amount of lawsuits, both in federal and state courts against firms that went public through a SPAC. Under the existing regime of SPACs, where it's fast and relatively easy, and with compromised due diligence to go public, one can expect that a lot of the skeletons in the closet will not be revealed in that negotiation stage, but only after the deal has been closed. 

Nathan Hunt: What would have to change about the market for SPACs to alleviate your concerns about them? 

Ivana Naumovska: SPACs are a new vehicle, a new investment class, there are a lot of unknown unknowns, there is a lot of experimentation that happens. Investors are learning about them. Sponsors are learning about them, we, as academics are learning about them, regulators are looking at them more carefully. So, in the near future, uh, as market knowledge, accumulates from multiple sources, I expect that we will become better at screening and identifying what SPAC characteristics work better than others. And as a result, make better decisions on which SPACs will eventually go public. Until a few months ago through February, pretty much every SPAC that filed an S-1 form and sought to go public managed to do so. So investors were not screening. Everybody and anybody could raise a SPAC. What we are seeing in these recent months is that some SPACs are actually withdrawing their filings and are not succeeding in going public, which suggests that there is some screening. So, market learning will be, I trust the primary driver of getting to an equilibrium state where both investors screen the SPACs they invest in, but also sponsors screen the targets they acquire. That will be the natural market-based changes we're going to see. That also needs to be pushed and fueled by regulatory action. And I think we're seeing that the SEC is taking actions. They've issued multiple alerts. They have noted to the public that they're looking at, new rules and regulations. They have made some new rules and regulations about the treatment of warrants as assets versus liabilities. So, new SEC regulation will do a few things. One is perhaps to make SPACs less opaque, but also align incentives between sponsors, institutional investors, and retail investors. We would reach a state of equilibrium where SPACs could fulfill the potential of allowing retail investors to take part in investments in younger high potential targets but without the expense of having their portion being diluted by warrants, or rights, or other opaque contractual terms we are seeing today. I believe that another aspect is the legal risks that the sponsors will be and targets will be facing in the months to come or in the years to come. We are seeing an increasing number of lawsuits in federal court and in state courts. So, this will inevitably make sponsors and targets to think twice before they close a deal under a certain set of terms. As the legal risks will become more salient in the eyes of both sponsors and targets, there will be also some market correction. Market learning hand in hand with the legal risks that sponsors will be facing and regulatory action would lead to a correction, I believe.

Nathan Hunt: Ivana. I want to thank you so much for joining me today and for providing such thoughtful answers to my questions.

Ivana Naumovska: Thank you, Nathan.

Nathan Hunt: The Essential Podcast is produced by Molly Mintz with assistance from Kurt Burger and Lundon Lafci at S&P Global. We accelerate progress in the world by providing intelligence that is essential for companies, governments, and individuals to make decisions with conviction from the majestic Heights of 55 Water Street in Manhattan, I am Nathan Hunt. Thank you for listening.

The Essential Podcast is edited and produced by Molly Mintz.