The Spac trap has been reset, not removed

In 2022, three out of four companies that went public in the US did so through a special purpose acquisition company, or “Spac.” While the boom lasted a few years, when the crash came it was swift and severe.

For more than a year, the US Spac scene has been dominated by bankruptcies, restructurings, suspended deals and reduced activity.

At the end of last year, confidence began to return. By the second quarter of this year, there had been 54 Spac initial public offerings (IPOs) in the US, compared with 34 for the same period in 2023. The UK has so far seen little sign of a rebound, but if there is continued growth in USA, can be expected to follow.

Then, in July, the US Securities and Exchange Commission (SEC) imposed changes to eliminate some opportunities for abuse in the Spac mechanism. While the new restrictions mean that activity may not immediately pick up as it did during its peak, many believe they have given the industry new legitimacy.

So if Spac recovery does develop, is it to be welcomed or, as I believe, treated with skepticism?

Gaps are formed when some well-known people (sponsors) raise a lot of money and start a new public company with the intention of merging it with an already functioning private company.

In the merger, many of the original investors exercise their right to buy back the money they contributed to the IPO, and other investors come in with a private placement to make up the shortfall. These investors usually receive sweeteners such as warrants.

At the end of the Spac process there is a public company with operations known as De-Spac.

Prior to the changes mandated by the SEC, Spac and De-Spac sponsors and issuers enjoyed several striking advantages.

The marketing of the De-Spac financing was helped by some protections against litigation. So, bankers often managed to paint a rather rosy picture of the company’s prospects, without particularly considering the consequences.

There was also no requirement to set out the many elements that should be included in a public offering, including details of fees, which typically gave the sponsors a blatant 20% interest in the merged company.

These features are now gone.

While the new restrictions mean that activity may not grow as it did in its prime, many believe they have given the industry new legitimacy.

Some advantages remain, but I think they are often partial or questionable. Meanwhile, the downsides, especially for investors, are still there ‒ and often understated.

One of the supposed advantages is that many companies that would not be eligible for an IPO due to their small size or lower quality can still issue a De-Spac. This is of questionable benefit to investors.

Another possible advantage is that the price at which a De-Spac merger is carried out is agreed, unlike in the case of an IPO. This is partly true, although De-Spac’s merger terms are often negotiated intensively until the last minute.

If a company needs to get to market quickly, then Spacs has the advantage. An IPO typically takes 12-18 months, while a De-Spac can come to market in six to nine months. Former President Donald Trump needed the owner of his social media platform Truth Social to go public this year — which he did.

More typically, the compressed timeframe for a De-Spac offer might be needed to catch the window of a hot market in a particular sector. But hot markets are generally not the best time to invest. During the boom times, EV company deals were popular, but according to Spac Insider, a specialist website, the median price of De-Spac EV shares since 2009 has fallen 96%.

Now consider some concerns facing investors in De-Spac stock.

Since no Wall Street investment bank has taken De-Spac public, there is likely to be no investment research into the stock, there could be few credible market drivers and little liquidity.

There is, however, an oversupply of potential sellers, particularly holders of the pile of equity instruments that were issued in previous financings. This may hinder the performance of De-Spac shares even if De-Spac is successful.

And while sponsor fees are now generally a little lower, they are still high — much higher than the 6-8% cost of an IPO — and hurt the risk-reward ratio.

It’s no wonder, then, that US De-Spac stocks have generally underperformed. According to University of Florida professor Jay Ritter, the average one-year return of US De-Spacs in 2023 is down 59%, with longer time frames showing similar declines. Trump’s De-Spac is currently down 84% from its peak.

To be fair to Spacs, the SEC’s partial cleanup of the mechanism should mean future performance will be slightly better.

And over time, bankers will almost certainly find new angles to enhance the appeal of Spacs. The ingenuity of Wall Street should never be underestimated.

However, investors would be well-advised to tread carefully as the Spac cycle picks up.

The author is CEO of Tail Wind Advisory & Management Ltd and was founder and manager of The Tail Wind Fund.