Special Privilege and Concessional (SPAC)

This phenomenon is yet another manifestation of cheap money (historic low interest rates) and excessive liquidity — and perhaps the perception that listed companies are already fully valued and that SPACs will acquire undervalued unlisted companies. There are currently 339 SPACs sitting on more than US$105.2 billion in trust money actively looking for acquisition targets.

For those who are unfamiliar with the term, SPACs are listed shell companies created specifically to acquire one or more privately owned, operating companies within a fixed timeframe, usually between 18 and 24 months. Because investors do not yet know what the eventual target companies are at the IPO stage, SPACs are often referred to as “blank cheque companies”: Raise the money first, then look for a business.

The value proposition for SPACs is that the management team (sponsors that typically comprise high-profile institutional investors, billionaires and CEOs as well as celebrities such as basketball players) can better seek out privately held assets with strong growth potential based on their combined experience.

The concept of SPACs is quite similar to that of private equity and venture capital funds, such as SoftBank Vision Fund, which is the pooling of capital to acquire assets and profit by arbitraging the valuation differences between privately owned and publicly traded assets. The difference is that SPACs are publicly traded and, therefore, more readily accessible to retail investors.

Proponents argue that SPACs are a chance for small investors to buy in on promising, high-growth start-ups at near-floor-level valuations. It purports to democratise the investment process — so, now, not only sophisticated, high net worth individuals and institutional funds get to benefit from the “super profits” of early investors, before the company hits IPO. Case in point: Prices for SPACs tend to jump sharply higher once a target company has been identified and, often, even well before one, on just rumours and speculation.

As mentioned, SPACs are all the rage in the US and starting to emerge in Europe — and may catch on in the rest of the world. Just last week, Bernard Arnault, the billionaire owner of LVMH Moët Hennessy Louis Vuitton SE (LVMH) announced that he would sponsor a SPAC.

Like many of the hottest themes of the day, there are reasons to be cautious — for both investors and regulators. We think the risks associated with SPACs are grossly underappreciated. Its structure may appear simple, but the devil is in the details. For instance, do retail investors even understand the hidden costs and huge dilution effect upon a successful acquisition and merger? And how do regulators ensure that the interests of sponsors are aligned with that of investors?

Going public via SPACs makes sense for target companies, at least at first blush. They represent a huge pool of readily accessible capital. Unlisted assets get a big step-up in valuations upon going public — because of the huge premium for liquidity.

Indeed, SPACs have become the alternative of choice, especially for cash-burn start-ups for which time to IPO is of the essence. A merger with a SPAC is faster, far less gruelling and comes with arguably less regulatory oversight than the traditional IPO or direct listing routes.

Targets can also directly negotiate valuations with the SPAC management team — for instance, adjust the selling price to compensate for any dilution effect and hidden costs. It means these costs often end up shouldered by SPAC IPO investors. The SPAC option was particularly attractive against the backdrop volatile market conditions amid uncertainties thrown up by the Covid-19 pandemic.

Ironically, these same reasons should raise red flags for SPAC investors. Rigorous due diligence in the traditional IPO process is there for a reason — investor protection. SPAC circumvents these guardrails. The promise (often times, illusion) of “super profits” comes at a price — high risks.

The entire value proposition for SPACs rests on trust in the management team — to find the best acquisition target at the right price and time. This may not necessarily be the case, especially with so many SPACs chasing a deal, often in the same “hot” sectors, and with the added pressure of a looming deadline. It is fertile ground for inflated valuations, if there ever was one.

Critically, the structure of a SPAC itself is flawed from the start. Sponsors stand to make hundreds of millions — in the form of “promote”, which is a customary 20% equity stake in the SPAC for practically free (typically priced at only US$25,000) plus deal fees as payments for finding the target company and executing the merger. Sponsors are also usually offered warrants in the SPAC that give them the option to acquire shares in the merged company. On the other hand, they will lose the initial (small) amount invested if an acquisition cannot be found within the stated timeframe and the SPAC is subsequently liquidated, with cash returned to IPO investors.

In other words, sponsors are very much incentivised to close a deal, any deal, in which case the SPAC may well end up housing assets of poor quality. Even if prices of the merged company subsequently fall, sponsors are most likely to still come out ahead because their stakes were acquired at such deep discounts.

Under such a lopsided structure, what are the odds that the interests of SPAC sponsors truly align with those of investors? Jim Cramer, host of Mad Money on CNBC, likens the SPAC mania to an “inside joke for the super-rich and a way for celebrities to monetise their reputations”. So much for democratisation!

Of course, there will be a few good SPACs — high-profile success stories such as the listings of DraftKings Inc and Virgin Galactic Holdings Inc that help fan the mania. But returns for SPACs in general, post-acquisition, have been mixed. According to researchers at Stanford and New York University law schools who analysed 47 SPACs that merged between January 2019 and June 2020, these SPACs lost a third of their value post-merger, on average, though some notable exceptions did produce positive returns.

Prices for SPACs often start rallying on mere speculation of target candidates — often, without taking heed of the risks of non-closure or quality of the acquisitions. Even for SPACs that do well post-merger, in the immediate term, their longer-term risks remain high. Many of the SPAC acquisitions are start-ups in emerging and exciting trends or sectors — for example, businesses related to the digital economy, biotech, electric and autonomous vehicles, space travel and clean energy.

Start-ups are notoriously hard to value — they have a limited track record and some have yet to have viable business models — and even more so in emerging sectors with cutting-edge technology that is also evolving at a rapid pace. Case in point: the controversy surrounding zero-emission vehicles company, Nikola Corp, once a darling of Wall Street.

What investors must understand is that, while a few will emerge hugely successful, many more will fail along the way. For industries in which the supply curve is steep, upfront costs are high and the gestation period is long, it is often the case of “winner takes all”.

In short, SPACs are far from “sure wins” — investors must still do their homework, and analyse and assess the business model and prospects. And that is doubly hard to do when you do not know what the business will be.

One could argue that buying a SPAC is similar to investing in holding companies such as Warren Buffett’s Berkshire Hathaway, which operates the same way — acquiring value-accretive privately owned businesses. This is true, except that Berkshire grows through previous successes and has a long track record. SPACs have no track record, save for blind faith in their sponsors. And, as we have articulated, sponsors have all the incentive to do something, anything, today whereas Buffett can sit it out until a good deal comes along.

Malaysian investors should be well aware of the pitfalls, as many have been burnt before. SPACs were fashionable once, a decade ago, but have been largely a failed experiment. Most were focused on oil and gas, which was the hot sector back then.

Hibiscus Petroleum Bhd was the first SPAC listed — in July 2011; its shares are now trading around a quarter of its price at the peak in 2013. Another, Reach Energy Bhd, is now valued at one-tenth of its market cap at IPO. A few of the SPACs were liquidated, having failed to complete a qualifying acquisition within the specified timeframe.

There is no question that Malaysia needs to attract exciting, high-growth companies to set up base in the country and list on Bursa Malaysia. SPACs may seem like an attractive option — but they are NOT.

For starters, if private companies can get listed through a SPAC, then what is the justification for having historical track record criteria in a traditional IPO? Proponents will argue that we trade the company’s track record with that of sponsors. Well, what are the criteria to evaluate sponsor credibility — qualitative and/or quantitative? And would that not be the same as issuing blank cheques to the privileged few? Perhaps we would be better off auctioning SPAC approvals to the highest bidder!

Even if approvals are issued based on sponsor-proven track records, what is the guarantee for the future? Ideally, sponsors should be rewarded based on only future performance, not get a big payoff simply by securing a deal. Will these sponsors be held accountable and personally liable if the venture fails several years down the road?

How can regulators ensure that SPACs are not just the guise for concessions for the select few or get-rich-quick schemes preying on unsophisticated small investors? If a SPAC is deemed a useful investment structure — to attract high-growth startups and deepen the capital market — why not level the playing field and relax listing requirements for all?

The Global Portfolio fell 1.5% in the week ended Feb 24 as a result of the broader market weakness. Last week’s loss pared total returns to 59.4% since inception. Nevertheless, this portfolio is still outperforming the MSCI World Net Return index, which is up 41% over the same period.

Stocks that will gain from the reopening of economies generally did well while highgrowth tech stocks bore the brunt of the selling. The notable gainers were Singapore Airlines Ltd (+7.5%), Walt Disney Co (+5.9%) and Bank of America Corp (+5.7%). On the other hand, Geely Automobile Holdings Ltd (-14.3%), Home Depot Inc (-7.5%) and ServiceNow Inc (-5%) were among the bigger losers in our portfolio.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.