Op Ed: A Buy-Side Investor’s View on SPACs & Regulation
We don’t typically post Op Eds, but a buy-side individual who has been investing in SPACs since 2003 approached us wanting to offer their own perspective on the current SEC proposal. It’s not often we get to hear from investors. Mostly due to compliance issues, but also because many investors are pretty secretive by nature (can’t give away the secret sauce!).
However, this investor made a compelling argument: that is, in finance you rarely hear differing views in the media because nearly everyone actually working on these deals is restricted from speaking. In fact, his original intent was to use his real name for this piece, but alas, his internal compliance would not allow it. Nonetheless, a compromise was made and we are posting this anonymously. Additionally, if you would like us to pass on your thoughts to the writer, please feel free to email us.
Read on to get an investor’s take on SPACs and the SEC proposal…
A Buy-Sider’s Perspective
Let’s start with the disclosures and disclaimers. I currently manage a SPAC Arbitrage fund. The first SPAC prospectus found its way to my desk nearly two decades ago, and I have been trading them ever since. Having traded them longer than most people, I have more than a passing familiarity with the sector.
The views expressed here are my own, and do not reflect those of my firm or employers (past or present). Nor those of my colleagues, service providers, brokers, clients, or compliance officers. It is not my intent to offend anyone. My intent here is to discuss why the market is the way it is, how I have viewed it these past two decades, and some suggestions to make it better.
Let’s start at the beginning. I read my first SPAC prospectus about five times, front to back, looking for “the catch”. It just seemed too good to be true. As an arbitrageur, I couldn’t help but fall immediately in love with the marvelous structure. And what’s not to love? A free look at the upside with built-in downside protection? Buying it at a discount to NAV? The ability to earn a yield on my investment? Free warrants (at that time, 2 warrants per unit!)? All of these combined to make SPACs the safest investment vehicles I have ever traded.
I believe that the SPAC structure is a wonderful financial innovation. There are, of course, problems with the market (which we will discuss below). But it is not the evil and sinister thing that regulators and the media are trying to make it out to be. The truth, as with most things, lies somewhere in the middle.
SPACs had lived in a quiet and obscure corner of the Capital Markets for nearly two decades until the world suddenly discovered them by accident two years ago. It was the perfect storm caused by the irresponsibly loose monetary conditions induced by the Fed, leading to rampant speculation in ALL assets. With generationally low interest rates, abundant liquidity, bored day traders stuck at home stuffed with government cash, a(nother) new technology paradigm, goading by new-age market pundits about how TAMs are king and valuations don’t matter, and we had all the ingredients in place for the perfect party. It did not last long, nor should it have. This was definitely not a SPAC-specific problem but the SPAC market is being singled out for punishment.
To me, SPACs are an essential tool for capital formation. Capital formation has been very much needed in our financial system because over the past few decades (again due to loose conditions and perverse incentives) the number of companies available in which to invest has been steadily shrinking, while their sizes have been growing. An abundance of M&A combined with the popularity of passive investing has meant that the big get bigger and the small disappear. The gene pool of companies needs to be refreshed.
At the same time, there is an entire universe of fresh new private companies just waiting to hit the scene. And they need a fast and efficient way to do so. The traditional IPO process had been slow, expensive and (importantly) not easily available to smaller companies. Enter SPACs, which offered a different route to the public markets.
In addition to being attractive to private companies, SPACs offered something else which has been sorely missing: a level playing field for non-Institutional investors (i.e., retail investors). Retail investors have never had good access to traditional IPOs, but SPACs offer a way for them to participate in new companies. A retail investor has the opportunity to get in on the same terms and at the same time as an Institutional investor in a newly-public company. This is not possible with the traditional IPO process, which is primarily reserved for the highest-commission-paying clients of the underwriters.
Obviously, bankers love the product because it is a new source of fee revenue. And, of course, the economics for SPAC sponsors are notorious and legendary (though exaggerated). All of that makes SPACs attractive to private company management teams, investors, arbitrageurs, bankers and the SPAC sponsors. SPACs also help the capital formation process, increase the number of companies available in which to invest, and offer more choice. So why are the regulators apparently trying to stick a pin in the ecosystem and bring it back to the old days of traditional IPOs?
Make no mistake: markets need regulators. Without them, we would be over-run by swindlers like Bernie who made off with billions, Enron which also stole billions, and countless others. Even though the regulations did not prevent the fraud, regulators are essential to the process in order to keep things fair and to at least try to police bad actors. Without the proper regulation, there would arguably be much greater fraud. I do believe that the regulators have sincere good intent, and they are needed.
“Good intent, however, can at times lead to bad outcomes”…
Good intent, however, can at times lead to bad outcomes, particularly if rules are not carefully enacted. The current rules envisioned by the regulators have the noble intent of protecting investors and enhancing disclosures. This is a great thing and to be applauded. The actual rules suggested, though, take away from the benefits of the product and revert the financial markets back to the good-old clubby ways of doing things.
Specifically, the SEC does not like the forward guidance that SPAC management teams give, and are proposing to limit this through limiting the use of the ‘Safe Harbor’ provisions. Traditional IPOs cannot give forward guidance. But is that really true? While traditional IPOs cannot give forward guidance directly to investors, they do speak with analysts. And the analysts then create forward guidance and opinions based on those conversations. And then pass their own guidance on to their Institutional clients. Which gives the Institutional clients not only favored information, but also favored access to the IPO. If the process is to be fixed, then this inequity needs to be resolved. I am definitely in favor of putting restrictions on forward guidance. Said guidance should be based on good faith, good facts and reality, and companies should be held accountable. However, the same rules need to apply to all, with equal access to all. The proposed rules will handcuff SPACs and revert access to an uneven situation. Only the richest institutions (that pay the banks) will have access to additional information. Essentially, the Traditional IPO process is plutocratic with wealth commanding the best information.
Even though the traditional IPO process is tilted massively in favor of Institutional investors, even these investors should appreciate the SPAC process. When the IPO gets done, investors can only get the information offered to them by the bank analysts. Management teams cannot (or at least should not) be offering out other information. With the SPAC process, all investors get a free look at the company and its on-going filings for months before having to commit to the investment. During this time, they can see performance, read the filings and even question management because they are available during the merger roadshows (and even do interviews). Compare this to the traditional IPO process in which the banks and the analysts control the information.
Non-Institutional (retail) investors appreciate the process even more because they now have an even chance of getting information and (more importantly) the ability to actually participate in the investment. The traditional IPO goes to the larger investors who direct commission fees to the banks. Retail investors are mostly shut out of this, and are required to purchase the stock in the secondary market from the Institutional investors at higher prices and with higher risk of loss because they are starting out at a higher level.
“A bull market makes everyone look like a genius”…
Another concern (for regulators and everyone else) is that SPACs have performed badly and that investors have lost money over the past two years. This is absolutely true. However, what gets ignored by both the regulators and the media is that traditional IPOs and existing companies have also been decimated. There are any number of tech companies that are down by 50%, 70% or even 80% or more. Has anyone looked at Peloton, Zoom, Paypal, Twitter, Netflix, Robin Hood, Coinbase, Meta or even Amazon lately?
The Ark Innovation fund is a proxy for non-profitable tech. It is down as much as most SPACs. There have been a number of analyses published that show that traditional IPOs perform as badly as SPACs. In addition, revenue misses by SPACs are also in line with traditional companies. And let’s not forget the crypto madness with situations such as Terra/Luna or the Reddit madness with Gamestop. So why do SPACs get the negative attention and not everything else?
It is said that a bull market makes everyone look like a genius. And for the past two years, aided by the previously mentioned reasons there was a bull market in everything. Anyone who dared to question the valuations was mocked and ridiculed. The real reason we had the party was the insistence by investors (led by Ark) that no valuation was too high because of the glory that (eventually) awaited mankind. And with near-zero interest rates, infinite multiples didn’t sound very crazy. As well, regulators and the media are always vilifying and investigating short sellers and at the same time apparently giving a pass to rampantly bullish cheerleaders. SPACs were along for the same ride as every other asset, both up and down. The SPAC market simply represents yet another vehicle for investors to express their views and do what the monetary authorities have set them up to do (ie. Take things to absurd levels). It is unfair to single out SPACs for punishment while giving everything else a pass. The SPACs were not the problem. The problem is the environment that has been created and the investor response to it.
One big overhang which has gripped the SPAC market is the insistence by the SEC that underwriters of SPACs will be deemed to be liable for the de-SPAC transaction. This has had the intended effect of slowing the market for SPAC IPOs and completions. The whole point of a SPAC is that it is a “Blank-Cheque” company. By the very rules, the end transaction cannot be known in advance. Furthermore, the underwriter may not even be involved in the final transaction. So how can the underwriter be held liable for something they cannot control and of which they have no prior knowledge? It seems the sole purpose of this is to stop underwriters from underwriting new SPACs. Which is not the best way to improve a market. I think this rule definitely needs improvement, and all the banks do as well (though unfortunately they do not want to tangle with their principal regulator).
Perceived incentives are also a concern. Everyone seems to grab on to the typical 20% headline promote that the SPAC sponsors initially stake for themselves. This seems like a high number, of course, but is not as obscene as it may appear. During typical negotiations, this promote gets whittled down and sponsors often have to give it up. Also, remember that the sponsors are putting up the risk capital and do run the risk of a failed deal. Granted the rewards are still great, but most observers only see the rewards. They do not see or acknowledge the risks undertaken by the sponsors.
Solutions
With all the background out of the way, we should think about actual solutions. SPACs (as a concept) are very useful capital markets instruments and have been evolving over the past two decades. But there are things that the underwriters, target companies and SPAC sponsors can do to improve things for all concerned.
If I could offer the sponsors one single piece of advice, it would be this: be long-term focused instead of short-term focused. This can help ensure the longevity of the product and the ecosystem. How to do this you ask bemusedly? Leave some money on the table for investors! This should be obvious but unfortunately seems to be a foreign concept. The easiest way to do this would be in the form of lower valuations. With deals coming out valued at double-digit multiples of forward revenues, is it any wonder they face extreme redemptions and then fare poorly in the after-market? This is not a SPAC-specific issue but one broadly faced by the markets.
Related to the valuation issue, we have the issue of quality. SPAC sponsors need to find better companies that are ready for the public markets. Historically, many companies have been brought forward which were not exactly ready to be public companies. But this is not a clear-cut issue. On the one hand, new tech companies need access to the markets in order to raise capital. On the other, some of them are clearly not ready for public markets. There needs to be a balance struck, and lately that balance has gone the wrong way. While it may sound naïve, if the sponsors can bring forth good companies at good valuations, everyone benefits. And really the point of the SPAC market was to give smaller companies access to markets. I will repeat that this is not a SPAC-specific issue but rather is endemic to markets in general. But SPACs can take the lead to show the world the better way.
The next easy fix: Disclosure. This is a big concern for all. In particular, disclosure pertaining to economics and incentives seems to be in demand. As it should. There currently are disclosures in both the initial SPAC prospectuses, as well as the merger docs. But how often and how closely are these read by the average investor? Perhaps it makes sense for the teams to prominently highlight this information so that it does not have to be a guessing game. Since it is there anyway, just make it more prominent rather than hiding it in filings. This can only help everyone make better decisions, and leaves fewer questions.
Jumping back to the issue of forward guidance (because it seems to have struck a nerve with regulators). This is an issue that needs to be delicately balanced. All companies need to give some form of guidance, so that investors can gauge the merits and prospects of the investment. It seems simple enough on the surface. The problems arise because management teams are always too optimistic and investors are always too willing to believe. The SEC is right to focus on the issue, and all parties need to come together to strike a balance. The parabolic growth rates seem absurd, and serve no purpose other than to try to generate hype and FOMO. I am not sure how companies can so confidently guide out for five years when most people do not know what can be happening in five months, weeks or even days. There needs to be some form of punishment for companies that give unabashedly optimistic guidance with not much to back it up. But it also cannot be so restrictive that investors cannot be given any information on which to base decisions. And it is definitely not right to take things back to the traditional IPO model, because that only serves one group of investors at the expense of others.
I know I have missed many arguments, both for and against SPACs. My purpose here was to explain broadly that SPACs are a very useful tool for the markets. They are essential to the capital formation process and for giving investors access to new high-growth companies. Without SPACs, smaller companies get shut out of the Capital Markets, again leaving us with fewer behemoths and less investing choice. And what happens to innovation and new ideas? With a few exceptions, true innovation happens in the smaller firms that are free to dream and develop. Remember that Apple, Amazon and Tesla were once tiny minnows themselves. We want to give smaller companies the ability to raise capital and grow. This helps with employment and growth, as well as letting everyone participate in the markets. Without the capital from SPACs, most of these smaller firms will turn to deeper private pools of capital, and those are largely unregulated and the domain of the rich. Seems pretty undemocratic from where I sit.
The rush to condemn the SPAC market needs to be tempered. SPACs in and of themselves are not the problem. The problem lies with investors’ use of them and the speculative market environment. Other vehicles were used to express speculative views before SPACs came on the scene, and other vehicles will be used if the SPAC market is killed and buried. The solution is to modify the excesses, because investor judgement and actions will never be tamed.
SPAC deals used to be completed before the recent froth. Investors that did not want to participate took a return of capital. The deals were completed using PIPEs, and then things progressed from there. The point was that new companies were created, and if there was value to them, they survived. If not, then they died. But the markets decided in either case.
SPACs may not yet be perfect, but have been around for long enough now and offer enough benefits that it is worth the effort on the part of all participants to try to fix things and move forward. Let’s try to keep the many benefits when fixing the problem areas.