Why SPACs falter as market conditions change

Matt Higgins, a former judge on the reality show “Shark Tank,” is a seasoned investor whose firm, RSE Ventures, helps young companies build their businesses.

So it was no surprise that in November 2020, Higgins embraced one of Wall Street’s biggest recent obsessions by launching a SPAC. Special Purpose Acquisition Companies, known by their acronym, are shell entities that sell shares of stock to the public and use those funds to purchase an operating business. Investors get their money back if the SPAC has not found a business to buy within a two-year period.

Last summer, Omnichannel Acquisition, the Higgins-backed SPAC, agreed to buy Kin Insurance, a fintech company. But in January, the two sides called off the deal, citing “unfavorable market conditions.” In May, Higgins decided that he had had enough. He is liquidating Omnichannel and returning to investors the $206 million his SPAC raised.

“We did months and months of work to prepare Kin,” Higgins said. “But the market completely turned against us.”

Wall Street’s love affair with SPACs is fading.

After two hot and heavy years, during which investors poured $250bn into SPACs, rising inflation, interest rate hikes and the threat of a recession are fueling doubts. Increasingly, investors are withdrawing their money from SPACs, which they are allowed to do at the time of the merger. With shares of high-growth companies taking a hit recently, they have been less willing to bet that SPAC mergers, which often involve risky companies, will be successful.

At the same time, regulators are stepping up scrutiny of SPACs. The Securities and Exchange Commission has opened dozens of investigations into SPACs and is proposing tougher rules. More regulation would make SPACs less profitable for the large investment banks that arrange these transactions, because they would have to commit more resources to comply. They too have started to regress.

“You could see this cliff coming,” said Usha Rodrigues, a professor of corporate law at the University of Georgia School of Law who has become a leading expert on CAPS.

The debris is piling up.

On Tuesday, Forbes Media became the latest company to scrap its planned merger with a SPAC. According to data from Dealogic, around 600 SPACs that went public in recent years are still trying to complete deals. About half of them might not find targets before their two-year window closes. At least seven SPACs have been closed since the beginning of the year. Another 73 SPACs hoping to go public have shelved their plans. A fund that tracks the performance of 400 SPACs is down 40 percent over the past year.

Although SPACs had been around for decades, they had long had a nasty reputation. Only companies whose financials would not survive investor scrutiny on the road to a traditional IPO used SPACs to go public. That changed in early 2020, when prominent financial firms, venture capitalists and startups embraced SPACs as a faster and easier route to public markets than an IPO.

Wall Street banks were too eager to arrange these standard deals for hefty fees. And investors desperate for returns bought eagerly.

Suddenly, everyone from hedge fund managers like Bill Ackman to celebrities like NFL quarterback Patrick Mahomes and tennis legend Serena Williams jumped on the SPAC bandwagon. Retail investors also got involved, as stock trading took off during the pandemic. Even former President Donald J. Trump struck a deal with a SPAC last year to take his fledgling social media company public.

“Why did venture capitalists turn to SPACs all of a sudden? Because big-name investment banks started underwriting them,” said Mike Stegemoller, a finance professor at Baylor University.

SPAC deals have been a major new source of revenue for Wall Street banks. According to Dealogic, since the beginning of 2020, the top 10 banks that organized SPAC public offerings generated just over $5.4 billion in fees. Citigroup, Credit Suisse and Goldman Sachs pocketed the biggest fees.

Companies that sell shares to the public through an initial public offering must go through a rigorous process with strict rules. But SPACs face little regulation, as publicly traded companies do not yet have actual operations. The shares are typically priced at $10 each.

Early investors also get warrants, a type of security that gives them the right to buy additional shares later at a predetermined price. If a SPAC’s shares rise after finding a merger partner, warrants can be financially profitable.

The SPAC has two years to find an operating business to purchase; otherwise, the money must be returned to the investors. Since investors don’t know which business a SPAC will end up buying, they have the option to redeem their shares when they vote on the merger, meaning the merged entity could end up with far less cash than the SPAC raised.

The SPAC boom was fueled by a long period of low interest rates, driving investors to riskier corners of the market in search of higher yields. SPACs became especially popular with hedge funds looking to cash in on the difference between the price of a share in a SPAC and the collateral they held.

It helped that prominent venture capitalists embraced SPACs as a faster way to take tech startups public. In late 2019, Richard Branson merged Virgin Galactic, his aerospace company, with a SPAC run by Chamath Palihapitiya, the Facebook executive turned venture capitalist. The following year, DraftKings, the popular online gaming company, went public in a SPAC deal backed by Goldman, Credit Suisse and Deutsche Bank.

The SPAC format also provided a lifeline to companies like WeWork, which had to withdraw its initial public offering in 2019 when investors balked at the office-sharing company’s finances. But that wasn’t a deterrent when WeWork merged with a SPAC last year and raised $1.3 billion in much-needed capital.

“Last year was one of the best years in terms of SPACs,” said Gary Stein, a former investment banking analyst and entertainment industry consultant who has invested in such companies for nearly three decades. “This year is probably one of the most difficult for me.”

Two things have cooled the fervor for SPACs. Inflation is skyrocketing, leading the Federal Reserve to raise interest rates and investors to withdraw their money from SPAC deals to park elsewhere. And regulatory scrutiny of the SPAC market is increasing, which has made these deals less attractive to the players involved.

In recent months, investors have increasingly invoked their contractual right to redeem their shares in a SPAC. Historically, about 54 percent of shareholders would opt to redeem shares when a merger was announced. Now as many as 80 percent of investors have sought a return of their money in some cases, a move that leaves the post-merger company with little of the promised capital.

Concerns that too many investors would seek cash for their shares torpedoed the merger between Kin Insurance and Omnichannel, Mr. Higgins’ SPAC. Media company BuzzFeed received just $16 million from its merger with SPAC, as investors recouped much of the $250 million it had hoped to make.

Some recently completed SPAC mergers look bleak. When MSP Recovery, a medical claims and litigation firm, closed its SPAC deal with Lionheart Acquisition Corporation II on May 24, the company’s shares fell 53 percent immediately. They are now trading around $2. Neither Lionheart nor MSP Recovery returned requests for comment.

The Securities and Exchange Commission has opened two dozen investigations involving SPACs since January 2020, according to Audit Analytics. Half a dozen involve electric vehicle companies, including Lordstown Motors, Lucid and Faraday Futures. The SPAC seeking to merge with Trump’s company is also under investigation.

Regulators have proposed rules that would make it easier for shareholders to sue companies that have merged with a SPAC for making fanciful financial projections and dubious claims about production capabilities. Banks could also face greater liability for their work on such deals.

On Tuesday, Senator Elizabeth Warren of Massachusetts released a report that focused on conflicts of interest involving certain players in SPAC deals. “The process of bringing a SPAC to market inherently favors institutional investors and financial institutions, the so-called ‘SPAC mafia,’ over retail investors,” according to the report.

Some Wall Street banks are now backing away from SPACs, concerned that they will be held liable in shareholder lawsuits over inflated financial projections made by private companies that merge with a SPAC.

Goldman has reduced its stake in SPACs in part because of the “changed regulatory environment,” said Maeve Duvally, a spokeswoman for the bank.

Ms. Rodrigues, the law professor, said that if Wall Street banks could be held liable for false statements made by a company merging with a SPAC, it would be similar to the liability they have when they stage a traditional IPO. to higher costs for banks and higher fees for customers, which would dampen enthusiasm for SPACs, she said.

Of the roughly 600 SPACs still struggling to find targets before the market closes completely, 270 have been searching for at least a year, according to Dealogic.

The backers of those companies are desperate, which could make them unwise in choosing merger partners, said Nathan Anderson of Hindenburg Research, a firm that specializes in publishing critical reports on publicly traded companies, including SPACs.

“The quality of SPAC offerings was never high to begin with,” Hindenburg said. “And now it has the potential to get substantially worse.”

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