Why SPACs are terrible for most investors?

SPACs are SCAMS. No. Really. This is what has been publicised by the media since the 1990s.

· 5 min read
Why SPACs are terrible for most investors?

Why are SPACs in news?
Warren Buffet: Stock Market :: Chamath Palihapitiya: SPACs ;

The face of SPACs realm, Chamath Palihapitiya, saw all of his six-blank-cheque companies plunging more than the 23% average decline in SPACs, as measured by the IPOX SPAC Index. Hitting the news was -- Virgin Galactic Holdings Inc. which went down more than 50%. Virgin Galactic Holdings Inc. is a space tourism business that’s backed by Richard Branson.

But what exactly are SPACs?
Special Purpose Acquisition Companies or SPACs are shell companies (non-operating companies that exist just on paper) that raise money through IPO and merge the raised capital in an existing company that needs funding. This process is known as a REVERSE MERGER.

SPACDex: Return Compared to S&P 500 on 19th April 2021

SOURCE: SPACDex

LIFE CYCLE OF A SPAC

The minimum size of a target company is roughly 80% of the funds in the SPAC trust. It’s typical for a SPAC to combine with a company that’s two to four times its IPO proceeds in order to reduce the dilutive impact of the founder shares and warrants. So, where exactly is the catch? Since the SPAC is only a shell company, the founders or sponsors become the selling point when sourcing funds from investors.  These sponsors purchase warrants and put in a minimal amount in exchange of 20% of the company’s equity for a nominal investment. Pretty darn attractive right?

Shockingly, these sponsors can be pretty much anyone, even any random CEO who ran his company to the ground, who can persuade shareholders to buy its shares. More often than not celebs become the charming ingredient. The celebrities aren’t so much the financial decision-makers but rather the promoters brought in to attract investors. And wait, if you were wondering they may be as clueless in this field as they want. No Compulsions. After all, they are there to charm the investors.

Build any product, get someone from the celeb fraternity to advertise it, get your sales up ,and earn millions and billions. Sounds familiar, doesn’t it?

...But what is in it for the celebs?

If a celebrity adviser had negotiated 1 percent of that deal and the SPAC raises $500 million in the public markets they are rewarded with a stake of $5 million in the company. Now, let’s say the same SPAC also successfully merges with a company and the deal is done at $10 billion. The celebrity’s 1 percent stake has netted them (on paper) a $100 million payday.

Basically, celebrities are risking their reputations for, let’s say, a few million dollars initially, but if it works out, it’s $100 million. Good deal if you ask me! So... Is it like the new age gold mine for the investors too?

So, if you are up for getting an empty company’s shares with zero track record and you’re betting that these celebs will eventually find something. Some companies with zero revenue are rushing to market. History shows that has not been kind to investors. 138 of the 248 SPAC listings of 2020 are still hunting for targets. Furthermore, while SPACs are required to return money to investors if no merger occurs within two years, the fine print of several SPAC prospectuses reveals that certain clauses may prevent investors from receiving their money back.

THE BEGINNING
Of the 267 articles published between 2001 and 2012, 148 were neutral, 113 were negative and only 6 were positive. By 2010, when reverse merger activity peaked, 70 percent of media articles on the phenomenon had a negative tone. Reverse merger firms’ share prices plummeted to the extent that cumulative returns neared -45 percent. The following year, in 2011, reverse merger activity plunged by 35 percent. As it’s popularity grew in the public domain, investors and media alike became skeptical about the practice. The negative bias further intensified as more and more reverse merger transactions involving high risk grew. All this led to discouraging reputed firms from adopting the practice... and three decades later similar dynamics have re-emerged in 2021.

BUT WHY SPACs?
SPACs can be thought of as a backdoor entry for a private company to go public. Previously, they were considered the last resort but currently have become the hottest trend. Let’s try to find out why.

  1. SPACs are a blessing for companies that can help drive tech innovation but are high risk that in normal times would have difficulty raising money.
  2. SPAC enables smaller companies to go public.
  3. SPAC provides a cheaper way to go public, has liberal regulations than traditional IPOs and it gives the company greater negotiation power and is much quicker.
  4. More reasons can be underpricing of IPO, market volatility ,or if the industry in which the company operates is not well understood.

WAIT...BUT WHAT ABOUT INDIA?

ACCELERATION IN INDIA
In India, renewable energy producer ReNew Power agreed to merge with RMG Acquisition Corp II, a blank-cheque company, in what became the first involving an Indian company during the latest boom in SPAC deals. ReNew Power will get listed on Nasdaq with gross cash proceeds of around $1.2 billion. Grofers, an online grocery platform, is also reportedly in the advanced stages of exploring a SPAC deal. In recent times, SPACs, centered on India, were more successful and included on the more prominent exchanges like NASDAQ. All of this suggests that SPACs are increasingly accepted as another way of raising capital in India.

MAJOR HURDLES IN THE INDIAN MARKET

  1. Company’s Act allows the registrar to strike off a company’s name if it has “failed to commence its business within one year of its incorporation”.
  2. SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 which requires a company to have net tangible assets of at least ₹3 crores in the preceding three years, minimum average consolidated pre-tax operating profits of ₹15 crores during any three of last five years and net worth of at least ₹1 crore in each of the last three years if it wants to go public. SPACs fail all of them.
  3. NSE requires the companies to have positive operational cash accruals (Earnings before Depreciation and Tax) for the last two years, making SPACs ineligible for listing.

The Securities and Exchange Board of India (SEBI) has formed an expert committee to investigate the feasibility of introducing regulations for SPACs in India, which could potentially boost the prospects of domestic listing of start-ups. Yes, SPACs are all the rage and some companies might end up benefiting the investors. But let’s look at the median and average for the year 2020-2021.

According to this academic paper


Mean returns for the year 2019 and 2020 following merger announcements are negative 12.3% and negative 34.9% respectively over 6 months and 12 months respectively. And, I agree IPOs are often a bad deal too for public investors, but there’s a big difference: transparency. You know what you are getting into in an IPO. You have the company’s audited financial statements, know about the risk factors and current shareholders information. Hence, SPACs are cool and all but for sponsors who earn millions even when the company suffers losses but the same can’t be said for retail investors. For now, I’ll continue my hunt to find authentic schemes which would make me a billionaire. See you again soon!

Image Credits: The Street

Related Articles

Crypto Staking | A beginners guide
· 3 min read
Evaluating Crypto Liquidity Pools
· 2 min read
Top 10 most promising crypto projects
· 5 min read
What are flexicap funds?
· 2 min read