Jittery investors wipe the gloss off SPACs and it's back to the IPO drawing board

Phil Wainewright Profile picture for user pwainewright December 14, 2021 Audio mode
SPACs have become a popular IPO alternative, but with ServiceMax one of the latest to have called off pending deals, the appeal is starting to fade.

Businessman looking at huge hand drawn chalkboard © Creativa Images - shutterstock
(© Creativa Images - shutterstock)

The past eighteen months have seen the sudden rise of a popular shortcut to a stock market listing — the SPAC, or Special Purpose Acquisition Company. But the gloss already seems to be coming off this alternative to a conventional IPO (Initial Public Offering). Last week, enterprise software business ServiceMax became one of the latest of several companies to abandon its stock market debut through a planned merger with a SPAC, citing "market conditions." Investor protections built into present-day SPACs make them particularly vulnerable to market jitters, turning the SPAC shortcut into a dead end when investors get cold feet.

If the SPAC's heyday is past, there have been some notable successes along the way, with emerging industries such as space tourism, electric vehicles (EVs) and biotechnology among the beneficiaries. Some of the most notable SPAC mergers completed so far include EV maker Lucid Motors, which set a SPAC record by raising $4.5 billion in fresh capital, space tourism outfit Virgin Galactic Holdings, and online gambling provider DraftKings.

The attraction for companies to list via merger with a SPAC is that the heavy lifting of completing the IPO process has already been done. Instead of the 24+ weeks an IPO typically takes, a merger with a SPAC is usually completed within 14-16 weeks. It's also cheaper, since much of the initial cost of the listing has already been borne by the sponsors who launched the SPAC and took it through its IPO. Their funds, invested as seed equity to create the SPAC prior to listing, cover the cost of the IPO and paying banks and underwriters. They also bring investment expertise and contacts, since they're typically from the venture capital or private equity sector — or in a few cases they may be angel investors or celebrities with industry expertise. For big deals, sponsors will raise additional capital to fund the merger from private equity, known by the acronym PIPE (Private Investment in Public Equity).

One further advantage for more speculative ventures is that SPAC merger prospects can market themselves based on projections of future performance, whereas in a traditional IPO they can only use their past financials and current product offerings to make their case to investors. This has a downside too, however, if investors later decide the company's executives were unduly optimistic in their projections. Such feelings have already led to CEO resignations at EV companies Nikola and Lordstown Motors after allegations instigated by an activist short seller. Truck maker Nikola's founding CEO was subsequently indicted by a grand jury on three fraud counts, accused of lying about "nearly all aspects of the business."

Change in investor sentiment

But what's really upset the SPAC bandwagon has been a change in investor sentiment from the heady days when markets surged from the lows of March 2020, exacerbated by the investor get-out clauses that are built into present-day SPACs. Merging with a publicly quoted 'shell' or 'blank-check' company has always existed as a backdoor way of achieving a public market listing, but these new rules have helped bring this formerly offbeat mechanism into the mainstream. When a modern SPAC goes looking for investors in its IPO, it typically gives them the right to get their money back if they don't like the look of the merger candidate, or if a deal isn't closed in a given timeframe. As a result, there's very little risk when putting money into a SPAC flotation. Buy any other stock and the whole of your capital is at risk if the stock price nosedives. Buy stock in a SPAC, and your capital gets locked away in ultra-safe Treasury bonds until the time of the merger with a target company, at which point you can get it back if you don't like what's proposed.

These rules have sent money flooding into more than 600 SPAC flotations since the beginning of last year, raising a grand total of almost $200 billion. Many observers believe that's far too many. About 30% are set to fail, according to Betsy Cohen, who has herself sponsored nine. "Everybody and everybody's brother-in-law have raised a SPAC," she told the Bloomberg Invest Global Conference in October. Unlike those who buy into the IPO, a sponsor's investment is on the line if the SPAC fails. The payback for this risk is an allocation of 'promoter shares' in the merged entity.

Meanwhile, investors have started taking advantage of those get-out clauses and are opting to redeem their investments. A quirk of the rules is that investors have the right to vote in favor of a merger going ahead, while still choosing to redeem their own shares, leaving less money in the pot to consummate the merger. Redemption rates of 10% earlier in the year have risen as high as 70% more recently, according to Phil Ingle, a managing director at Morgan Stanley, speaking to the spaceflight industry's ASCEND conference last month. Last week, media company BuzzFeed completed its SPAC merger despite suffering a 94% redemption rate that left just $16 million in the coffers, although it also raised $150 million through a convertible note issue. At the time of writing its stock price stands at $6.

Scupper the deal

A high redemption rate can be enough in itself to scupper a deal, which typically will have a minimum cash level built into the terms agreed with the target company. If there isn't enough cash left in the pot to cover that minimum, the target company can call off the deal. Sponsors can opt to make up the shortfall by bringing in another investor at a discount, but in exchange they're often asked to give up a proportion of their own promoter shares entitlement, so may not be willing to.

The other deciding factor is the likely price the stock will settle at once the merger is completed. Any stockholder that hasn't exercised their redemption rights by the time of the merger is then at the mercy of the market. Most SPAC IPOs list at $10 per share, so if the price falls below that level, their investment will have shown a loss. Sponsors will also be looking for a return on their initial investment from their promoter shares, which are typically locked up for at least a year.

Weighing up all these issues, a rising number of SPAC deals are now getting canceled, although bear in mind this is out of a record high of 121 deals that were outstanding at the beginning of this quarter. Eight have failed so far this quarter, compared to only one in the first half of the year, SPAC Research founder Ben Kwasnick told Axios. In addition to the ServiceMax deal, other mutually agreed cancelations include Valo Health, a target of a SPAC set up by storied VC firm Khosla Ventures, and Wynn Interactive. In some cases, such as Fertitta Entertainment and Apex Fintech Solutions, the target has unilaterally called off the deal. Other deals have been renegotiated or had the minimum cash level changed.

A question mark hangs over those SPACs still without a deal in place, including Pathfinder Acquisition Corp, which must now find a new partner having agreed to call off its merger with ServiceMax. They now face what looks like a sellers' market, in which target companies can dictate terms. Another SPAC sponsor, Atanuu Agarrwal, comments:

If sponsor teams are unable to demonstrate sufficient value-add either through their technical, commercial, or capital markets expertise, they will have to agree to give up most of their [promoter shares], or worse, see their SPACs liquidated and their investments completely written off.

My take

When I first heard about SPACs, I was instantly reminded of the stock issued during the feverish South Sea Bubble in the early eighteenth century, "For an Undertaking which shall in due time be revealed." Historians record that it sold well at a price of two guineas for a hundred shares. Such offerings seem to do exceptionally well when stock prices are racing ahead, but fall back when investors are less trusting.

It's unlucky for the likes of ServiceMax to have been caught up in this shift in sentiment, when in principle the SPAC option looked like a rapid and effective route to a public listing. Now it's back to the drawing board and the tried-and-tested method of a traditional IPO — unless a deep-pocketed trade buyer chooses this moment to come knocking. As we've often said, given that Salesforce already has a stake in ServiceMax, the CRM giant is an obvious potential acquirer. When the SPAC deal was first unveiled, we asked whether the price tag had just gone up. Who knows, perhaps now the price is right?

A grey colored placeholder image