It is easy to critique SPACs—they are generally unprofitable and earlier-stage than even typical IPOs, which means that they have been more susceptible to the macroeconomic winds of change and valuation compression this year. They also don’t offer investors the same opportunity to question the business model that an IPO does (through the roadshow), and there is a lot less in the way of practical restrictions around fanciful and optimistic long-term projections from company management in the case of SPACs compared to IPOs. Is it any wonder that WeWork, which saw its own IPO famously flail and burn upon entry to the capital markets gravity well, opted for a SPAC transaction instead the second time around?
SPACs have been around well before Virgin Galactic ignited the markets’ animal spirits—they were used in small doses throughout the 1990s and 2000s. Yet, this time was supposed to be different—SPACs had been reforged and reformed into a more investor-friendly format that should have made them a viable competitor to IPOs. Nevertheless, things haven’t quite worked out the way SPAC proponents, bankers or investors may have hoped. SPAC performance has been miserable, and with the one-two punch of higher interest rates and greater regulatory scrutiny, the rebirth of the SPAC market may be over already.
Fundamentally though, it doesn’t have to be this way. The SPAC mechanism is a method to bring a company public—just like an IPO. The issue is as much one of adverse selection as anything else. Essentially because low-quality companies have historically used SPACs as a way to go public, investors look at SPACs suspiciously and assign them a lower valuation than they do IPOs. As a result, higher-quality companies choose to eschew SPACs and go the IPO route. That leaves (mostly) only low-quality firms using the SPAC method. Of course, low-quality firms could go through an IPO (and some do), but the scrutiny in IPOs is greater, and so, the benefits of the valuation certainty for a SPAC are greater for these low-quality firms. Given the opacity and information asymmetry that exists in capital markets between investors and management, this essentially means that SPACs suffer an adverse selection problem—investors don’t know if they are high-quality or low-quality companies but have to assume the SPACs are low-quality. Nikola and the former CEO Trevor Milton are exhibit A for that information asymmetry.
Wall Street was loathing to admit the realities of the challenges facing SPACs and the information asymmetry in large part because the arbitrage opportunities were so great in SPAC/de-SPAC transactions. But it should be telling that very few SPAC companies were rated by analysts even after the de-SPAC mergers were complete. On Wall Street, it’s much easier to drop coverage or just never initiate it, than to assign a Sell rating after all. To quote Shakespeare, “the more pity that fools may not speak wisely what wise men do foolishly.”
So what is the solution to the SPAC dilemma? The only answer is to reduce the information asymmetry and help investors to better establish the quality and value of SPAC targets—and that likely means more regulations and rules. But imposing those rules and regulations will create significant costs and valuation pressure for existing and new SPACs alike, which of course means greater investor disinterest and lower prices. Pity the SPAC. Pity the SPAC investor.
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