Capital Note: The SPAC Slowdown

A U.S. flag hangs above an entrance to the New York Stock Exchange in 2015. (Lucas Jackson/Reuters)

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the SPAC craze slows down, Hwang’s leveraged blowout, and S&P 4,000. To sign up for the Capital Note, follow this link.

Are SPACs Whack?
The boom in special-purpose acquisition companies (SPACs) has driven global deal activity to its highest level since 1980. Each blank-check company begins with an equity offering and ends with a merger, all in the span of less than two years — great news for the investment bankers collecting fees on the transactions. With 103 SPACs issued last year executing the “reverse mergers” by which they take companies public, M&A activity is up nearly 100 percent since last year. The velocity of SPAC deals is so high that banks are reportedly turning the lucrative deals down:

The pipeline of SPACs rushing to market is getting so clogged that bankers, lawyers and auditors are turning away business as they struggle to keep pace, according to people familiar with the matter. As founders of blank-check companies wait in line, the deep-pocketed investors needed to take them public have grown squeamish.

Some banks, such as Citi and Moelis, are compensating their overworked junior employees with cash bonuses, but analysts appear slated to have a lighter workload this summer as the SPAC craze slows down. In the past two weeks alone, four blank-check deals have been halted, with SPAC shares declining significantly from their highs early this year. The slowdown follows an influx of short-sellers into the opaque financial vehicles and a sell-off in high-profile SPACs such as Churchill Capital Corp IV.

Weakness in SPACs is partially a function of increased competition: With so many SPACs hunting for targets, merger valuations have grown unsustainable, and sponsors are getting laxer about the companies they choose to take public. “They are bringing lower and lower quality companies public,” an investment analyst told CNBC. “They run up against the capacity of reasonable quality companies especially in the niches that are popular.”

That means a good chunk of SPACs issued last year will see a longer lag before they take targets public, and the pop in first-quarter M&A activity could prove to be short-lived.

Another issue is tepid appetite from the private investors who finance SPAC mergers. Blank-check companies raise money in the public markets, but they require private capital to finance their take-public transactions. Private-investment-in-public-equity (PIPE) financing is the last leg of fundraising in the blank-check lifecycle, and it’s been a key pillar of the recent boom in SPACs.

Recently, however, PIPE financing for SPACs has begun to dry up. Some of the high-profile SPAC sell-offs appear to have tightened the spigots of capital from private-equity firms, which are committing less money to SPACs now than they did last year. A partner at Morrison & Foerster told Bloomberg that “PIPE investors are becoming increasingly discerning,” causing delays in deal closures.

Meanwhile, the Securities and Exchange Commission — invigorated by the Biden administration’s more aggressive posture toward Wall Street — has launched an inquiry into SPACs. Concerns about retail activity in the opaque investment vehicles could lead to increased disclosure requirements for SPACs. In the meantime, the SEC has slowed down its response time for SPAC filings, with more filings requiring amendments or revisions than they did last year.

Around the Web
S&P 500 hits a record 4,000

Technology and energy shares propelled US stocks to a new record on Thursday while government bonds rallied, in the return of a popular pandemic trade predicated on continued social curbs and supportive monetary policy. The benchmark S&P 500 passed the 4,000 level for the first time, closing 1.2 per cent higher in New York. The tech-focused Nasdaq Composite, which is stacked with growth companies whose valuations are flattered by lower market interest rates, climbed 1.8 per cent.

Bloomberg goes in-depth on Bill Hwang’s “leveraged blowout”

Underscoring the chaos of an escalating situation, representatives from Credit Suisse Group AG floated a suggestion as they met last week to confront the reality of such an exceptional margin call and consider ways to mitigate the damage: Maybe wait to see if his stocks recover? Viacom, some noted, seemed artificially low after its run-up past $100 just two days earlier.

Yet it was Hwang’s own orders that had helped make Viacom the year’s best performer in the S&P 500, forcing benchmark-tracking investors and exchange-traded funds to buy as well. Without him creating that momentum, Viacom and his other positions had little hope of rebounding.

At several points during those exchanges, bankers implored Hwang to buy himself breathing room by selling some stocks and raising cash to post collateral. He wouldn’t budge, people who participated in the meetings said.

Random Walk
In a Harvard Business Review article last month, business professor Ivana Naumovska warned that the SPAC bubble was coming to an end:

Research shows that when more people adopt a practice, it will become increasingly widespread due to growing awareness and legitimacy. But that’s for non-controversial stuff. Things get a little more complicated for controversial practices like SPACs and reverse mergers, where third-party concern and skepticism also grows as the practice becomes more widely used.

Our study offers an institutionally and sociologically informed explanation of the boom-to-bust dynamics of controversial practices. While finance and economics have suggested that decision makers’ cognitive biases drive these bubbles, we add to evidence that such bubbles can relate to institutionally driven dynamics. In effect, we show that the popularity of reverse mergers planted the seeds of its own demise.

We collected data on the use of reverse mergers, market responses, and firm characteristics, including market value, earnings, total assets and debt, exchange listing and between 2001 and 2012. We also studied how the media evaluated reverse mergers. Of the 267 articles published between 2001 and 2012, 148 were neutral, 113 were negative and only 6 were positive. Finally, we gathered share price data to examine how stock markets valued reverse mergers.

Our analysis of this data shows that — as you would expect — higher popularity of the practice (i.e., higher number of past adoptions of reverse mergers) initially triggered imitation and further adoption. But, simultaneously, as the number of reverse mergers grew, investors and the media became increasingly skeptical about the practice. The skepticism and negative reactions were further intensified as the proportion of reverse merger transactions involving firms with relatively low reputations increased. The poor stock market valuations of reverse merges, and the negative media coverage discouraged firms with good reputations from adopting the practice. The regulators duly waded in. Both the Securities and Exchange Commission’s 2005 disclosure rules for reverse mergers and its 2011 warning to investors about investing in reverse mergers amid an influx of Chinese players — a phenomenon studied in another of my recent papers — triggered negative market reactions and led to a decline in the practice.

In essence, investors, regulators, and the media — important arbiters of financial innovations — fed off one another’s cues and evaluations. Negative media coverage weighed on stock market valuations and the subsequent diffusion of reverse mergers. 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. In effect, the popularity of reverse mergers planted the seeds of its own demise.

— D.T.

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