This week, Edward Chancellor, our esteemed once-a-year guest writer, again digs deep into contemporary financial deceptions, “lipstick on a pig” reincarnations of past “beggar thy neighbor” scams. Because there’s a smidgen of truth in every lie and a pinch of rationality in every bubble, his forensic prism sees clearly through the fog of obfuscation. Moreover, Chancellor peels away more layers of onions we’ve dissected in earlier posts – e.g. WeWork and SPACs – taking the reader ever closer to the core.

Some claim we are seeing a rebirth of the “roaring twenties” (a.k.a., the “Age of Wonderful Nonsense”). As previous untouchables like Modern Monetary Theory (MMT) are gaining credence, the INEPT pricing theory seems almost rational.

Regulators will kill the SPAC frenzy

Three centuries have passed since the launch of “a company for carrying on an undertaking of great advantage, but nobody to know what it is.” It’s easy to think that only fools would invest in a shell company which had yet to declare its purpose. But investors in the most famous of these so-called bubble companies, which sprouted in London’s Exchange Alley in early 1720, weren’t complete idiots. Since its shares were issued on a partly paid basis, they were hugely leveraged to a rising stock price. Some speculators made 30 times their initial down payment. Likewise, most players in the current craze for blank-cheque vehicles, known as special purpose acquisition companies, or SPACs, are rational. But even rational bubbles eventually burst.

The original English bubble companies covered a wide variety of offerings, including “Settling Terra Australis”, making starch out of potatoes, a “Copartnership for Trading Hair”, as well as others for furnishing funerals, extracting gold and silver from lead, and “A Company for Emptying the Necessary Houses” (i.e. public toilets). The ambitions of the recent batch of SPACs are still more ambitious: there are several flying taxi startups, a “developer to augment humans to enhance productivity and safety”, a producer of synthetic meat, a high-rise farmer, a maker of recyclable plastic and, naturally, a cannabis producer. Many SPAC promotions are makers of electric vehicles, sensors and batteries – the latter now restyled as “electrification solutions for commercial applications”.

Over 300 SPACs have been launched this year, raising $93 billion, more than during the whole of 2020, according to Refinitiv data. Not everyone on Wall Street is drinking the Kool-Aid, however. Investors in the SPAC IPO can ask for their money back when the company merges with its target. What’s more, they get to keep warrants in the merged entity. In effect, IPO investors are buying risk-free convertible bonds. Pre-merger SPACs have recently produced returns in the low double-digits. A group of hedge funds, known on Wall Street as the “SPAC mafia”, use leverage to extract greater profits.

The vehicles’ promoters have an even juicier deal: at the IPO, they put in some cash to cover the launch costs. In return, promoters receive warrants and a 20% stake in the company. The odds are so heavily stacked in their favour that promoters can even make money when completing deals that destroy value for other shareholders. At the time of the proposed merger, the SPAC raises more money in a so-called “private investment in public equity”, or PIPE. These new investors are offered shares at below market price, warrants and other sweeteners.

Given that listing shares via a SPAC is reckoned to be three times more expensive than a traditional initial stock offering, it’s a wonder that companies choose to list in this manner. But merging with a SPAC offers a speedier way to market than an IPO, allowing companies to catch the current wave of speculative euphoria before it fizzles. Last year, as Tesla’s (TSLA.O) share price soared into the stratosphere, many SPACs announced mergers with nascent firms in the electric vehicle industry.

Promoters of the 1720 bubble companies made impossible promises. SPAC promoters also entice investors with fantastical visions. Unlike during conventional IPOs, companies merging with SPACs have more freedom to make forecasts about their future sales, profits and valuations. Silicon Valley is happy to turn to this “market for lemons” to offload its duds. To wit: WeWork, the office-sharing company, whose IPO spectacularly collapsed, is now planning to debut via a SPAC.

The big losers are investors who buy shares at the SPAC launch but don’t redeem at the point of merger, and those who acquire shares after the merger. Not only are they picking up wooden nickels, but their investment is diluted by all those warrants and the outsized promoters’ stake. Why do they do it? Investment writer Bill Bernstein suggests that people who get their kicks from gambling are willing to pay more for shares than they are worth from a financial perspective. Bernstein’s “investment entertainment pricing theory” (INEPT) explains why investors hold on to SPACs even though, on average, they’re guaranteed to lose money.

It’s no coincidence that the SPAC market slowed in late February, at the same time as the collapse of GameStop (GME.N), which had been pumped on WallStreetBets and traded by INEPT investors on the Robinhood trading platform. SPACs now face challenges on many fronts. The SPAC “free lunch” is disappearing as the number of warrants issued in IPOs has declined. The imminent expiry of lockups on last year’s deals may soon flood the market with more SPAC shares. There are concerns that the hundreds of SPACs currently looking for deals will have trouble finding suitable partners, as well as lining up PIPE financing. Promoters are on the back foot.

Several SPACs, which launched with great fanfare, are scaling back their ambitions. For instance, when EV battery maker Romeo Power (RMO.N) announced a SPAC deal last October, the California-based firm projected 2021 sales of $140 million with sales compounding by 59% over five consecutive years. At the end of the first quarter, however, Romeo lowered its 2021 guidance to up to $18 million. Its share price has fallen by more than 75% from the peak.

Earlier this month, the Securities and Exchange Commission said it was examining “some significant and as yet undiscovered issues with SPACs.” The regulator has suggested that SPACs may not have properly accounted for their warrants. The SEC is also clamping down on shell companies which make misleading statements during their mergers. If the “safe harbor” rule which protects SPACs from lawsuits is taken away, as seems likely, their advantage over conventional IPOs disappears. There are also concerns that some SPACs may have spoken to their merger partners before their IPOs – if true, this would be a flagrant breach of the listing rules.

In June 1720, the English government declared that companies which hadn’t been officially endorsed by Parliament were a “public nuisance”. This regulation killed the bubble companies, and the collapse of these speculative ventures brought down the London stock market. After 1720, only two bubble enterprises continued trading. No doubt future historians will look back with equal amusement at today’s SPAC frenzy, and dub it the most rational bubble the world has ever seen.

-Edward Chancellor

Leave a Reply