Why a SPAC Bubble Is Actually Good for the Economy
A boom in blank-check IPOs is setting off alarms, but they solve a very real problem for some companies
Money Talks is a column that explores what happens when business, the economy, and culture collide.
In 1720, the English economy was gripped by a speculative mania known as the South Sea Bubble. The hysteria began with a steep rise in the stock price of a government-connected firm called the South Sea Company, but soon investors were happily bidding up stock prices across the board. In response, a host of new companies offering a wide array of unlikely products and services quickly incorporated and sold shares to hungry investors. One company described its business as trading in hair. Another promised to transmute quicksilver into a malleable fine metal, and one said it was going to build “a wheel for perpetual motion.”
That these claims were outrageous and impossible to verify — when not self-evidently false — was, at that moment, seemingly irrelevant to investors. It was enough that their stocks were going up. So soon the most clever of all these new companies came forward, and sold shares to the public with a prospectus that said it was raising money “for carrying on an undertaking of great advantage, but nobody to know what it is.” In other words, it promised nothing more than a promise.
More than 175 SPACs have gone public already in 2020, raising $65 billion in capital… That’s more than the amount of money raised by SPACs in the last decade.
That might sound totally improbable. And yet, if you look at Wall Street today, you might wonder how much has really changed over the past 300 years. The most important investing craze of the moment is centered on Special Purpose Acquisition Companies (or SPACs). And what, at the core, is a SPAC? It’s a company that goes public and raises capital from investors in order to make an acquisition. (Typically, a SPAC doesn’t buy a whole company, but rather acquires a stake in it.) It does this without investors knowing what that acquisition will be, or how much it will cost. Investors do know who’s in charge of the SPAC (they’re called the “sponsors,” oddly), and they know the deal has to be done within two years, or else the sponsors have to give the money back. But at heart, a SPAC promises to carry on an undertaking of great advantage, and at the time it goes public, nobody really knows what that undertaking will be.
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This has, understandably, raised a lot of worries about whether the SPAC boom is just the latest example of the madness of crowds. While SPACs have been around, under one name or another, for decades, and while they enjoyed a little boomlet in the late 2000s, they have exploded in popularity this year. And more than 175 SPACs have gone public already in 2020, raising $65 billion in capital. (In the biggest deal this year, hedge-fund manager Bill Ackman raised $4 billion for his Pershing Square Tontine Holdings SPAC.) That’s more than the amount of money raised by SPACs in the last decade. Signs of frothiness in the market are easy to see, with everyone trying to cash in on the boom — participants in recent SPACs include Shaquille O’Neal, Martin Luther King III, and former House Speaker Paul Ryan. And with retail investors rushing to jump on the bandwagon, the first-ever SPAC ETF has already been launched.
IPOs have become an extraordinarily inefficient way for companies to raise money.
It’s easy, in other words, to dismiss this as a short-term fad. And to be clear: For retail investors, buying shares of a SPAC is a gamble at best. Historically, SPACs have performed dismally: A study by Renaissance Capital found that between 2015 and September 2020, less than a third of all SPAC IPOs had positive returns. (SPAC performance this year is better: through mid-October, the annualized rate of return this year was 35%.) And a recent paper by law professors Michael Klausner of Stanford and Michael Ohlrogge of New York University argues that institutional investors and SPAC sponsors take so big a cut of SPAC deals (sponsors have traditionally gotten 20% of the shares) that it’s almost impossible for ordinary investors to make money, particularly if they hold onto SPAC stocks after they make their acquisitions.
And yet the truth is that the point of capital markets isn’t to make investors rich. It’s to raise money for companies so they can invest and grow. And when you look at it from that perspective, it becomes clear that SPACs aren’t just hot because they’re the flavor of the month. They’re hot because they are filling an important hole in those capital markets: They’re providing companies with a quicker and cheaper way to go public than the traditional IPO, and more certainty about the price they’ll get when they sell a stake in their business.
Why is this the case? Because the traditional IPO model doesn’t work that well for many companies. If you’re a giant like Airbnb or DoorDash — two companies that recently filed for IPOs — it works okay. But companies are sometimes too risky, or not in a hot enough field, to get investment banks to underwrite them or to raise money at a reasonable valuation via IPO. Going public is also a long and complicated process. Most important, IPOs have become an extraordinarily inefficient way for companies to raise money.
More SPACs means more competition for deals, which means the companies SPACs are interested in can drive harder bargains and sell themselves for higher prices, and can get better terms than were once possible.
When a company goes public via an IPO, its offering price — the price that it actually sells shares to investors — is now pretty much expected to be well below its true valuation. That’s what creates the big first-day pop in the stock price that gets investors excited. In fact, according to a recent piece by venture capitalist Bill Gurley, the average IPO in the first half of 2020 saw a first-day jump of 31%. That’s great for investors. But it means companies that go public via IPO are leaving tens if not hundreds of millions of dollars on the table. And that’s on top of the already hefty fee they pay investment banks.
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The SPAC boom has changed this equation. The tens of billions of dollars that all these SPACs have raised has to be used to buy stakes in real companies. More SPACs means more competition for deals, which means the companies SPACs are interested in can drive harder bargains and sell themselves for higher prices and can get better terms than were once possible. (For instance, the 20% cut for sponsors is no longer fixed in stone. In fact, Bill Ackman reduced his cut in the Pershing Square SPAC to 0% up-front.)
Like most bubbles, this is almost certainly not a sustainable state of affairs: at some point, investors will stop being willing to subsidize high-priced acquisitions.
This means that in many cases, companies are able to raise capital more cheaply and quickly than they would by trying to go the route of a traditional IPO, were that even available to them. You might think that, between the sponsors’ cut and the fees that you pay to complete an acquisition, selling a stake to a SPAC would be as or even more expensive for a company than a traditional IPO. But the magnitude of the underpricing in traditional IPOs, and the increase in the price SPACs are willing to pay target companies, has changed that. In fact, as that paper by Klausner and Ohlrogge demonstrates, the companies that are selling off stakes to SPACs mostly don’t bear the costs of these deals — those costs are largely borne by SPAC shareholders. That’s what has made investing in SPACs risky for ordinary investors (though not for sponsors). But it’s also what’s made them a boon to target companies.
Like most bubbles, this is almost certainly not a sustainable state of affairs: At some point, investors will stop being willing to subsidize high-priced acquisitions. And the SPAC boom has a clear downside: It means that lots of money will be invested in overhyped and sketchy companies, as seems to have happened with electric-vehicle maker Nikola, or in startups that never make it out of the fledgling stage.
But for the economy as a whole, it’s likely to do more good than harm. As the economists Ramana Nanda and Matthew Rhodes-Kropf have shown, investing bubbles, for all their messiness, can help drive technological innovation by channeling money to high-risk ventures that in normal times would have difficulty raising money at all. And that’s precisely what the SPAC bubble is doing: Just think of the more than $10 billion SPACs have put into the electric-vehicle industry, Nikola included. Just watch out for the moment when a SPAC buys a company that promises to build a perpetual-motion machine.