Why Most SPACs Fail
In Essence
In times where the market is distressed, with a looming threat of recession and embattled with high inflation and geopolitical uncertainties, there tends to be a flight to safety among investors, from early-stage growth stocks to high-quality dividend stocks. As a result, SPACs these days are struggling to get deals done, and those that have completed mergers are saddled with tanking stock prices and an uncertain future.
Our view is that this market correction is healthy, and the tightening of SEC regulations will pave a more level playing field for all stakeholders involved in the SPAC lifecycle. SPACs should not be the shortcut to IPOs or a mechanism for a select group of self-serving people to get rich at the expense of others. In the coming months, we anticipate seeing a wave of SPAC restructurings as many SPACs are set to expire. Those that will successfully rise above and become truly successful in the long run will have to be disciplined at identifying and merging with extraordinary assets that can withstand the test of time.
Seiya Tabuchi / iStock via Getty Images
Introduction
Not too long ago, everyone seemed to be talking about SPACs, or special-purpose acquisition companies, commonly referred as “blank-check companies”. As suggested by the name, a SPAC’s sole purpose is to merge with an operating company through a reverse merger. Once the merger is completed, the operating company takes over the SPAC and becomes the public trading entity. SPACs became so popular in 2021 that anyone who had access to a network of institutional money and / or exclusive deal sourcing would create a SPAC. In those high-flying days, institutional money poured into SPACs without many questions asked. At its peak, SPACs seemed to be the cure for all problems in the western hemisphere.
Fast forward to today, investor sentiment is the exact polar opposite; everyone is scared of uttering the four-letter word. It’s painful to see companies that went public via reverse mergers with SPACs are struggling to meet their narratives at the time of merger – the unfulfilled promises on revenue growth, earnings expectations, production timeline, technology viability, among others, translated into the free fall of stock prices. Many people saw their dreams crushed and wealth dwindled. Additionally, with low stock prices and the challenging market, many of these companies are finding the prospect of raising additional capital to fund their business plans unattainable. With little prospect of additional funding, these companies are faced with the threat of getting de-listed if company performances do not turn around soon.
Out of 280 closed mergers in North America since 2020, only 29 (10%) companies are trading above $10 per share, 59 (21%) are trading between $5 - $10, and the vast majority trade below $5.
Data as of September 2022 and by CapIQ
Every sector except Energy has been experiencing significant decline in market value.
Data as of September 2022 and by CapIQ
Recent History
While SPACs have been around for a long time, the investment vehicle quickly made its fame during COVID and became a popular way for early-stage companies to access both public and private capital. For founders, SPACs offered many of the benefits of an IPO without going through the hassles of a more rigorous and time / resource consuming traditional IPO process. In addition, 2020 and 2021 were unique times from macro standpoint which ultimately led to the explosion of SPACs.
First and foremost, after years of low interest rates, investors were desperate to deploy their ever-increasing cash hoards. Hit by COVID in early 2020, the IPO market was uncertain. The Fed and government released fiscal and monetary stimulus packages in an effort to save the economy. All these factors precipitated a rosy market for the second half of 2020 through 2021, characterized by high public valuations (including early-stage, pre-profit technology companies), a robust M&A environment, and unprecedented capital raising activities.
The symphony of these factors combined created an optimal environment for the rise of SPACs. Investment bankers and lawyers experienced increased deal volume and fees, SPAC sponsors diluted equity ownership and received handsome promotes for sourcing deals, institutional investors got first looks at private opportunities and the possibility to put large amounts of money to work, and founders & CEOs finally got to see their companies become public and their personal wealth skyrocket. This was capitalism at its finest. Everyone who participated in this process got richer and became one or multiple steps closer to achieving financial freedom. If only the music never stopped…
By late 2021, the flywheel started cracking. It initially started with investor fatigue for more SPAC deals as the market started getting saturated; more SPACs than ever tried to compete for investor money. Then it became increasingly difficult to secure a private investment in public equity (“PIPE”) for a merger between a SPAC and the underlying operating business (which is oftentimes an early-stage company with negative profitability and little revenue). Then, companies that went public via SPAC started missing quarterly earnings and having trouble scaling production and meeting timelines. In certain instances, investors felt misled by companies on the maturity of their technologies and their extremely rosy business plans. In early 2022, to the world’s surprise, Russia invaded Ukraine. The geopolitical catastrophe and continued ramifications of the COVID pandemic compounded supply chain issues, semi-conductor supply shortages, labor shortages, energy supply issues, and other challenges around the world. This created a high inflationary environment which ultimately forced the Fed to take tightening measures that resulted in the current (relatively) high interest rates.
As a result, most companies that merged through a SPAC failed spectacularly.
Lessons Learned
While there are many systemic forces that influence the markets, SPACs and companies that wish to go public can certainly learn from recent experience. We have summarized important lessons learned:
Cultural transition – Going from private to public is an enormous cultural transition. For privately held companies and family-owned businesses, hitting quarterly financial targets and meeting annual guidance may not be as critical when balanced with executing long-term vision; however, when in public, these companies are scrutinized and judged for every action that management takes or does not take. Therefore, public readiness is extremely critical. SPACs, founders, and private CEOs need to be very honest with themselves when evaluating public readiness.
Rosy projections – How many of you have reviewed a PIPE investor deck and wondered how in the world anyone could have come up with such a comically crazy business growth plan that defies everything we know. In addition to that, did all these companies copy each other’s business plans or use the same consultant? Because all of their projections followed the same growth trajectory! While it’s not illegal (yet) to provide rosy and unattainable financial forecasts, it’s certainly borderline unethical and misleading to investors. While these financial forecasts may get a deal done in the short run, investors (if not investors, certainly the internet!) have a memory of what’s promised and will hold companies accountable for achieving expectations. In the long run, a company’s inability to fulfil its narratives will hurt them and cause them to lose all credibility from investors. Losing credibility is irreversible and is one of the worst possible things to happen to a public company.
SPAC value-add – Just like each company is unique in its DNA, some are more likely to succeed in the public context than others. SPACs are the same way. Going from private to public is a cultural transition, and having a high-quality SPAC with relevant industry expertise to support this transition is critical. One of the open secrets that is so well known in the SPAC investor community is that once a SPAC is formed and capital is raised, its original investment targets do not really matter anymore. Those SPACs that are disciplined and truly differentiated by proprietary deal sourcing will merge with companies that fit into their domain expertise. Those that are desperate and would merge with any available private companies should immediately raise red flags to potential investors.
When evaluating a SPAC partner, it’s critical to find ones that have matching industry knowledge and can provide more value than just capital. It’s no surprise that the best performing companies that merged through SPACs have high-quality sponsors that can truly add operating value and have a deep network of resources that the operating companies can tap into as needed.
Financial reporting – Any company looking to go public via a SPAC will need to be prepared with rigorous audit and reporting procedures, as well as internal controls assessments to meet public company reporting guidelines. These processes require an extensive dedication of financial and human capital resources. Many private companies simply do not have such infrastructure in place to deal with the amount of regulatory and market scrutiny.
Disclosure: This article solely represents Her Investing’s opinions. Her Investing is not receiving compensation for it, nor has any business relationships with any company whose stock is mentioned in this article.