Column: Wall Street’s love affair with “blank check” investments does not end happily

Someone on Wall Street should build a statue of Henry Villard.

Villard discovered that if you do not tell investors how to spend their money, they will be more eager, not less.

Villard tried to raise millions of dollars in capital to take over a company but did not want to disclose his goal for fear of driving the price out of his reach, Villard sent out a prospectus for a “blind pool” and stated he would disclose the exact nature ”of his plans 90 days later.

Maybe driven by hype is … press reports that focus on some successful SPACs with high visibility.

Michael Klausner and Michael Ohlrogge

Rather to his surprise, his pool was sold for 24 hours; in fact, investors bid twice what he asked. “Everyone wanted more,” he recalls.

The year was 1881. Villard’s quarry was the Northern Pacific Railroad, with which he hoped to build a rail network to the Northwest Pacific.

But what makes his plan relevant is that the same principle of raising money through an empty check has become the latest maniac to sweep Wall Street.

Today, they have a new name – Special Purpose Acquisition Companies or SPACs – but the concept has not changed since Villard’s day. SPAC raises money, usually in the hundreds of billions, for pools that only promise to merge with another company at some point in the near future.

Some SPACs say they will be looking for merger partners in some areas, but in general the goals are unknown, not even for SPAC promoters.

According to last month, according to the marketing service SPAC Research, 204 new SPACs have raised $ 65.4 billion so far this year, which means that the 2020 record of 248 SPACs raising $ 83.4 billion is expected to fall. And that was six times as much as SPAC had increased in 2019.

SPAC has become the latest must-have among bigshots. The field has attracted pop stars and sports stars, former political heavyweights and of course leading Wall Street and business figures.

Colin Kaepernick, Arianna Huffington, former Trump aides Wilbur Ross and Larry Kudlow and former house speakers Paul Ryan are all associated with SPAC in one capacity or another.

At the other end of the pipeline, SPAC has received companies in lively fields such as cannabis and online gaming. And these companies know that they are the bells in the SPAC ball.

Like my colleague Russ Mitchell recently reported, “Fuel cell company Nikola, electric car manufacturer Fisker, electric bus company Proterra, electric car manufacturer Lordstown, electric robot taxi company Canoo and many more have completed or announced SPAC offers.”

One reason why companies, assuming future dates, become pregnant with SPAC is that financial supervisors give mergers of SPAC much easier scrutiny than conventional IPOs.

It points to the punchline of this story. If you’ve followed economic history, you already know: When a craze metastasizes from Wall Street to the outside world, the smart policy is to escape.

The SPAC concept is already adorned with misleading jabs and completely incorrect presentation. SPAC has been described as “poor man’s private equity” and “instrument of financial democracy.”

This means that they are a good way for the average person to get into investments previously reserved for rich insiders. They are also presented as cheaper ways for start-ups to be listed on the stock exchange than IPOs.

These descriptions are all “off the mark”, law professors Michael Klausner of Stanford and Michael Ohlrogge of New York University reported in a newspaper in November last year. (Their paper is entitled “A Sober Look at SPACs.”)

Their conclusion, based on an analysis of all 47 SPAC offerings that took place between January 2019 and June 2020, was that the SPAC market is still dominated by large institutions.

They are not necessarily cheaper than conventional IPOs, they found: “Costs built into the SPAC structure are subtle, opaque and much higher than previously recognized.”

In other words, for investors and start-ups, SPAC presents nothing new under the sun. They just look new.

Let’s examine how SPAC works in its modern form.

The process starts when a promoter – “sponsor”, in SPAC terminology – conducts an IPO, usually at $ 10 per share. Investors are promised that the resulting fund will seek a merger partner sometime within the next two years.

In the meantime, the money will be parked in government bonds. if no transaction occurs before the deadline, SPAC will be liquidated and the money will be returned to investors with interest.

In addition to shares in SPAC, the initial investors also receive a warrant to acquire shares in the merged company, usually at an exercise price of $ 11.50 per share, and sometimes an additional right to acquire shares after the merger.

When a SPAC finds a target and proposes a merger, the original investors have the opportunity to redeem or sell back their shares, get back their initial investments plus interest. But they can keep the warrants and the rights.

The SPAC investor’s game is that SPAC will announce what Andrew Walker, an investment analyst who follows the field, calls “a particularly good deal in a particularly lively sector. “If this is the case, the SPAC shares will be traded higher, before the transaction.

If the announced deal produces yawns, SPAC investors can redeem, recoup their original investments, put together their risk-free interest income, and retain their warrants if the merged entity is a winner.

A possible pitfall is that SPAC sponsors will rush into a merger when the two-year deadline beckons. That’s the charge behind it a class action filed in 2019 against Landcadia Holdings, a SPAC that merged with the food delivery service Waitr 2018. The case is awaiting a key decision in federal court this month.

Investors in SPAC claim that their experience shows that the urgency of a deal is a “disaster recipe”. Waitr, they say, was not close to profitability and had no plans to reach black ink. But the deal was accompanied by too rosy forecasts. They want Landcadia to be held accountable.

According to Klausner and Ohlrogge, the vast majority of SPAC investors save through redemption – the average redemption rate among the 47 SPACs they surveyed was almost 60%, of which a quarter of the SPACs received redemptions of more than 95%.

Sounds like a pretty good deal. But as Klausner and Ohlrogge calculated, this is true mostly for the redemption investors. For those who remain invested through the merger phase, a panoply of hidden costs starts. These include sponsors’ receivables for shares, which can amount to 20% of the total SPAC value.

SPAC shares “fall by a third of their value or more within a year of a merger,” Klausner and Ohlrogge report. In fact, “many SPACs with high-profile sponsors have worked disastrously.”

A pitfall is compliant regulation. The Securities and Exchange Commission introduces strict standards for traditional IPOs. The issuing company must report its previous financial results with audited figures. The SEC is frowning on investors with assumptions about future financial expectations, which obviously cannot be examined.

SPAC deals with start-ups are not treated as IPOs but mergers where forecasts are allowed. It is inviting for many start-ups,

Think of what has become a notoriously disappointing SPAC merger, which merged a SPAC called Churchill Capital IV, run by a financier with three former SPAC units under its belt, and the electric car company Lucid Motors.

Lucid aims to compete with Tesla in the luxury car market with a model that originally cost up to $ 170,000. Tesla cars, it sniffed in one investor presentation issued with the concentration notice are “innovative but not luxurious.”

Lucid had no previous results to reveal, as it has never sold a car and does not expect it to arrive until the end of the year at the earliest (after predicting that its luxury vehicle would roll off its assembly line in Arizona as soon as the second quarter of this year ).

But the company projected an ambitious ramp-up from $ 97 million in revenue this year to $ 2.2 billion in 2022 and $ 5.6 billion in 2023.

Churchill shares had more than quintupled in price to $ 57.37 after the Lucid deal was first rumored in January but fell to $ 35.21, down nearly 40%, on the same day the $ 4.4 billion deal was announced. They now trade in the region $ 29.

The disappointment was probably due to the production delay and some gloomy financial statistics: Lucid said it would need $ 600 million in financing even after the merger and expects to burn about $ 9.8 billion in cash until it becomes cash flow positive in 2025. No one can be sure if or how it will fill the financial hole.

SPAC has therefore started to show all the signs of a bubble. The success record for the investment devices is mixed at best and really worse than what would justify the enthusiasm.

So what does madness stand for? “Maybe driven by hype,” Klausner and Ohlrogge write, “are … press reports that focus on some successful high-visibility SPACs.”

Over time, however, it is likely that more deals with Lucid’s disappointing color will emerge. The advantages of start-ups that go public via a SPAC are the product of a “loophole” that should be closed by the SEC, Klausner and Ohlrogge say.

It will not be long before sophisticated investors come to life in the pitfalls of SPAC investments, including their hidden costs. They will be drawn to SPACs sponsored by financiers with good results and leadership skills, not those associated with figures from the entertainment, sports and political worlds.

Everyone would be advised to consider the final fate of Henry Villard. As he approached the height of success, he built a landmark home on New York’s Madison Avenue, designed by Stanford White, which is still remembered as the Villard houses.

One night after moving in, he visited a delegation of investors and auditors who informed him that he was bankrupt. He and his family left the home, which was sold to Whitelaw Reid, publisher of the New York Tribune.

Much later, it served as the facade of the 55-story Helmsley Palace Hotel, where the social figure Leona Helmsley ruled until her conviction of tax evasion in 1989. The hotel passed to the Sultan of Brunei, who eventually sold it to a South Korean tourist company that runs it today.

Villard had another brush with grandeur. In 1887 he was invited to resume the presidency of the North Pacific, but went bankrupt by charging himself extortionate loans.

Villard, as it happened, was much more adept at raising money than using it wisely. It’s a Wall Street story that never seems to get old.