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SPAC Bubble

Finan­cial Markets

The SPAC Bubble Is About to Burst 

by Iva­na Naum­ovs­kaFebru­a­ry 18, 2021

It’s not yet two mon­ths old, but 2021 alrea­dy loo­ks poi­sed to out­do 2020 in one area: SPACs, or spe­cial pur­po­se acqui­si­ti­on com­pa­nies, rai­sed around $26 bil­li­on in Janu­a­ry this year in the United Sta­tes, near­ly a third of the record $83 bil­li­on collec­ted by 248 SPACs over the who­le of 2020. The­se so-cal­led “blank check” shell com­pa­nies have no ope­ra­ti­ons or busi­ness plan other than to acqui­re a pri­va­te com­pa­ny using the money rai­sed through an IPO, ther­eby enab­ling the lat­ter to go public quick­ly.

It seems almost ever­yo­ne who is anyo­ne is “spon­so­ring” or set­ting up a SPAC, from ex-Trump advi­ser Gary Cohn to bas­ket­ball star Shaquil­le O’Neal to Hong Kong tycoon Richard Li. But, as my recent paper shows, signs bey­ond the head­line figu­res sug­gest that SPACs are a bub­ble about to burst.

Remember Reverse Mergers?

SPACs are a form of rever­se mer­ger, the sub­ject of my paper. In a stan­dard rever­se mer­ger, a suc­cess­ful pri­va­te com­pa­ny mer­ges with a lis­ted empty shell to go public without the paper­work and rigo­rs of a tra­di­tio­nal IPO. The shell is usual­ly a rem­nant of a pre­vious­ly ope­ra­tio­nal public firm or a public vir­gin shell for­med to com­bi­ne with a pri­va­te com­pa­ny. Whe­re SPACs are dif­fe­rent is sim­ply that the shell com­pa­ny is a proac­ti­ve par­ty, flus­hed with cash from the IPO and hun­ting for pri­va­te targets.

Often cri­ti­ci­zed, rever­se mer­gers have exis­ted for deca­des, most­ly on the mar­gins of finan­cial mar­kets, and we have seen several waves of them sin­ce the 1970s. They sur­ged in the mid-2000s, outn­um­be­ring IPOs in some years, and pea­ked in 2010, befo­re fal­ling off a cliff in 2011. In our paper, my co-aut­hors and I sought to iden­ti­fy what dro­ve the boom and bust of rever­se mer­gers and to draw les­sons from the rever­se mer­gers sto­ry in order to under­stand the life cycles of con­tro­ver­si­al prac­ti­ces more generally.

From Boom to Bust

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.

If all the­se sound fami­li­ar — rapid pro­li­fe­ra­ti­on of a con­tro­ver­si­al finan­cial inno­va­ti­on, plagued by poor-qua­li­ty play­ers, bad publi­ci­ty and regu­la­to­ry con­cern — it’s becau­se simi­lar dyna­mics have re-emer­ged in the SPACs boom.

Here We Go Again

The most obvious sign is the fren­zied growth. Amid the glo­bal stock mar­ket vola­ti­li­ty, last year’s $83 bil­li­on haul by SPACs was six times the amount rai­sed in 2019 and near­ly equa­led the figu­re mus­te­red by IPOs. Even David Solo­mon, chief exe­cu­ti­ve of major SPACs under­wri­ter Gold­man Sachs, war­ned in Janu­a­ry 2021 that the boom is not “sus­tainab­le in the medi­um term.”

Then the­re is the fact that many firms taken public by SPACs have litt­le to show in terms of busi­ness plan or reve­nue, in some cases trig­ge­ring share­hol­der lawsuits by dis­gr­unt­led inves­tors. The most infa­mous examp­le is Niko­la. Three mon­ths after going public last June via its mer­ger with a SPAC, the electric truck start­up was accu­sed of fraud by short sel­lers, resul­ting in the resi­gna­ti­on of its foun­der and a flur­ry of lawsuits by share­hol­ders. Nikola’s stock pri­ce has fal­len to a mere frac­tion of its peak in June. Mean­while SPAC suc­ces­ses such as fan­ta­sy sports bet­ting firm Draft­Kings and data com­pa­ny Cla­ri­va­te Ana­ly­tics are rela­tively few. In fact, a recent stu­dy found that most SPACs’ post-mer­ger share pri­ces fall.

Ano­t­her red flag comes in the form of nega­ti­ve media sen­ti­ment and regu­la­to­ry con­cern. Reports about SPACs are often nega­ti­ve and cau­tio­na­ry. “SPACs are oven-rea­dy deals you should lea­ve on the shelf” war­ned a Finan­cial Times head­line in Decem­ber. SEC Chair­man Jay Clay­ton has signal­ed simi­lar reser­va­tions. The SEC was watching SPACs clo­se­ly, he said in Sep­tem­ber, in efforts to ensu­re SPAC share­hol­ders “are get­ting the same rigo­rous dis­clo­sure that you get in con­nec­tion with brin­ging an IPO to market.”

Under the rules gover­ning them, SPACs must iden­ti­fy firms they can mer­ge with wit­hin 24 mon­ths after they have rai­sed their funds or they will be wound up and the IPO pro­ceeds retur­ned to inves­tors. More than 300 SPACs need to pull that off this year or risk being liqui­da­ted. But with only so many qua­li­ty tar­gets to go round, and SPAC foun­ders’ strong incen­ti­ve to clo­se deals — even at the expen­se of share­hol­der value — SPACs may well end up in a nega­ti­ve spi­ral of poor quality/bad press/tighter regu­la­ti­on. And we know how that ended for rever­se mergers.

Iva­na Naum­ovs­ka is a pro­fes­sor at INSEAD, a busi­ness school with cam­pu­ses in Fran­ce, Abu Dha­bi, and Sin­g­a­po­re. Her rese­arch exami­nes how social and eco­no­mic for­ces shape finan­cial mar­ket dyna­mics, focu­sing on the dif­fu­si­on of novel prac­ti­ces and the con­se­quen­ces of cor­po­ra­te finan­cial fraud.

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