Does SPAC Spell SCAM?

by: Roger Ehrenberg

To be clear, I don't see the SPAC industry itself as bad. Well, not too bad. What I do see, however, is an industry that might be moving towards a role that is neither good for SPAC investors nor consistent with an alignment of interests among private equity firms, SPAC sponsors and their investors. A good friend of mine got my thoughts flowing after forwarding me a recent article from Bloomberg:

May 16 (Bloomberg) -- Kohlberg & Co., Madison Dearborn Partners LLC and Kirtland Capital Partners have resorted to selling holdings to so-called blank-check companies, a path more private-equity firms may follow as other buyers remain scarce.

Leveraged buyout firms stepped up the pace of takeovers in the past five years, aiming to cut costs at businesses ranging from newsprint makers to crane purveyors and then sell them to the public. Now they're turning to special-purpose acquisition companies as demand for IPOs sinks to a three-year low and tight credit markets make it harder to borrow money to finance LBOs.


While SPACs are flush with cash, the other buyers private-equity firms have traditionally relied on are unable or unwilling to invest, according to Steven Kaplan, a finance professor at the University of Chicago's business school.

``Buyout firms are selling into these situations where they can't go public by the normal route and there's no one to sell it to,'' Kaplan said.

So have SPACs become the buyer of last resort for those private equity-backed companies in need of liquidity? Probably not exactly what SPAC investors had in mind, unless the prices paid by the SPACs are cheap. The words "private equity" and "selling cheap" generally don't go hand-in-hand, so this recent phenomenon has caused my BS detector to emerge from its week-long slumber.

It kind of seems like a case of adverse selection; since institutional investors aren't eager to fund a current IPO calendar, perhaps retail investors can be tapped indirectly by selling these companies to SPACs? Maybe I'm just being cynical.

But wait a minute, these deals are pretty good for those SPAC sponsors, right? They get a big chunk of equity for simply putting together the SPAC and are long a call option on, say, 20% of the business if a deal goes through. And these sponsors are under time pressure, because they've been sitting on a pile of cash and in need of a deal, or their money will be returned (less fees) to investors. So it is just this kind of a dynamic (a ready-to-deal private equity industry, closed IPO markets and SPAC sponsors in need of deploying cash - now) that makes me wonder: Is something rotten going on here?

Consider the key constituencies and what they have to gain by the current PE portfolio company-to-SPAC deal cycle:

Private equity firms: They want liquidity and can't do so via an IPO. Sales to possible strategics are often harder to accomplish and result in lower sales proceeds, and sometimes come under regulatory scrutiny. SPACS offer ready pools of public markets liquidity, the incentive to get deals done, less price sensitivity and complexity than selling to a strategic buyer. Not bad. It's pretty clear why the private equity industry is heading in this direction given today's less-than-friendly market environment.

SPAC sponsors: They are all about getting a deal done, since the clock is always ticking on deploying their funds before they have to be returned to investors. Buying public companies is hard, because dealing with multiple shareholders, regulatory approvals and SEC red tape is a major hassle. Further, the risk of the deal not getting done is far higher than dealing with a single entity, e.g., a private equity firm. One could imagine a scenario where SPAC management might not sharpen its pencil to get a deal done at the right price, since the motivation to get a deal done is so great. And while the proposed acquisition has to be approved by 60% of SPAC shareholders, unless the deal is a dog on its face it is easy to imagine it getting through.

SPAC investors: The original investors, under the SPAC structure, pay a boatload of fees for the privilege of participating in the SPAC. And these fees don't get returned, even if the SPAC never does a deal. So there is a lot of motivation for investors to support the SPAC sponsor's proposed deal, since flushing 7% down the toilet is a hard thing to stomach. So even if the sponsors appear to be overpaying for a deal, unless the deal smells very, very bad it is pretty likely to get through.

So my word to SPAC investors is: be careful out there. First, does buying into a SPAC make sense in the first place? Second, are you better off voting down a deal, even if it means giving up the fees, in order to avoid an even worse outcome? Best advice: if you must invest in a SPAC, wait until after it has traded for a while and begins to trade at a discount to NAV. Then you won't have to shoulder the full weight of the upfront costs and are simply long a call option on the sponsor's ability to get a good deal done. And if they don't, you don't get burned. Today is a time for prudence; this is my Rx.