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Good morning. Shares came to a split decision yesterday: the large-cap S&P 500 rose slightly, while the tech-heavy Nasdaq and small-cap Russell 2000 both fell slightly. The ten-year treasury yield rose sharply. After the volatility of recent weeks, it would be reassuring to see a trend; it does not look like one of them is coming. While we wait for one, my first chance is at a topic I have so far deliberately ignored: Spacs. Email me: firstname.lastname@example.org
The case of the 122% Spac fee
Here is my simplified understanding of how a special purpose acquisition company works:
A company without current assets raises money in an initial public offering, at $ 10 per share. The new shareholders usually also receive warrants, which give them the right to buy more shares in the company later and at a price that is slightly higher than $ 10. The “sponsors” who founded the Spac also get a lot shares – maybe 20 percent of the total – in exchange for just a nominal fee, because they are so wonderfully smart.
The Spac will then look for a trading company to buy. If it finds one, it says to the shareholders, what do you think? Shareholders have the right to say ‘no thank you’ and get their $ 10 back with interest – while retaining the warrants, if they wish. The Spac then uses the rest of the IPO proceeds, possibly supplemented by money from private investors, to invest in the target. Hopefully, under the management of the wonderfully smart sponsors, the value of the target then rises enough that the shares sold in the exchange are worth more than $ 10, even after being diluted by the almost free shares of the sponsors and the warrants.
As a way to finance a business, it may or may not make sense. But there are certainly cases where it did not go so smoothly, such as the FT reported this week. According to Dealogic, more than 50 percent of Spac shareholders demanded a refund in the third quarter of this year (“redemption” is the preferred term) when they asked for it. At one company it was much worse than this:
‘Bio-pharmaceutical start-up eFFECTOR Therapeutics is expected to receive at least $ 100 million in proceeds from the merger with Locust Walk Acquisition, a Spac that raised $ 175 million when it was listed in January. However, the cash held in the trust account was almost completely wiped out when 97 percent of the shareholders chose to pay, leaving only $ 5.2 million.
While some of the deficits were covered by a $ 60 million private investment in public equity transactions, eFFECTOR received only $ 53.5 million in fees and expenses.
Now, it’s bad on several levels, and one of them – as Duncan Lamont of Schroders pointed out to me – is fees. One of the theoretically attractive features of a Spac is that the underwriting fee for the initial exchange rate is slightly lower, by 5.5 percent, than what the 7% investment banks charge in a standard IPO. But in a standard stock market, investors cannot get their money back from the business.
The result of the shareholder’s option, the underwriting fee that Locust Walk paid to its IPO underwriters (Cantor Fitzgerald was the pilot) was greater than the amount of money the stock market eventually raised. Here’s how the numbers worked, according to Lamont. I checked them against the S-1 filing, and they look right (my red marks):
Even after the underwriters waived half of the deferred underwriting fees (sort of them), they charged a commission of 122 percent of the final return.
This is clearly not the standard case, but you can see how the math would work with the 50 percent redemptions that were standard this term. Furthermore, according to a academic paper published last year, the average effective underwriting fee of the 47 Spacs that completed mergers between June 2019 and June 2020 – before things got really ugly for the industry – was more than 16 percent.
Why should we care? I mean, buyer beware. But as Lamont points out, we have a real need for new ways to bring businesses to the public markets. The cost and effort of being public increased at the same time as venture capital and private equity funds grew with funds, allowing them to finance private enterprises almost indefinitely. According to the World Bank, the number of public enterprises in the US has decreased by almost half in the last 25 years data.
Large public markets are good because corporate equity is the asset class that creates the most wealth, and all investors need good access to it – not just donations, large pension funds and the very rich, who are the core clients of private equity. This is also not good news for investors as the only way to own the shares of a majority of US companies is to pay a private equity fund 2 percent of the assets and 20 percent of the profits and to own the companies in the strongly designated capital. structure that the PE company needs to achieve respectable returns after taking out the huge fees.
Spacs, properly structured, may have helped with this problem. But if their average fees are even higher than the cruel and absurd 7 percent Wall Street changes for a standard stock market (the first price I think of when I hear the phrase ‘market failure’), what’s the point?
The Spac trend seems to be retreating. Well.
A good reading
Is it true that expected inflation causes real inflation? The idea makes intuitive sense. If I expect the prices I pay to rise, I will increase the prices I charge to protect my income. Workers will demand higher wages, companies will spend an extra price increase, just to be safe, and the game is on. But Fed economist Jeremy Rudd argue that this intuitive narrative – and the myriad economic models based on it – has little theoretical meaning and even less empirical support. I can only follow sections of the newspaper, but it was written in all the funny way.