“Deal, or no Deal?” – Howie Mandel
I was getting caught up on one of my favorite podcasts over the weekend when the guest said something that inspired me to write this short piece on special purpose acquisition companies (SPACs). Maureen Farrell, a fantastic reporter for The Wall Street Journal and co-author of the recently released book The Cult of We: WeWork, Adam Neumann, and the Great Startup Delusion, was being interviewed by the brilliant and prolific Demetri Kofinas on his wildly popular show, Hidden Forces.
WeWork’s first attempt to go public in 2019 via a traditional initial public offering (IPO) was an epic fiasco that was aborted before launch. As discussed on the show, WeWork is making a second attempt to go public, this time by cutting a deal with a SPAC. During the overtime segment (available to paid subscribers), Kofinas asked Farrell for her thoughts on where we’ll find the next WeWork (i.e., the next big market scandal). This was the essence of her answer (emphasis added):
“I think where we’ve seen some questionable behavior already, questionable companies, and I think we’re almost guaranteed to see a lot more is in the SPAC market… you go out and you raise money and you have two years to put it to work or else the investors in it get their money back. But the people who are the sponsors of the SPAC do very well. They get a very big return if they just execute a deal to buy a company. So, there’s been more money in SPACs in 2020 and 2021, by orders of magnitude, than we have ever seen before. So, there’s suddenly this huge captive pool of cash sitting there, on the sidelines, that just has to make deals. And the clock is ticking, and the clock is ticking every single day… It’s a recipe for disaster.”
The implication of the conversation is as follows: perversely incentivized SPAC sponsors, facing the expiration of their allotted time to find a private company to merge with before the money in the SPAC’s trust is returned to investors, will cut terrible deals. They will do so because any deal is better than no deal and the competition to buy private companies among unmarried SPACs is fierce (an unmarried SPAC is the colloquial phrase used to describe a SPAC that has not yet found a target to buy). As a result, we are bound to witness a parade of even more questionable companies coming to the public markets than we saw in the past year. This is a commonly held belief among many market observers.
While I agree with much of Farrell’s setup of current SPAC market dynamics, I have a different view on what’s likely to transpire next. I believe almost all existing unmarried SPACs won’t be able to consummate a deal and the majority of that huge captive pool of cash currently sitting in trust is going to be returned.
Because of the change in market dynamics induced by the Securities and Exchange Commission (SEC). The honeymoon phase is decidedly over for SPACs. Importantly, bringing enough cash to get a transaction closed has become more challenging, especially for questionable deals. This is a material change to the courtship. A SPAC sponsor can still try to cut a terrible deal, but the odds of such a deal actually closing have become vanishingly small in this new reality.
Let’s say I’m a SPAC sponsor and I’ve raised $300 million in cash. The stockholders of my SPAC have the right to redeem and get cash back if they don’t like the deal after it is announced. In fact, by recent convention, most SPAC shareholders can vote for a proposed deal and still elect to redeem and receive their money back in lieu of staying in the deal after close. That $300 million sitting in trust can be an illusion, and the right to redeem acts as a restraint on SPAC sponsors.
Because of this redemption risk, target private companies almost always have a requirement that a minimum amount of cash be delivered at close or the deal is off. This makes sense – if the deal is deemed materially unfavorable, the SPAC shares will often trade below trust value, and in my example the shareholders could redeem all $300 million, leaving the private company with nothing. To hedge against this risk and ensure a successful close, SPAC sponsors often raise a concurrent funding round called a private investment in a public entity (PIPE). Unlike the SPAC shareholders, PIPE participants can’t renege on their commitment once made, but they also have the advantage of knowing what the proposed transaction will be before committing.
To take this illustrative example further, assume I cut a deal to merge with a private company and the minimum cash to deliver at close is $250 million. Without a PIPE, I can only suffer a maximum of $50 million in redemptions without risking the deal. I showcase the proposed transaction to sophisticated PIPE investors and they like it. The company is real and solid and the deal terms are fair. They agree to throw another $400 million into the mix. Since their commitment is firm, the deal almost certainly closes, even if all the SPAC shareholders redeem. (Technically, these deals also often have a redemption threshold past which the deal can be called off, but that requirement to close is almost always waived by the target private company if the minimum cash delivered threshold is met).
Now that new SEC Chair Gary Gensler has shown up as the chaperone to the SPAC dating game, market interest as expressed by price and volume is decidedly less hot-and-heavy than it was in 2020, and PIPE investors are taking a more cautious stance.
Bad deal? No PIPE. No PIPE? No deal close. It’s that simple.
Good deals struck by top-tier SPAC sponsors are still getting interest from PIPE investors, but the days of private companies with more dreams than revenue coming to the public markets appear to be largely over. There are only so many good private companies available to be acquired at any given time, and most unmarried SPACs looking for a deal today will eventually have to return their funds to investors, leaving their bewildered sponsors at the altar. If it saves the market from the next WeWork, maybe that’s a good thing.
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