Since I started this series on the dangers of SPACs, Bloomberg has run an in-depth story about one of the kings of SPACs, Chamath Palihapitiya, and how he’s promoting SPACs as an end run around the “morons” who run Wall Street. Palihapitiya (Facebook exec turned wunderkind venture capitalist) was recently touting a new target for one of his SPACs: a health insurer who just happens to be under investigation by the US Department of Justice.
But, Palihapitiya told CNBC’s Squawk Box, he and his partners had staked over $170 million into the company and, “There is no way that I can win unless the stock goes up. This is not some get-rich-quick scheme, at least for me.” I don’t know how much richer Palihapitiya needs to be. But since he owns part of the Golden State Warriors, I’d say it’s a safe bet he’s already well on his way.
A Cautionary Tale About the Dangers of SPACs
When I look at investment opportunities, they’re generally in the clean energy sector. That’s what I know, and I have been around long enough to know where the weak spots are in a sparkling prospectus. But since SPACs can blow all the sunshine they want about their targets, most investors just believe the hype.
This is a good example of how the dangers of SPACs make them just like Vegas on a bad night.
Palihapitiya found an easy target, Clover Health. He was able to talk it up, raise some money, and then go on Squawk Box to talk about it. The DOJ has been looking at Clover since late 2020. They issued a subpoena to at least one former employee that enumerated 12 separate areas of investigation. Palihapitiya had agreed to the merger with Clover a few weeks before the subpoenas were sent and just a few months before the merger would be finalized.
So whatever else happens with Clover, investors have lost 28% of their investment as of mid-May, but not to worry. Palihapitiya did get richer quickly. He and his sponsor team almost doubled their money — which, according to Bloomberg, was already borrowed to begin with.
On May 17th, Clover closed under $7 on Q1 losses of over 41 million, almost doubling their Q1 2020 numbers. And the King of SPACs moved on months ago. If Palihapitiya’s SPAC had to focus on Clover’s losses and lawsuits during the IPO period rather than their lucrative prospects in the Medicare markets, it’s likely they wouldn’t have made such huge profits.
How Do SPACs Looks Now?
SPACs in general have nosedived in Q2, at 17% on average as of mid-May. Palihapitiya’s SPACs, mimicking Icarus, fell 50% on average. Also, the blockbuster Virgin Galactic deal he made with Richard Branson crashed and burned — a 68% free fall and a delayed test flight.
The Dangers of SPACs for Investors
Okay, any investment is inherently risky, I get that. But when you put some money into a new company (whether as an early-stage investor or when it goes public), you’re making that decision based on either your own research or that of your investment advisor. Either way, you’re working with information that the SEC has pored over in great detail. They’ve cross-referenced and verified and done everything humanly possible to ensure that the company is presenting itself accurately. Private companies that don’t have to report anything tend not to let anyone know they’re bleeding cash. So investors have only the SPAC team’s word that the flying tricycles are a sure thing.
Because a SPAC can make all kinds of unsubstantiated claims about EVs that recharge on marshmallows or batteries that last forever (and because lots of these SPACs are hobbies for some of the biggest names in venture capital), investors believe the generous projections. They write the check. If Bill Ackman is pushing the deal, who’s going to second-guess him? The problem is, there’s one Bill Ackman and a hundred wanna-be Chamath Palihapitiyas.
Hedge funds love SPACs (and if that’s not a red flag, I don’t know what is) because they can get in so cheap. They also get a money-back guarantee if they decide they don’t like the deal. Even if they redeem their shares, they get to keep the warrants — a win-win.
SPACs Encourage IPOs to Believe Their Own PR
The dangers of SPACs don’t stop there. As I said before, speculators hate a vacuum, and SPACs filled the one left by the blank-check companies nicely. But that doesn’t answer the question of why some startups find SPACs so appealing. I wonder that myself because the risk of merging with a SPAC is not worth the reward. A SPAC has no real business to run; it’s just money in an escrow account. So they don’t have to file financials with the SEC. Okay, that makes sense.
But here’s the catch. When a startup bypasses the traditional (and highly regulated…not that I support regulation) IPO route and merges or (more realistically) is acquired by the SPAC, they are immediately subject to SEC regulatory compliance. Most newly public companies get a grace period for full compliance — of course they do; the SEC has already inspected every detail of the company and knows it is sound. But a SPAC acquisition foregoes that compliance waiver, which is usually a year. Instead, it becomes part of the SPAC and must adhere to their filing deadlines.
Shortened Deadlines Are One of the Major Dangers of SPACs
If you’re a neophyte investor, you’re thinking, “So what — how hard is it to keep your paperwork in order?” The time frame to transition from private to public is typically 18-24 months. That translates to at least a year and a half of non-stop work developing the enterprise-level operations and processes necessary to go forward as a public company. What’s the upside to a careful and granular approach to an IPO? A strong valuation, a happy buzz around the company, and satisfied shareholders.
When a company goes the SPAC route, that transaction is usually finalized within four or five months. The startup that has dazzled the SPAC — or at least convinced the board that they can sell the idea to somebody else — does not have the time to complete the due diligence that the SEC requires for a public offering. The companies merge. Now the new company finds itself facing filing deadlines when they haven’t had the chance to put the data together.
The downside to this folly?
The SEC breathing down your theoretical back before the champagne goes flat. Oh, and the ensuing lower market value, bad press, and unpleasant shareholder action when the investment world gets wind of your regulatory issues. Those are the dangers of SPACs. As I mentioned last time, the SEC has kicked SPAC-led mergers out of the safe harbor they give companies with a track record. So litigation is a distinct possibility as a reward for those overly ambitious projections.
Regulatory Challenges That SPACs Let Startups Avoid
Now’s a good time to go over the nuts and bolts of the due diligence that the SEC requires for a company to go public the old-fashioned way. Then we’ll discuss the pitfalls that a SPAC encourages. If you’re an entrepreneur who’s gotten some venture capital funds on your side — both financially and in an advisory capacity — don’t for a minute think they’re looking out for your best interests. While they’re your best pals now, they’ve always got their eye on the next deal — one like the Churchill Capital IV (CCIV) and Lucid Motors merger is everybody’s dream gig. You’re a stepping stone. On Wall Street, greed is still good.
Public companies live and die by their SEC dealings — financial, regulatory, and governance.
The Dangers of SPACs That Can’t Comply
The 2002 Sarbanes-Oxley (SOX) Act set a high bar for the financial and auditing requirements for public companies, thus the extended timeline to prepare for an IPO. For a company to be ready for prime time from a SOX perspective, that 18-24 month period is the benchmark. Also, the SEC wants their filings early in the calendar year. So a late or even midyear merger can make meeting these deadlines a real challenge.
Then there’s the financial reporting. The rules for disclosure have gotten more complex over the past decade. Also, the penalties for failure to comply have kept up with compliance requirements. The SEC isn’t known for leniency in this area, so an incomplete financial profile is a huge risk for a new company. Because of the existence of the SPAC, you’re not new in the eyes of the regulators.
Governance doesn’t appear to be a bogeyman when you put it up against the other two, but let’s be clear — it’s every bit as tricky. SEC rules demand a particular makeup of the board of directors, transparent investor relations, and functioning internal control. Running afoul of these rules creates a PR nightmare that can take a company down before the SEC regulators can find the paper clips.
If You’re Determined to Invest in a SPAC
If you’ve got to scratch the SPAC itch, I can’t stop you. The reality is that there are some solid deals out there. The CCIV-Lucid one is the gold standard so far, and it’s fair that you hunt around for similar opportunities. Here’s how I recommend you do your research.
Dig into who’s the guy behind the curtain and what their track record is — not just with SPACs, but in bringing traditional IPOs to market. Look for the fundamentals of their deals over the pizazz of the hype, and stick with what you know. I know energy. So if I’m looking for a SPAC, it would be one “like” the Rogers Silicon Valley Acquisition (RSVA, NASDAQ) that launched in January. They’re targeting green energy, IoT, and AI and have already found their first acquisition. Enovix designs and manufactures silicon-anode lithium-ion batteries in the US and has good fundamentals. But do go taking my word for it.
Next time, I’ll dig deeper into SPACs in the clean energy sector.