Worries about a stock market bubble diminished this month after a sharp pullback in growth stocks brought down valuations.
The S&P 500 currently trades for 22.6x this year’s earnings estimates and 19.6x next year’s earnings estimates—elevated multiples historically, but levels that could be justified in the current low-rate, booming economic environment.
That said, the latest valuation concerns were never really associated with the broad market. Most would argue the S&P 500 is expensive, but not necessarily in a bubble.
The same consensus doesn’t exist for other pockets of the market. There are individual stocks and groups of stocks that are trading in ways reminiscent of the dot-com bubble, where hope and hype are more important drivers than underlying business fundamentals.
Here we take a look at one such area of the market that has attracted an enormous amount of speculation: SPACs.
Perhaps no part of the market is frothier than special purpose acquisition companies, better known by their abbreviation: SPACs.
These investment vehicles went from something most investors had never heard of a few years ago to the hottest investment trend of the year.
SPACs are another way of bringing private companies onto the public markets. They raise money from investors in an initial public offering and then merge with a target company, giving the latter a quicker way to raise funds and go public than if they had IPO’d themselves.
While there is nothing necessarily nefarious about SPACs—several big-name companies like DraftKings and United Wholesale Mortgage successfully went public through this route—the way most blank check companies are structured leads to perverse incentives.
Time Is Of The Essence
For one, SPAC sponsors are highly incentivized to merge with a private company within the allotted two-year window, or else they have to return the money they raised to investors.
Second, sponsors really want to do a merger since a successful combination usually results in a windfall of shares for them (typically equal to 25% of the SPAC IPO proceeds).
This ability to collect shares potentially worth hundreds of millions of dollars or more—often equal to multiples of at-risk capital—has attracted dozens of would-be sponsors into the SPAC game. Everyone from Shaquille O’Neal to Alex Rodriguez to Paul Ryan to Jay-Z has gotten involved with SPACs.
It’s gotten to the point that the SEC felt obliged to warn investors that a celebrity endorsement of a SPAC doesn’t necessarily mean it’s a good investment opportunity.
Record Year For SPACs
So far, the SEC’s warnings have fallen on deaf ears. While SPACs, as measured by The SPAC And New Issue ETF (SPCX) and the Defiance Next Gen SPAC Derived ETF (SPAK), have fallen 10-15% off their highs, they’re still as hot as ever.
Returns For 'SPCX' And ‘SPAK’ Since Inception
According to SPAC Track, already this year, 258 SPACs have raised $82.7 billion, matching in less than three months the $83 billion raised by 248 SPACs in all of 2020 (for context, the money raised in 2020 was 6x the amount of money raised in 2019).
There are currently 405 SPACs with $130 billion that are searching for merger targets. Another 222 SPACs have filed to raise more than $59 billion.
That means SPACs will need to put upward of $189 billion to work over the next two years. Because SPACs usually only buy minority stakes in companies, that could mean private companies collectively worth close to $1 trillion may need to be identified as targets.
With so much capital chasing the same private companies, SPACs are outbidding each other, leading to froth in the private markets. So far, this has been supported by an equally frothy public market, which has embraced SPACs wholeheartedly.
Perfectly encapsulating this phenomenon is Archer, an “urban air mobility company” that is developing an electric vertical takeoff and landing aircraft. Like many SPAC targets, Archer doesn’t have a commercial product yet and isn’t expected to generate revenues until later this decade, yet it was still able to command a $2.7 billion valuation from its SPAC sponsor, Atlas Crest Investment Corp (ACIC).
By comparison, Archer raised money at a $16 million valuation less than a year ago, according to Bloomberg. In other words, the pre-revenue company’s valuation has jumped 169x since last April.
Hype Over Fundamentals
The fact that ACIC paid such a hefty premium for a pre-revenue company hasn’t fazed investors in the SPAC. Many SPAC buyers are retail investors looking for moonshots with lottery ticket upside in categories like electric vehicles, electric planes, alternative energy, etc. Valuations, profitability and even revenues don’t seem to matter.
The day the merger was announced, shares of ACIC surged 22%. They’ve since come all the way back down, with the last trades going through at just above $10, suggesting there are limits to how high SPAC prices can go just based on hype.
Ten dollars is a key level for most SPACs. That’s where SPAC IPO investors can redeem their shares for cash value, a valuable perk for the hedge funds and other institutional investors who collect nearly risk-free returns for participating in the offering (buyers keep warrants on the SPAC even if they redeem their shares).
Beware Of Bag Holders
But that same risk-free upside doesn’t extend to buyers of SPACs on secondary markets, often retail investors. Many SPACs have recently plunged after announcing mergers, leaving those who bought at the highs holding the bag.
And unlike SPAC IPO buyers, $10 is no floor for those who buy in later. Historically, most SPACs have delivered sharply negative returns. Given extremely frothy state of the current SPAC market, there is little reason to think this pattern will change.
More competition among SPACs will lead to higher valuations for SPAC targets and an increasingly unfavorable risk/reward calculus for SPAC investors.
At some point, SPACs may even struggle to get deals done as sentiment on the asset class sours. If SPAC prices falter on public markets, institutions will redeem more of their shares and additional private funding will be harder to come by, jeopardizing mergers.
That may finally put an end to the SPAC party.
SPACs Aren’t Going Away
That’s not to say that SPACs are going away. There’s perhaps no other vehicle better for bringing early- stage, high-risk/high-reward companies public. Along with traditional IPOs and direct listings, they are just another means of coming to market.
While IPOs and direct listings may be more appropriate for companies further along their growth journey, SPACs are a way for promising upstarts to accelerate their public market debut. Not every private company will be ready to make the transition to the public markets. And not every sponsor has the ability to add value to a SPAC.
But if you combine the two—a good company and a good sponsor—there’s a chance you will have demand from investors, at least in most market environments.
Of course, right now, there is demand for everything—the good, the bad and everything in between. Eventually, the market will become more selective and the SPAC market will be cut down to size. But it’s not going away.