It’s not yet two months old, but 2021 already looks poised to outdo 2020 in one area: SPACs, or special purpose acquisition companies, raised around $26 billion in January this year in the United States, nearly a third of the record $83 billion collected by 248 SPACs over the whole of 2020. These so-called “blank check” shell companies have no operations or business plan other than to acquire a private company using the money raised through an IPO, thereby enabling the latter to go public quickly.
It seems almost everyone who is anyone is “sponsoring” or setting up a SPAC, from ex-Trump adviser Gary Cohn to basketball star Shaquille O’Neal to Hong Kong tycoon Richard Li. But, as my recent paper shows, signs beyond the headline figures suggest that SPACs are a bubble about to burst.
Remember Reverse Mergers?
SPACs are a form of reverse merger, the subject of my paper. In a standard reverse merger, a successful private company merges with a listed empty shell to go public without the paperwork and rigors of a traditional IPO. The shell is usually a remnant of a previously operational public firm or a public virgin shell formed to combine with a private company. Where SPACs are different is simply that the shell company is a proactive party, flushed with cash from the IPO and hunting for private targets.
Often criticized, reverse mergers have existed for decades, mostly on the margins of financial markets, and we have seen several waves of them since the 1970s. They surged in the mid-2000s, outnumbering IPOs in some years, and peaked in 2010, before falling off a cliff in 2011. In our paper, my co-authors and I sought to identify what drove the boom and bust of reverse mergers and to draw lessons from the reverse mergers story in order to understand the life cycles of controversial practices more generally.
From Boom to Bust
Research shows that when more people adopt a practice, it will become increasingly widespread due to growing awareness and legitimacy. But that’s for non-controversial stuff. Things get a little more complicated for controversial practices like SPACs and reverse mergers, where third-party concern and skepticism also grows as the practice becomes more widely used.
Our study offers an institutionally and sociologically informed explanation of the boom-to-bust dynamics of controversial practices. While finance and economics have suggested that decision makers’ cognitive biases drive these bubbles, we add to evidence that such bubbles can relate to institutionally driven dynamics. In effect, we show that the popularity of reverse mergers planted the seeds of its own demise.
We collected data on the use of reverse mergers, market responses, and firm characteristics, including market value, earnings, total assets and debt, exchange listing and between 2001 and 2012. We also studied how the media evaluated reverse mergers. Of the 267 articles published between 2001 and 2012, 148 were neutral, 113 were negative and only 6 were positive. Finally, we gathered share price data to examine how stock markets valued reverse mergers.
Our analysis of this data shows that — as you would expect — higher popularity of the practice (i.e., higher number of past adoptions of reverse mergers) initially triggered imitation and further adoption. But, simultaneously, as the number of reverse mergers grew, investors and the media became increasingly skeptical about the practice. The skepticism and negative reactions were further intensified as the proportion of reverse merger transactions involving firms with relatively low reputations increased. The poor stock market valuations of reverse merges, and the negative media coverage discouraged firms with good reputations from adopting the practice. The regulators duly waded in. Both the Securities and Exchange Commission’s 2005 disclosure rules for reverse mergers and its 2011 warning to investors about investing in reverse mergers amid an influx of Chinese players — a phenomenon studied in another of my recent papers — triggered negative market reactions and led to a decline in the practice.
In essence, investors, regulators, and the media — important arbiters of financial innovations — fed off one another’s cues and evaluations. Negative media coverage weighed on stock market valuations and the subsequent diffusion of reverse mergers. By 2010, when reverse merger activity peaked, 70 percent of media articles on the phenomenon had a negative tone. Reverse merger firms’ share prices plummeted to the extent that cumulative returns neared -45 percent. The following year, in 2011, reverse merger activity plunged by 35 percent. In effect, the popularity of reverse mergers planted the seeds of its own demise.
If all these sound familiar — rapid proliferation of a controversial financial innovation, plagued by poor-quality players, bad publicity and regulatory concern — it’s because similar dynamics have re-emerged in the SPACs boom.
Here We Go Again
The most obvious sign is the frenzied growth. Amid the global stock market volatility, last year’s $83 billion haul by SPACs was six times the amount raised in 2019 and nearly equaled the figure mustered by IPOs. Even David Solomon, chief executive of major SPACs underwriter Goldman Sachs, warned in January 2021 that the boom is not “sustainable in the medium term.”
Then there is the fact that many firms taken public by SPACs have little to show in terms of business plan or revenue, in some cases triggering shareholder lawsuits by disgruntled investors. The most infamous example is Nikola. Three months after going public last June via its merger with a SPAC, the electric truck startup was accused of fraud by short sellers, resulting in the resignation of its founder and a flurry of lawsuits by shareholders. Nikola’s stock price has fallen to a mere fraction of its peak in June. Meanwhile SPAC successes such as fantasy sports betting firm DraftKings and data company Clarivate Analytics are relatively few. In fact, a recent study found that most SPACs’ post-merger share prices fall.
Another red flag comes in the form of negative media sentiment and regulatory concern. Reports about SPACs are often negative and cautionary. “SPACs are oven-ready deals you should leave on the shelf” warned a Financial Times headline in December. SEC Chairman Jay Clayton has signaled similar reservations. The SEC was watching SPACs closely, he said in September, in efforts to ensure SPAC shareholders “are getting the same rigorous disclosure that you get in connection with bringing an IPO to market.”
Under the rules governing them, SPACs must identify firms they can merge with within 24 months after they have raised their funds or they will be wound up and the IPO proceeds returned to investors. More than 300 SPACs need to pull that off this year or risk being liquidated. But with only so many quality targets to go round, and SPAC founders’ strong incentive to close deals — even at the expense of shareholder value — SPACs may well end up in a negative spiral of poor quality/bad press/tighter regulation. And we know how that ended for reverse mergers.
Ivana Naumovska is a professor at INSEAD. This article was published at HBR.org