Gabriel Grego was scanning a directory of newly-listed companies when his eyes landed on his next potential target: Akazoo, a Greek music streaming service that billed itself as the Spotify of emerging markets.
Mr Grego, a hedge fund manager known for his short selling campaigns, remembered Akazoo as a subsidiary of the London-listed tech company called InternetQ. In September 2019, Akazoo re-emerged on the Nasdaq stock exchange through an unusual financial structure known as a special-purpose acquisition company — or Spac.
Akazoo had merged with a shell company called Modern Media Acquisition Corp. Modern Media had no assets other than $200m in cash that it had raised in an initial public offering: investors had been willing to pay $10 per share in Modern Media because of their confidence in Lew Dickey, a successful entrepreneur in the radio industry who had created the shell.
In early 2019, when Modern Media announced its combination with Akazoo, Mr Dickey called the streaming service “a terrific company” and praised its “patented Sonic AI music recommendation and profiling technology”.
Mr Grego, however, started digging. He went on to allege that Akazoo was a massive accounting fraud, claiming he had found no evidence that its 5.5m claimed subscribers existed.
“The [Spac] structure itself seems engineered to attract fraud,” says Mr Grego, whose Quintessential Capital Management shorted Akazoo shares and then published its findings in a 2019 report.
Akazoo’s board launched an investigation, eventually concluding that the company’s previous management had “participated in a sophisticated scheme to falsify Akazoo’s books and records”, including the due diligence materials that had been given to Mr Dickey’s Modern Media and its lawyers and bankers. Modern Media’s backers lost their entire investment.
Until recently, Spacs were an investment vehicle more associated with companies such as Akazoo than with the most exciting new businesses from Silicon Valley. But since the start of the year, Spacs have become perhaps the hottest asset class in American equity markets.
From hedge fund billionaire Bill Ackman to sports executive Billy Beane of Moneyball fame, some of the most high-profile investors have sought to raise cash in blank cheque companies, believing they have the special eye to find under-appreciated businesses which they can bring to the public markets. By using Spacs, they can skip over the expensive and time-consuming IPO process.
They have been motivated in part by a set of high profile success stories, including sports betting site DraftKings and electric truck start-up Nikola, which both now boast valuations of more than $10bn. These investors are convinced that Spacs have now shed the reputation for being a vehicle that shady financiers use to unload dodgy businesses on the unsuspecting masses.
The boom in Spacs is taking place at a time when trillions of dollars sitting in private equity and venture capital funds and many promising companies feel less pressure to go through the costly and time-consuming process of listing on the stock market in order to raise new money. For retail investors, Spacs present a chance to buy into fast-growing companies that might otherwise remain private.
Yet a Financial Times analysis of the US blank cheque companies that were organised between 2015 and 2019 shows that these cash shell structures remain a dicey bet for ordinary investors. The majority lie below $10 per share, the standard price where Spacs first sell their shares to the public. Such disappointments have beset even veteran investors such as private equity firm TPG, which has three Spacs, none of which trade higher than $10.20.
The poor investment record of many Spacs is a reminder that when Wall Street pushes a new product, clever financiers invariably find a way to shift the most risk on to ordinary investors – even if a new generation of Spac founders believes they will avoid the problems of the past.
“Overall, investing in a Spac is like flipping a coin, where only half of them are shown to be value creating,” says Milos Vulanovic, a finance professor at EDHEC Business School who has studied the structure for years.
A painful process
For decades, a private company looking to list its shares on a stock exchange pursued a tried and true method. It would spend months working with the Securities and Exchange Commission to finalise a prospectus that detailed its financial information and operations.
During a breakneck 10-day roadshow, the company’s CEO and CFO would hold brief and superficial meetings with large institutional investors, being careful not to be too candid. The culmination of the process would be a late afternoon conference call to price the shares where seemingly the company’s future would be determined by what a handful of large mutual funds such as T Rowe Price, Wellington or Fidelity would decide what a company was worth.
“It all gets sorted on the 4pm pricing call with the whole Street waiting for Fidelity to come in and price the deal a few dollars below the range”, half-joked Jeff Mortara, head of equity capital markets origination at UBS, referring to the process for a traditional initial public offering.
Critics of this time-honoured ritual say it is racked by opacity, inefficiency and most of all expense. Investment banks collected 7 per cent of the proceeds as an underwriting fee. The IPO price was also supposed to be priced at a 10 to 15 per cent discount to fair value to give some immediate upside to buyers. Often, listed companies would also see their shares “pop” on the first day, rising 30 or 40 per cent. Those gains then represented either cash the company itself could have raised or additional shares it did not need to sell.
“Clearly, the rampant and worsening underpricing of IPOs has created a huge arbitrage opportunity for Spacs,” Bill Gurley, the famed venture capitalist and harsh critic of traditional IPOs, wrote in an email to the FT.
“It’s the price discovery that is driving the Spac model,” explains Jeff Sagansky, who with his business partner and close friend of 40 years, Harry Sloan, formed his first shell company, Global Eagle Acquisition Corp, nearly a decade ago.
At that time, Spac had become a dirty word. Several blank cheque companies had been raised prior to the financial crisis but virtually all of them flopped due to poor acquisitions and subpar management.
The Spac structure itself also proved problematic. In a typical blank cheque listing, the shell company sells a “unit” in its IPO for $10 dollars each. The unit includes 1 common share and a warrant to purchase another share later typically at a strike price of $11.50. The Spac then has two years to find an operating business to purchase and shareholders get to vote to approve the deal. If they decide to vote “no” and redeem their shares, they can get their $10 back in cash along with interest.
The structure tended to attract arbitrage funds seeking to park cash but who would not vote in favour of deals unless they extracted a ransom payment from Spac sponsors. In 2011 regulators changed the rules, making acquisitions easier to approve, and thus began the era known as “Spac 2.0”.
Since then, Mr Sagansky and Mr Sloan, who had both been top Hollywood executives, have raised six different Spacs — each with the word Eagle in the name — totalling more than $2.3bn. They view a Spac deal as a way to craft a nimble and bespoke acquisition using cash and stock.
They tout their December 2019 deal to take public DraftKings, the sports betting app, as an example of the elegance of a well-designed Spac transaction. One of their Spacs, Diamond Eagle, had raised $400m in its share sale in May 2019. When it announced the merger with DraftKings, it simultaneously announced that Fidelity Investments would lead a group of funds buying another $380m of fresh stock, giving the transaction a prestige boost.
After DraftKings was merged into Diamond Eagle, the new public company had more than $500m of cash on its balance sheet even after spending $200m in cash to acquire a third company, SBTech, a gaming software company. The transaction valued the new DraftKings business at $2.7bn.
Perhaps the harshest criticism of Spacs is aimed at the favourable terms that sponsors extract. Typically, Spac founders are given a “promote” of 20 per cent of the shell’s company virtually for free. The stake is for their efforts in finding a target company. But by giving away a fifth of the company, critics say it becomes much trickier for shareholders to overcome the drag of those sponsor shares. Moreover, since the sponsor shares are essentially free, there is a diminished incentive to find a quality business.
To that point, Mr Sagansky and Mr Sloan explain that the DraftKings terms only allowed their founder shares to fully vest after DraftKings stock jumped to $16.00 — in other words, after the shares had risen 60 per cent from their IPO price.
Just a few months after closing, DraftKings has soared on the hype around sports betting. Its stock price now is roughly $35 and its overall enterprise value of $12bn makes it among the most highly valued company to be listed through a Spac merger.
A new generation
Of the Spacs that have faded badly, several were smaller vehicles that raised less than $100m, while several others chose to merge with energy companies and have been hammered by the collapse in commodity prices. But the most prominent criticism of investors about Spacs is that sponsors did not pick quality companies simply because they were likely to personally profit no matter how the new company ultimately performed.
“The traditional Spac has a clock and is under pressure to do a deal, and Spacs have traditionally worked for financial sponsors, not for investors,” said Charles Kantor, a portfolio manager at Neuberger Berman who has invested in the structures and is positive about recent changes in the market.
Spac supporters say the new generation of vehicles are backed by a more accomplished group of sponsors who are better able to find attractive merger targets. Michael Klein, the former Citigroup dealmaker once on track to lead the bank, has raised cash shells with four, all named after Winston Churchill, which have now raised $3.5bn in total.
Clarivate, an industrial company that his first Spac acquired, now trades at nearly $30 and has a market capitalisation approaching $10bn. Mr Klein touts the global connections he built during his decades-long career on Wall Street as an advantage in finding deals.
Still, Mr Klein has also benefited from simply pushing reverse mergers across the finish line. His eponymous firm, Klein & Co, has earned fees on each of the two Churchill transactions announced, taking in more than $30m in fees.
“People are spending a lot of time trying to come up with a better model on how to deal with the promote,” said Gregg Noel, head of Skadden’s West Coast capital markets practice.
Bill Ackman confidently asserts that he has found a solution. The brash and often polarising Mr Ackman, recently raised $4bn for his blank-cheque company, Pershing Square Tontine Holdings. It is by far the largest single blank cheque vehicle ever raised.
Mr Ackman says his vehicle, which eschews the typical 20 per cent promote, far better aligns the interests of ordinary investors and his firm. Pershing Square itself is buying a minimum of $1bn of units at the public offering price. It has also separately purchased warrants for $65m, which it says reflects fair market value and do not become exercisable until three years after a merger is completed and the stock rises 20 per cent. The dilution to ordinary shareholders from these warrants, Mr Ackman says, will be limited to 6 per cent.
“We’ve eliminated the whole concept of founder stock,” Mr Ackman told the FT. “We’ve overcome the 20 per cent dilution and reduced the underwriting costs. It’s no longer really a Spac. It should be called a Sparc — special purpose acquisition for real companies.”
Mr Ackman is hoping to find his target in Silicon Valley where venture capital firms are being weighed down by a backlog of ageing investments, as start-ups increasingly avoid the glare of public markets for as long as possible.
CB Insights, the data service, estimates there are 487 private venture-backed companies valued at more than $1bn, representing more than $1.5tn of equity value, waiting to be listed on public markets. Mr Ackman’s explicit interest in this group has fuelled speculation that he is looking at the travel lodgings company Airbnb or a similar blue-chip name.
One tech investor said all of his portfolio companies had been approached by Spacs about doing deals this year.
“The Masayoshi Son story of the cool kids stay private forever — I think the wheels have come off the bus on that one,” said Niccolo de Masi, a video game executive and Spac founder, referring to the SoftBank chief executive whose $100bn Vision Fund has become synonymous with huge investments in start-ups.
Some Silicon Valley investors are now devising creative ways to rebrand the Spac. Kevin Hartz, a well-known angel investor and co-founder of the ticketing business Eventbrite, is aiming to raise $200m for a Spac simply titled “one” — the first in a series to come. The name of Mr Hartz’s sponsor, A-star, is a reference to a search algorithm engineered to find the optimal path to a solution.
New Spacs could come from an unlikely source: venture capital firms looking to find another way to list their own portfolio companies or other tech start-up ready for public markets. One well-known firm, Ribbit Capital, is targeting $600m for fintech businesses, people briefed on the plans have said.
“Silicon Valley has started to realise [the] Spac is not a gimmick, it’s a financial tool,” said Mr Mortara.
In the midst of a bull market that even a global pandemic cannot stop, hope springs eternal as Wall Street naturally averts its eyes to numerous wrecks on the side of the road and gazes to the handful of recent Spac successes that have centred on visionary businesses.
“It’s the imagination, that’s what captures people,” says Mr Noel, the lawyer. “There are all these Spacs that have come out of the gate and performed in the marketplace really well, in part because they caught the imagination of people.”
“It’s not about what it is. It’s what people believe it could be,” he said.