Why a SPAC Bubble is Actually Good for the Economy

More than 175 SPACs have gone public already in 2020, raising 65 billion in capital. This is more than the amount of money raised by SPACs in the last decade, making the most important investing craze of the moment centered on Special Purpose Acquisition Companies (SPACs).

What are SPACs?

At their core, SPACs are companies that go public and raise capital from investors with the intent to make an acquisition. Typically, a SPAC doesn't buy a whole company but rather acquires a stake in it. The same way that an investor wouldn't know what a specific acquisition will be or how much it will cost, the shareholders know the "sponsors," an important term to keep in mind. The deal has to be done within two years or else the sponsors have to give the money back. At their heart, SPACs promise to carry on an undertaking that will be of great advantage, although nobody really knows what that undertaking will be.

Impact on the Economy and Technological Innovation

The tens of billions of dollars that all these SPACs have raised have to be used to buy stakes in real companies. More SPACs mean more competition for deals, which means the companies SPACs are interested in can drive harder bargains and sell themselves for higher prices and get better terms than were once possible. For example, the 20% cut for sponsors is no longer fixed in stone. Bill Ackman reduced his cut in the Pershing Square SPAC to 0% up-front.

This means that companies can raise capital more cheaply and quickly than they would by trying to go the route of a traditional IPO. You might think that between the sponsors' cut and the fees you pay to complete an acquisition, selling a stake to a SPAC would be as or even more expensive for a company than a traditional IPO. However, the underpricing in traditional IPOs and the increased willingness of SPACs to pay target companies have changed this. In fact, the companies that are selling stakes to SPACs mostly don't bear the costs of these deals—they are largely borne by SPAC shareholders.

Economic Pros and Cons

For the economy as a whole, it is likely to do more good than harm. As the economists Ramana Nanda and Matthew Rhodes-Kropf have shown, investing bubbles can help drive technological innovation by channeling money to high-risk ventures that, in normal times, would have difficulty raising money. And that is precisely what the SPAC bubble is doing.

Like most bubbles, this is almost certainly not a sustainable state of affairs. At some point, investors will stop being willing to subsidize high-priced acquisitions. And the SPAC boom has a clear downside: It means that lots of money will be invested in overhyped and sketchy companies. For example, the electric-vehicle maker Nikola or startups that never make it out of the fledgling stage.

Risk and Uncertainty

Despite these concerns, there are reasons to be optimistic. The underpricing in traditional IPOs and the increased willingness of SPACs to pay are creating a more efficient market. This has led to a 35% annualized rate of return in SPACs in 2020 (up from less than 30% historically).

However, the SPAC boom has also raised worries about the madness of crowds. While SPACs have been around for decades and enjoyed a little boomlet in the late 2000s, their explosion in popularity this year has brought everyone into the game, with retail investors rushing to jump on the bandwagon.

Conclusion

IPOs have become an extraordinarily inefficient way for companies to raise money. SPACs, on the other hand, are filling a critical hole in capital markets by providing a quicker and cheaper way for companies to go public and offering more certainty about the price they'll get when they sell a stake in their business.

In summary, while SPACs are not without their risks and potential downsides, they are also driving significant economic growth and technological innovation. As investors, it is essential to stay informed and be prepared to deal with the uncertainties that come with any bubble.