Special purpose acquisition companies, or SPACs, have made a rapid and dangerous return to the forefront of investing. Once shunned as the successor to blind pools — the investment vehicle used by ‘Wolf of Wall Street’ Jordan Belfort to defraud thousands of investors — SPAC mergers have grown increasingly popular as an alternative to direct listings and traditional IPOs.
While today’s SPACs are subject to stricter regulations and greater investor protections than their 1980s precursors, many operate with the same core premise: convincing retail investors to buy into get-rich-quick schemes by exaggerating gains and downplaying risks. A new generation of investors, courted by commission-free investment apps, dubious ‘buy’ ratings, and a small chance at big returns, are rushing headfirst into these offerings without a full appreciation of their risks. United Wholesale Mortgage’s $16 billion IPO today, the largest IPO to have ever originated from a SPAC deal, epitomizes the growing danger of Wall Street’s new favorite money printer.
SPAC mergers function through two main stages. First the SPAC undergoes an IPO in which its manager — usually a famous investor or fund executive — solicits blank-check investments with a promise to identify a high-potential, privately held acquisition target within a two-year period. With shareholder approval the SPAC manager then facilitates a merger, taking the target company public and awarding investors shares proportional to their stake. Done correctly, all involved parties benefit: SPAC investors get early access to an exciting new stock, companies targeted for acquisition go public in less time and at lower cost than they would through traditional mechanisms, and SPAC managers collect fees and receive a ‘promote’ worth up to 25% of the SPACs value as payment for their efforts.
The appeal of SPACs’ unique structure is evidenced by their surging popularity. According to the SPACInsider financial database, there were more than four times as many SPAC IPOs in 2020 as in 2019, at a record average size of over $330 million. When United Wholesale Mortgage (UWM) announced plans to merge with SPAC Gores Holdings IV last September, financial media recognized the $16 billion deal, anomalous even within the record-breaking upswing, as the capstone to the ‘Year of the SPAC.’ However, rather than indicating the viability of SPACs as a legitimate and well-balanced investment vehicle, the $16 billion deal is reflective of the widespread investor hubris and corporate opportunism fueling their popularity.
It is no accident that rise of SPACs has coincided with a surge in the share of trading volume constituted by individual investors. The release of new zero-commission trading apps, coupled with the rapid recovery of the market from March lows and sophisticated marketing campaigns by startups and tech unicorns, has fundamentally reshaped the demographics and risk propensity of investors as a whole. SPACs, more than most other investment vehicles, are structured to benefit from these trends. Their dual-stage IPO process and expediency enables them to generate and quickly capitalize on investor interest, and their regulatory efficiency makes them particularly well suited to the tech sector. However, these benefits are offset by substantial risks, which are disproportionally shouldered by inexperienced retail investors who pile into newly listed companies.
Despite their popularity, shares created by recent SPAC mergers have yielded a median return of -29.1%, indicating that they are a consistently bad investment. Tony Cannizzaro, an Assistant Professor and Area Director at The Busch School of Business at The Catholic University observes, "While blank check IPOs are not necessarily unethical, they are inherently less transparent than traditional IPOs. Moreover, empirical evidence suggests private firms using SPACs to go public actually underperform."
This isn’t a problem for SPAC managers, who are all but guaranteed to profit because of their fees and bonuses. In fact, the ‘promote’ they receive incentivizes them to complete any deal they can, without regard for investor wellbeing. Nor is it an issue for company owners, who instantly benefit from a windfall of capital and a substantial increase in their own personal net worth. As a result this creates a moral hazard where both parties have every reason to pump out deal after deal, creating poorly managed, overvalued companies destined to crash. Investors, misled into believing that they are getting a great deal, almost always lose out.
Concerns over SPAC mergers are not just hypothetical; Nikola Corporation’s rise and fall in the span of just a few months is emblematic of how they can go wrong. When the electric vehicle maker announced last March that it would go public through a $3.3 billion SPAC merger, many financial analysts touted the offering as a rare opportunity for exceptional returns. By September, Trevor Milton, founder and executive chairman of Nikola, was forced to resign in the wake of allegations that he had deceived investors as to the status of Nikola’s technology. Its market cap is now just a third of what it was last June. Corporate fraud isn’t exclusive to SPAC mergers, but their reliance on short-term investor excitement encourages it by incentivizing deception.
Even where fraud is absent, SPAC mergers are generally arrangements with risks that scale according to the size of the deal. For this reason, the United Wholesale Mortgage/Gores Holdings IV merger stands out as particularly concerning. The massive $16 billion dollar valuation might mislead investors into believing that UWM’s upcoming IPO is safer than that of other companies who have gone public through smaller deals. In reality, it only means that there was even more incentive for UWM and billionaire Alec Gores to reach an agreement and that there is even greater potential for major investor losses.
With regards to UWM, recent lawsuits and a history of questionable executive conduct do little to assuage these concerns. Although Gores’ record has no such blemishes, the fact that he has created two more SPACs after Gores Holdings IV attests to the fact that he, like other SPAC managers, view them as an easy and quick source of profit.
All investments entail some risk, but SPACs have proven themselves to be uniquely risky investment vehicles that often lead to enthusiastic and inexperienced new investors realizing significant losses. The rapidly growing rate and size of SPAC mergers suggests that more and more managers and executives are looking to them for a quick payday, without necessarily being upfront about their risks and limitations. In this regard, United Wholesale Mortgage’s $16 billion SPAC deal should give investors pause. As of early afternoon on the day of the IPO, UWMC shares were declining 3%, more than market indexes. While past performance may not be an indication of future performance, and the falling share value could certainly be reversed, there is a good chance that millions of investors have bought shares, tempted by the promise of massive returns, only to collectively lose billions.
Jack Yoest is a consultant and Assistant Professor of Practice in Leadership & Management at The Catholic University of America in The Busch School of Business, in Washington, DC. He teaches in both graduate and undergraduate students. He is the author of "The Memo: How the Classified Military Document That Helped the U.S. Win WWII Can Help You Succeed in Business."
