From Lagado projectors to modern-day SPAC sponsors
Montreal, September 23, 2020
FROM LAGADO PROJECTORS TO MODERN-DAY SPAC SPONSORS
In Jonathan Swift’s Gulliver’s Travels, Gulliver visits Lagado, the metropolis of the fictional island of Balnibarbi where he is given the privilege to examine the works of the Grand Academy’s scholars called Projectors. There, he is acquainted with Projectors that dedicate their life to futile studies such as the extraction sunrays from cucumbers, the transformation of ice into gunpowder or the softening of marbles to make pillows more comfortable. Swift was one of the most famous political satirists and pamphleteers of his time and this passage can be interpreted as a parody of the speculative excesses that were prevalent in the late 17th and early 18th century. It is worth noting that Gulliver’s Travels was published shortly after Swift’s generation had witnessed the collapse of two of the most notorious stock market bubbles in history.
The first one took place in the mid-1690s. It involved a flurry of companies that had become public a few years earlier. Almost all of these companies were engaged in the manufacturing or distribution of diving apparatus and pumps, industries that had suddenly become ebullient after Sir William Phips and his associates, on a private expedition, were able to recover nearly 3,000 gold coins and three silver bars from the wreck of the Spanish armada ship Nuestra Señora de la Concepción. The view was that anyone with the right equipment could ‘strike gold’. Ultimately, most expeditions were ruinous and the companies supplying equipment for those ventures ended up worthless.
The second one has a dedicated chapter in almost every financial market history book: the South Sea Bubble, which almost bankrupted England in 1720. This speculation mania centered of the South Sea Company which was founded in 1711 and enjoyed a British government monopoly to trade slaves with Spain controlled Central and South America. For many years, the South Sea Company’s stock languished, in spite of its guaranteed 6% interest, as the terms of the Utrecht Treaty with Spain in 1713 were less favorable than had been anticipated. In effect, an annual tax and a strict quota were imposed on slaves imported to the Americas. Confidence was restored in 1718 when King George I himself was nominated to the Board of Governors of the South Sea Company but it is only in 1720 that the South Sea Company’s stock took flight after the British Parliament accepted its offer to take over the National debt in exchange for an upfront loan. The company expected that the expansion of its trading activities would enable it to pay the government debt. Soon after the announcement, the South Sea Company stock went up eightfold. Business was lucrative for shylocks who were granting loans to Londoners who couldn’t get enough of the stock, and for swindlers and fraudsters who were promoting the stocks of other trading companies engaged in similar activities. One adventurer even set up a company whose prospectus stated “…an undertaking of great advantage, but nobody to know what it is.” Eventually, the stock market collapsed, dragging down the entire country with it, including notable members of the aristocracy. The collapse of the South Sea Company led Sir Isaac Newton – who reportedly lost a fortune in the debacle – to declare: “I can calculate the movement of the stars, but not the madness of men.”
To be clear, we do not think that the global stock market as a whole is in bubble territory from a valuation standpoint. In fact, relatively speaking, developed markets government bonds, with maturities ranging between 5 and 20 years and with their yield to maturity standing at levels well below the expected inflation rate over the same maturity, appear to us in a far more precarious state. This is particularly true now that the Federal Reserve acknowledged that it will let inflation to overshoot above its long-term target of 2% before raising interest rates. Nonetheless, there are symptoms that bubbles may be forming in certain parts of the stock market, some of which would certainly draw Swift’s attention as a fertile source of inspiration were he alive today. For example, there are situations when dilutive stock offerings or stock split announcements are perceived positively on the grounds that more marginal buyers will now be able to participate. Other examples include the recent record high transaction volume on short-term single stock call options and, last but not least, the exuberance around Special Purpose Acquisition Companies, or “SPACs.”
By way of background, a SPAC is a publicly listed company established with the sole purpose of acquiring another company, within a given time frame, typically 2 years. On its formation date, the SPAC does not own any assets and the money it raises from investors through its own initial public offering (IPO) is kept in a trust until the SPAC sponsor successfully consummate a merger with an operating company. Following the merger, the operating company becomes a publicly traded stock. Typically, SPAC sponsors receive a combination of shares in the SPAC (typically 20% of the outstanding shares), and warrants with an exercise price marginally above the SPAC’s IPO price, in exchange for small consideration. Importantly, the sponsor is compensated in shares once a merger is completed, not as a function of the company’s performance following the merger. In other words, SPACs sponsors tend to be incentivized more by the strict completion of a merger transaction itself than by the financial success of the operating company. If a SPAC fails to complete a merger within the time frame, it is contractually obligated to return capital to its shareholders.
In 2020, more SPACs are raising IPOs than ever before. Separately, the amount of money raised by SPACs and the number of deals completed are also on record track. Our estimate suggests that SPACs are collectively sitting on more than 40 billion in cash raised from their respective IPOs. Once a tiny and obscure stock market niche attracting a number of unsavory characters, SPACs have gained notoriety as more sophisticated investors such as Bill Ackman are getting involved. Celebrities and political figures are also surfing the wave. For instance, Billy Beane, of Moneyball fame, is behind Red Ball Acquisition Corp. while Paul Ryan, the former Republican party house speaker, is the Chairman of Executive Network Partnering Corp.
Some argue there are legitimate reasons that underpin the decision for an operating company to become public through a merger with a SPAC, as opposed to the more traditional IPO route. Rapidity of execution and certainty of proceeds probably rank amongst the most important reasons in comparison with the IPO process which is tedious and for which the value of the proceeds is usually not known until 24-48 hours prior to the IPO.
From the vantage point of the SPAC shareholder, however, we do not see many good reasons, quite the contrary. First, as described above, there is an inherent misalignment between the interests of the SPAC promoter and the interests the shareholder. In effect, the SPAC promoter generally gets compensated simply for completing a transaction while the shareholder compensation is tied to the longer-term success of the company. Basically, unless the SPAC promoter manages to acquire a company that is undervalued by a greater percentage than the percentage of the company that he obtains for completing a transaction, SPAC shareholders tend to get a smaller fractional share of the post-merger entity than what they paid for. While some argue that IPOs are notoriously undervalued, given the lackluster performance of a large number of stocks post-IPO in recent years, we think the argument is debatable. Second, a SPAC shareholder does not have the same degree of regulatory scrutiny and transparency into the books and records of the operating company targeted by the SPAC as they would during the normal IPO vetting process. After all, investors that were contemplating the acquisition of WeWork shares were rewarded when the company’s IPO filing documents revealed its weak governance and aggressive accounting practices, ultimately forcing the company to shelve its IPO plans. Unfortunately, if history is a guide, in a world awash with liquidity and zero interest rates, while many SPAC sponsors are undoubtedly well intended, it is almost certain that many dramatically overvalued companies and potentially fraudulent ones will get the attention of SPACs.
In many aspects, the SPAC promoters’ financial engineering approach to value creation may not be that different from the pseudo-science techniques employed by the Lagado Projectors which were dubious.
Thankfully, signs of speculative excesses seem to transpire from relatively concentrated segments of the growth equity space. As such, the idea is not to eliminate growth stock exposure altogether. In fact, we find that certain growth stocks remain undervalued relative to value stocks. Therefore, from a portfolio construction standpoint, the key is to maintain a good balance between different types of stocks and between asset classes.
Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer
 Jonathan Swift, Gulliver’s Travels. Original title: Travels into Several Remote Nations of the World. In Four Parts. By Lemuel Gulliver, First a Surgeon, and then a Captain of Several Ships, Benjamin Molte, 1726.
 Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, London, 1841.
 In July, Bill Ackman raised 4 billion for the IPO of Pershing Square Tontine Holdings Ltd., the largest SPAC IPO to date.
 Billy Beane is the former General Manager of the Oakland Athletics professional baseball team from 1997 to 2015 whose attempt to assemble a competitive team is depicted in the movie Moneyball (2011, directed by Bennett Miller) based on Michael Lewis’s book Moneyball: The Art of Winning an Unfair Game (W.W. Norton & Company, 2003).