By James Mackintosh
Oct. 20, 2020
Spotting asset bubbles is hard because there is almost always a good underlying reason for what's going on. Canals, railways and the internet really were going to revolutionize the economy. The mistake with bubbles is that prices disconnect from what the new development will justify. The difficulty for those of us trying to spot bubbles is to tell how much is really justified, and how big the disconnect will become.
Today there are two obvious bubble candidates, and as usual, both come with good underlying reasons for their success. Big Tech's high profits and growth prospects make it a beneficiary of lockdown and of low-forever interest rates, justifying a high valuation. As usual, the question is how high is too high.
The boom in cash shells, or special-purpose acquisition companies, also known as SPACs, is in some ways more troubling. One of the characteristics of bubbles is that hope of profit encourages exuberant optimism, and investors hand over money for projects they'd never consider in normal times. The apocryphal tale from the 1720 South Sea Bubble of "an undertaking of great advantage, but nobody to know what it is" might seem not so far removed from SPACs today: Investors hand over money in an IPO to be used for an unspecified acquisition.
However, SPACs don't require the sort of blind faith in management the way blank-check initial public offerings did in the 1980s or cash shells do in many countries. They are pretty safe. The standard structure gives investors a vote on any deal, the option to get their money back if they don't like the deal and a deadline of two years to do a deal or hand back cash, almost all of which is held in escrow. Stock promoters can't just siphon off all the money, as they could with blind pools (and with many of the ventures of 1720), and can't do a dumb deal without getting investors onside.
Low interest rates help explain some of the growth of SPACs, because they make the downside more palatable. In the worst case—barring fraud—investors can get back almost all their money. In normal times, that money might have earned more interest elsewhere, but with rates at zero, the opportunity cost of a SPAC is low. There should be more demand for them, all else equal.
SPACs have a real-world reason to exist, too. They offer a simpler and quicker alternative to an IPO for private companies that otherwise face prodigious amounts of paperwork to list. As one example, Playboy Enterprises is going public via SPAC Mountain Crest Acquisition Corp., expecting the deal to close in two to three months, which would be hugely optimistic for an IPO from first Securities and Exchange Commission filing to first trade.
SPACs aren't cheap—most managers get stock worth 20% of the cash raised when a deal is completed—but remove the pricing uncertainty of a traditional IPO and offer a speedy listing.
Yet I still find the SPAC boom unsettling. The last boom peaked in 2007 along with the stock market, and might have been a sign of investors having a get-rich-quick mind-set. If SPACs were one of the many warning signs in 2007, they should be far more so this year: In 2020 so far SPAC IPOs have raised a record $53 billion, according to Dealogic.
Add 2019 and 2020 together and more was raised than in all SPACs since the concept restarted in 2003. SoftBank said this week it plans its own SPAC, too, and big names are starting to cash in, with one announced this month advised by basketball legend Shaquille O'Neal.
Even if this isn't a sign of froth, too much money chasing the companies ready for the public markets inevitably drives up prices, suggesting lower future returns. Worse, as SPACs near the end of their life, the managers are incentivized to rush to do any deal, even a bad one.
"The fact that there are so many SPACs out there searching for mergers certainly allows an operating company to play them off against each other," says Jay Ritter, a finance professor at the University of Florida. One successful SPAC manager agreed in private that too much money is already chasing too few good-quality deals.
This doesn't bode well for SPAC investors. It is true that they can always reject a deal they think is overpriced and choose not to take part even if other investors liked it, but there is less disclosure than with an IPO so it is harder to assess. As one example, if SoftBank had had its SPAC up and running last year, WeWork could have avoided the scrutiny of the IPO process and might have made it to the public market before falling apart.
Companies with negligible revenue such as space-tourism company Virgin Galactic and electric-truck developer Nikola successfully used SPACs, with their shares soaring and then crashing afterward—although both remain well above the pre-deal SPAC price.
None of this provides much help in the question of whether this is a bubble. Is the flood of money into tech or SPACs because investors have lost touch with reality? Or is it because the new environment—tech's high profits at a time of historically low rates, or SPACs as an alternative to IPOs—has changed what should count as normal? Things that would have been solid warnings of a bubble in the past are easier to justify today.
Intellectually, valuations aren't extreme at a time of free money, and rapid SPAC growth is understandable. I'm left with just the gut feel that it is all too much.
Write to James Mackintosh at James.Mackintosh@wsj.com
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