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This week I focus on the recent record issuance levels involving
SPACs (special purpose acquisition companies) and concludes that
there are indicators of financial overheating, with potential for
greater downside risk than in other asset categories.
US equity market issuance has started 2021 very strongly.
According to Renaissance Capital research, the US IPO market
enjoyed a record month in January, with larger IPOs continuing to
trade strongly. However, special focus is being given to the record
flow of SPAC issuance. So far in 2021, there have been 67 deals for
special purpose acquisition companies, a clear record.
The SPAC area was a focal point of US stock markets in 2020,
with a total of 242 deals sold, reportedly accounting for almost
half the total IPO US volume. So far in 2021, this pace has
accelerated even further with an average of five flotations on each
business day. Within the first two weeks of January the full year
SPAC total for 2019 already was overtaken. Within 2021, by 21
January over USD20 billion had been raised for SPACs, more than the
2021 total for follow-on secondary sales across all sectors and
comparing with USD13 billion of SPAC sales in full-year 2019.
In assessing issue activity, we should highlight that the SPAC
segment is not the only active component of US equity markets. A
Wall Street Journal article on 22 January noted that 80 follow-on
secondary offerings have been undertaken by US companies so far in
2021, with proceeds of USD16.35 billion, according to Dealogic
data. Both figures - number of deals and their volume - imply a
record pace of share sales so far this year. The largest such sale
was by Zoom Video Communications Inc., which sold USD2 billion of
equity to fund its business expansion. This pace of sales looks
likely to remain strong, indicated by a heavy filing calendar for
further issues. Many of those raising equity are health care and
pharma firms which are benefitting from the positive sentiment
towards these sectors.
A further indicator of equity market strength is given by the
continued "pops" (sharp initial price appreciation) in larger new
IPOs, a strong trend in late 2020 which has continued for larger
deals in early 2021.
Our take
In multiple prior reports, we have noted that the expansion of
central bank balance sheets has become a critical driver in the
valuation of financial assets, with bond and share prices boosted
by the very sizeable additional financial sector liquidity. The
scale of expansion is shown by the Federal Reserve's total assets:
these went from USD4.17 trillion at end-2019 to USD7.4 trillion on
18 January, when last reported.
In debt markets, this has led to weaker emerging market credits
- such as Oman, Bahrain and Turkey within January 2021 - recently
enjoying very strong demand for longer-dated bond sales on
attractive terms. In Europe, growth in Euro-area central bank
assets from EUR4.7 trillion to EUR7 trillion between March 2020 and
the present has permitted heavily indebted European sovereign
borrowers like Spain and Portugal to issue 10-year liabilities at
negative cost, along with Slovenia, while Italy attracted over
EUR100 billion in demand for a 15-year syndicated sale earlier this
year priced just below 1% yield. Very strong demand also has been
forthcoming for riskier subordinated and hybrid debt from banks and
corporates.
In many cases, there is a reasonable case to argue - and we
share the assessment - that current valuations across multiple
financial instruments indicate elements of financial distortion,
with the search for yield forcing bond investors to take excessive
credit and duration risk to improve their returns. However, this is
not new, and has been a regular feature in recent years. Moreover,
the risk of near-term heavy capital loss is limited for investors
by the strong likelihood that the Federal Reserve, European Central
Bank and other central banks will maintain a soft monetary stance
for several years to come, in a low inflation environment in which
real economies are struggling to recover, and that eventual
tapering also will be cautious to avoid "taper tantrums".
By contrast, there are now some distinct some signs of "bubble
risk" or irrational overheating in the US SPAC market. While the
concerns over exceptional demand levels also apply to the wider IPO
market, the particular worry regarding SPACs reflects their
specific risk profile.
SPACs are special purpose acquisition companies designed to
enable their managers to have funds available to make acquisitions
quickly and on an opportunistic basis. While a manager's past track
record may be known, the investment merits of a SPAC's future
purchases are not. In this regard, SPAC IPOs differ from
conventional IPOs in that there is no business or financial history
for the entity being sold, nor is there a defined business case
based on the firm's existing activities, business model and future
plans. Other than detail on which type of assets might be obtained,
and the past reputation of their managers, SPACs largely live up to
their name of being "blank cheque companies".
For issuers, listing rules for SPACs are attractive, in that
they avoid the lengthy disclosure and need to supply a track record
commonly associated with conventional IPOs: for several firms
working together with (and being acquired by) a SPAC has offered an
accelerated route to flotation. Within the SPAC segment, there are
several vehicles in sectors that are now a positive focal point for
investors, notably the electric vehicle segment, making some
earlier SPACs very attractive and successful investments for their
purchasers.
Ultimately, however, a new SPAC is a "blank cheque company" and
its purchase cannot be based on a detailed investment thesis,
instead relying on investor trust in its management to select,
obtain and manage the right acquisition targets in the future.
The recent rush of deals is thus a potential cause for concern,
particularly regarding its unprecedented deal numbers. These
suggest that investors may be buying relatively indiscriminately,
or with only limited basis for judgement. From a simple deal-count,
it is hard to imagine that all purchasers have undertaken detailed
scrutiny of the track records and other credentials of all 67
issuers that have sold shares in the short period of three weeks :
at best, the deal calendar suggests that due diligence has become
more cursory, but with the risk that it also may be at least
partially negligent.
Our concerns are reinforced by the view raised by Goldman Sachs'
CEO David Solomon in that firm's latest quarterly earnings release
call that SPAC issuance needs to "be pulled back or balanced in
some way", warning that SPAC deal-flow has "gone too far", and thus
is subject to sharp reversal. This note of caution is salutary in
that Goldman Sachs was the third most active SPAC underwriter in
2020.
As another apparent indicator of apparent overheating, a SPAC
sold in 2020 by SoftBank is reported to have appreciated one-third
since flotation - but has yet to announce any targets for
purchase.
As a further warning, on average, Fortune's Q1 Investment Guide
describes SPAC deals as "lousy for investors".
IHS Markit does not offer investment advice but the risk of
excessive optimism appears clearly elevated within the current SPAC
deal flow. Given the unprecedented number and volumes of SPAC deals
being completed, and the lack of business fundamentals underpinning
the offerings, there appears to be a stronger case of "bubble risk"
in this segment than in the market for conventional IPOs or fixed
income securities.
In the debt markets, stressed borrowers may have recourse to
official resources such as the International Monetary Fund's
facilities or EU support mechanisms, and even in default scenarios,
partial recovery of capital is commonplace during debt
restructuring. In the IPO market, deals can of course go wrong, but
investors at least have a tangible investment thesis on which to
have based their eventually erroneous judgements. In the SPAC area,
by contrast, the fundamentally largely-unknown nature of how funds
will be deployed - combined with the rush of new supply - suggests
that some recent investment decisions possess the characteristics
of a "bubble" or "financial overheating".
Posted 27 January 2021 by Brian Lawson, Senior Economic and Financial Consultant, Country Risk, IHS Markit
