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Capital Markets Weekly: SPAC IPO sales set record pace but indicate financial overheating risk
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.
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".
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