How a SPAC deal can go horribly wrong

Benj Gallander, Ben Stadelmann, and Philip MacKellar
July 3, 2022

Have you ever written a blank cheque or made a purchase without knowing what you’ve just bought? The answer is probably “no,” unless you’ve participated in a SPAC or two. Over the past few years, SPACs, or Special Purpose Acquisition Companies, have been all the rage, and investors haven’t been able to get enough.

If you’re new to the term, a SPAC is a corporation without operations. Instead of providing a product or service, they raise capital and use the funds to purchase an existing organization. From a startup’s point of view, the SPAC is a wonderful source of funding and provides entrepreneurs with an alternative to IPOs (initial public offerings) as an avenue to public markets.

From an investor’s point of view, however, investing in a SPAC is a shot in the dark, because you won’t know what it will buy – it could acquire a health care provider, fintech enterprise, or an e-commerce business – or anything else, for that matter. You also won’t know if the target will be well-financed, profitable, and have good valuations, or be debt-heavy, without revenue, and expensive. As a result, SPACs have been referred to as “blank cheque companies,” and create ideal conditions for speculation.

As you might suspect, not all SPACs do well. In fact, some do horrendously. Electric Last Mile Solutions (ELMSQ) exemplifies what can go wrong. In late 2020, a SPAC called Forum Merger III listed at US$10 a unit and started looking for an acquisition. The target they settled on was ELMS, which started trading in June, 2021.

This outfit is an electric-vehicle maker that focuses on building “last mile” commercial delivery vehicles – the last link in the chain of product distribution. In many ways, this was a classic SPAC. It was well-promoted, had slick presentations projecting strong growth, and had a great story behind it associated with a sizzling sector. That said, even during its heyday as a publicly listed entity, things did not look great.

In the third quarter of 2021, it produced only US$139,000 in revenue, posted a net loss of US$17.8-million, and was burning through cash at a rapid rate – yet its valuations were sky high. At that time, the share price was around US$8.50 and there were 118.8 million shares outstanding, which generated a market cap of roughly US$1-billion.

Unfortunately for stockholders, it did not get better. In 2022, late filing notices from the SEC started to appear; instead of quarterly earnings reports, the organization fell into NASDAQ listing rules non-compliance; and the chief executive officer resigned. As this was unfolding, the shares tanked, issues regarding solvency increased, and then in mid-June, the corporation filed for bankruptcy.

The stock is currently trading for pennies, and the U.S. Chapter 7 bankruptcy process will almost assuredly wipe out the existing owners. To make a long story short, ELMS is a cautionary tale for investors speculating on new companies coming to market. Many SPACs (and IPOs for that matter) come with big promises and hot prospects promoted by excellent salespeople, and align with an important macro trend to give investors a misleading “feel-good” vibe.

Indeed, Electric Last Mile Solutions is far from alone. According to research firm Audit Analytics, 25 SPACs listed between 2020 and 2021 have issued going-concern warnings in recent months. This equals more than 10 per cent of the 232 SPACs listed during that period. Compared with IPOs listed during the comparable timespan, this is double the potential near-term fail rate. In short, it highlights the risk of this relatively newfangled way of going public.

The final point to highlight here is one that Warren Buffett and Charlie Munger like to hark to. They regularly point out that revolutionary industries with excellent prospects (such as electric vehicles) may make wonderful contributions to society, but that doesn’t automatically translate into good investor returns. In fact, investors may be left holding the bag or losing their shirts. They reference automobile stocks listed in the 1910s and 1920s to drive home their point. During that era, there were thousands of automobile makers in the United States, many of which were listed, yet most of them went bust early on. Those that did survive competed against each other to the point where returns on capital were low, and eventually, there were only three publicly traded U.S. automakers left. To add insult to injury, two of them then went bust during the 2008-2009 financial crisis and had to be recapitalized. Mr. Buffett and Mr. Munger go on to note how similar experiences have befallen airlines from the 1950s, semiconductor manufacturers in the 1970s, and internet start-ups in the 1990s.

Taken all together, investors in ELMS or other SPACs looking to profit from revolutionary industries may be forgiven if they get caught up in the hype. At the end of the day many will be left exasperated as they yell into the void, “What the SPAC?!”