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Why SPACS Are A Bubble That’s About To Burst.

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It’s not yet two months old, but 2021 already looks poised to outdo 2020 in one area: SPACs, or special purpose acquisition companies, raised around $26 billion in January this year in the United States, nearly a third of the record $83 billion collected by 248 SPACs over the whole of 2020.  These so-called “blank check” shell companies have no operations or business plan other than to acquire a private company using the money raised through an IPO, thereby enabling the latter to go public quickly.

It seems almost everyone who is anyone is “sponsoring” or setting up a SPAC, from ex-Trump adviser Gary Cohn to basketball star Shaquille O’Neal to Hong Kong tycoon Richard Li. But, as my recent paper shows, signs beyond the headline figures suggest that SPACs are a bubble about to burst.

Remember Reverse Mergers?

SPACs are a form of reverse merger, the subject of my paper. In a standard reverse merger, a successful private company merges with a listed empty shell to go public without the paperwork and rigors of a traditional IPO. The shell is usually a remnant of a previously operational public firm or a public virgin shell formed to combine with a private company. Where SPACs are different is simply that the shell company is a proactive party, flushed with cash from the IPO and hunting for private targets.

Often criticized, reverse mergers have existed for decades, mostly on the margins of financial markets, and we have seen several waves of them since the 1970s. They surged in the mid-2000s, outnumbering IPOs in some years, and peaked in 2010, before falling off a cliff in 2011. In our paper, my co-authors and I sought to identify what drove the boom and bust of reverse mergers and to draw lessons from the reverse mergers story in order to understand the life cycles of controversial practices more generally.

From Boom to Bust

Research shows that when more people adopt a practice, it will become increasingly widespread due to growing awareness and legitimacy. But that’s for non-controversial stuff. Things get a little more complicated for controversial practices like SPACs and reverse mergers, where third-party concern and skepticism also grows as the practice becomes more widely used.

Our study offers an institutionally and sociologically informed explanation of the boom-to-bust dynamics of controversial practices. While finance and economics have suggested that decision makers’ cognitive biases drive these bubbles, we add to evidence that such bubbles can relate to institutionally driven dynamics. In effect, we show that the popularity of reverse mergers planted the seeds of its own demise.

We collected data on the use of reverse mergers, market responses, and firm characteristics, including market value, earnings, total assets and debt, exchange listing and between 2001 and 2012. We also studied how the media evaluated reverse mergers. Of the 267 articles published between 2001 and 2012, 148 were neutral, 113 were negative and only 6 were positive. Finally, we gathered share price data to examine how stock markets valued reverse mergers.

Our analysis of this data shows that — as you would expect — higher popularity of the practice (i.e., higher number of past adoptions of reverse mergers) initially triggered imitation and further adoption. But, simultaneously, as the number of reverse mergers grew, investors and the media became increasingly skeptical about the practice. The skepticism and negative reactions were further intensified as the proportion of reverse merger transactions involving firms with relatively low reputations increased. The poor stock market valuations of reverse merges, and the negative media coverage discouraged firms with good reputations from adopting the practice. The regulators duly waded in. Both the Securities and Exchange Commission’s 2005 disclosure rules for reverse mergers and its 2011 warning to investors about investing in reverse mergers amid an influx of Chinese players — a phenomenon studied in another of my recent papers — triggered negative market reactions and led to a decline in the practice.

In essence, investors, regulators, and the media — important arbiters of financial innovations — fed off one another’s cues and evaluations. Negative media coverage weighed on stock market valuations and the subsequent diffusion of reverse mergers. By 2010, when reverse merger activity peaked, 70 percent of media articles on the phenomenon had a negative tone. Reverse merger firms’ share prices plummeted to the extent that cumulative returns neared -45 percent. The following year, in 2011, reverse merger activity plunged by 35 percent. In effect, the popularity of reverse mergers planted the seeds of its own demise.

If all these sound familiar — rapid proliferation of a controversial financial innovation, plagued by poor-quality players, bad publicity and regulatory concern — it’s because similar dynamics have re-emerged in the SPACs boom.

Here We Go Again

The most obvious sign is the frenzied growth. Amid the global stock market volatility, last year’s $83 billion haul by SPACs was six times the amount raised in 2019 and nearly equaled the figure mustered by IPOs. Even David Solomon, chief executive of major SPACs underwriter Goldman Sachs, warned in January 2021 that the boom is not “sustainable in the medium term.”

Then there is the fact that many firms taken public by SPACs have little to show in terms of business plan or revenue, in some cases triggering shareholder lawsuits by disgruntled investors. The most infamous example is Nikola. Three months after going public last June via its merger with a SPAC, the electric truck startup was accused of fraud by short sellers, resulting in the resignation of its founder and a flurry of lawsuits by shareholders. Nikola’s stock price has fallen to a mere fraction of its peak in June. Meanwhile SPAC successes such as fantasy sports betting firm DraftKings and data company Clarivate Analytics are relatively few. In fact, a recent study found that most SPACs’ post-merger share prices fall.

Another red flag comes in the form of negative media sentiment and regulatory concern. Reports about SPACs are often negative and cautionary. “SPACs are oven-ready deals you should leave on the shelf” warned a Financial Times headline in December. SEC Chairman Jay Clayton has signaled similar reservations. The SEC was watching SPACs closely, he said in September, in efforts to ensure SPAC shareholders “are getting the same rigorous disclosure that you get in connection with bringing an IPO to market.”

Under the rules governing them, SPACs must identify firms they can merge with within 24 months after they have raised their funds or they will be wound up and the IPO proceeds returned to investors. More than 300 SPACs need to pull that off this year or risk being liquidated. But with only so many quality targets to go round, and SPAC founders’ strong incentive to close deals — even at the expense of shareholder value — SPACs may well end up in a negative spiral of poor quality/bad press/tighter regulation. And we know how that ended for reverse mergers.

 

Ivana Naumovska is a professor at INSEAD. This article was published at HBR.org

When We Can’t Agree On Anything, Let’s Live Apart.

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When the melting pot has stopped melting and started stirring, you need to try something else. America was always the land of opportunity, where working hard meant getting ahead and doing well was not just allowed but encouraged. Where you could mind your own business and where your right to believe the craziest of things was routinely accepted and then overlooked in service of more worldly things. From Disneyland to massive film festivals to setting up crazy cities in the desert, the American way was to cherish diversity and independence: the ability ‒ right, even ‒ for everyone to do their thing.

Or so it told itself.

Now, however, something seems broken ‒ and I’m certainly not the first to point that out. Many clashes at dinner tables and arguments in the living room have exposed the rifts between people: over politics, over the ruling of the country, over health care and who ought to pay for it, over how the pandemic changed people’s lives and how we ought to behave in this strange new world. The particular American fight over masks ‒ wearing them or not? Do they work or not? ‒ became an illustrating symbol that signaled righteousness or deviance, loyalty to the establishment and others’ well-being or a hatred for the same.

The personal became incredibly political.

In an age just slowly adjusting to how megaphone-esque social media landscapes alter our behavior, perception and understanding of our fellow humans, no personal stone seemed unturned. The political parties have noticeably become more hostile towards, as well as moving ideologically away from each other. Somewhere between one-sixth and one-third of Republicans and Democrats alike report that they would be upset if their child married someone from the opposite party. Perhaps there was always some resentment for political opponents, but it seems on display and on a magnitude not previously seen.

The pandemic, both through its invasive political policies and behavior among people, is only the tip of this collapsing iceberg, where everyone’s business is everyone else’s to meddle with. Where your ideological or political persuasion is a moral failure subjecting you to an endless amount of scorn, hatred, and even violence.

We see it in our families, where everyone now has political rifts; we see it in our dating life, where sorting according to partisanship is increasingly a thing; we most certainly see it among friends that can no longer put politics aside and even break friendships because you voted for the wrong ruler or wore (or didn’t wear) the wrong piece of cloth before your face. In the workplace, you better sign off on the correct values or see your employment at risk.

Increasingly, like media commentators left and right have sputtered for years, Americans live in isolated informational bubbles. They literally don’t see the same reality; they misinterpret facts presented to them according to partisan convictions. A longstanding result in psychology is that intelligence does not help to offset this: the smarter one is, the clever ways one finds to spin factual results and arguments in buttressing one’s own already-established opinion.

The British journalist Douglas Murray in The Madness of Crowds: Gender, Race and Identity reflects a lot on this inability to value discourse and disagreement. Reflecting on the widening chasms in British and American political life, he writes that to live together

“[W]e have to find some way to get along together. It is the only option we have because otherwise, if we have come to the conclusion that talking and listening respectfully are futile, the only tool left for us is violence.”

For years before the January “Storming of the U.S. Capitol,” Murray ‒ and many others with him ‒ have warned about the dangers of politicizing life and staking moral and social triumph on whoever sits in the White House or runs Westminster. While the protests and the event itself was unexpected, nobody is really surprised that it happened. This is what political life has come to ‒ under a large and powerful government, I might add.

It’s easy to file the storming under “crazy right-wingers” or boiling fascist tendencies of all Republicans, but that’s a mistake. Had the November election gone differently, very few of the societal wounds that have opened during the 2010s would have closed. Nothing would have been better and a number of things probably worse.

But it was Trump supporters who stormed the Capitol and put our grand democracy at risk, you might say. Yes, but had the election gone only slightly different and the shoe been on the other foot, we would most likely have seen Democratic supporters storming the Capitol, preventing what they saw as an unlawful power grab.

Don’t believe me? According to a number of surveys done by political scientists Nathan Kalmoe and Lilliana Mason well before the November election, a higher proportion of left-wing voters (18%) than right-wing voters (14%) said that violence was justified in case of an unfavorable outcome in the Presidential election in 2020. Even more scary than a fringe for whom violence isn’t a barrier is that much larger shares of partisan crowds view their opponents as “downright evil.”

Considering how much moral fire was received by everyone even remotely connected to the right for the protests in early January, that forces us to scale back our moral condemnation. In an alternate universe where Trump had won, my guess is that we’d be in exactly the same situation, with a uniquely disliked President and an unruly population and a society at odds with itself ‒ and a violent attack on some public institution attempting to reverse the result.

At some point of societal schism, there is no way back. Perhaps we’re not there yet and perhaps we can still mend the wounds of the last few decades. I keep wondering that maybe, just maybe, some part of the extreme right-wing segregationist claims have merit. If it’s unthinkable for you to live alongside someone of the wrong class, sex, religion, race, or political persuasion… perhaps you shouldn’t. Perhaps then, dividing, separating, or even seceding is the only solution.

Ignoring one another is a peaceful way of coexisting; Not interacting is a viable solution unless we’re forced to do so through a one-size-fits-all political process. Playing the political game makes it worse, and the collapse of personal grand narratives have let politics substitute for every other desire we have.

We could decentralize political power, have people self-select into what sort of governance and/or people they wish to live with, and we can peacefully separate instead of violently combat one another.  After the year we’ve had ‒ Trump, Trump, Anger, Pandemic, Lockdown, BLM, Election, Coup ‒ does anyone still think that living apart from one another is such a bad idea?

Once The Government Gets Involved In Any Market, Rampant Price Inflation Follows.

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In his book Bubbles and Crashes, Brent Goldfarb says a bubble is much like a stock that traders keep buying because others are doing the same thing.

“This usually happens when a company or product has a compelling narrative around it that isn’t backed up by data,” Goldfarb writes. “They’re easy to invest in, there’s a lot of uncertainty about the future value, and it’s often about a lot of novice investors.”

The student loan bubble checks all of these boxes. Americans have been hearing about a student loan “crisis” for over a decade, and there’s a reason for that. Forty-three million Americans hold $1.5 trillion in federal student loan debt. The average debt per borrower is $37,127. Since the late 1970s, tuition has risen at a rate three times that of inflation.

Not only is a college degree getting more expensive, it’s doing so while arguably becoming less valuable.

The Wall Street Journal reports that 43 percent of graduates are underemployed in their first job. Of those, two-thirds remain in jobs that don’t even require a college degree five years later.

Meanwhile, the Washington Post found that only 27 percent of graduates work in a job related to their major. And estimates show that the rate of return on a degree has been decreasing since the Great Recession.

Already, over 1 million people default on their student loans every year. Some studies estimate nearly 40 percent of borrowers could follow their lead by 2023, leading many to warn of the coming student loan bubble.

One trait all bubbles share is an obscured understanding about the value of a commodity relative to its actual worth. In this instance, it’s why you see people paying $100,000 for a degree in graphic design that might pay them $40,000.

Sometimes, the debt is even more. Just ask Shaun Dunn, a 38-year-old 3-D designer who racked up more than $400,00 in student loan debt after attending the Academy of Art University in San Francisco.

“I just feel they were dishonest, saying you’ve got this great future in front of you,” Dunn told the San Francisco Chronicle earlier this year. “But I feel we were ripped off. Bamboozled. Tricked.”

As of February, Dunn had no job, owed $431,607, and was bankrupt.

So, given these circumstances, why do we continue to see young people paying small fortunes to earn these degrees—especially those that offer little prospect of earning potential?

It goes back to Goldfarb’s point on the importance of a compelling narrative in the making of a bubble. Americans have been told the only way to upward mobility, respectability, and the American Dream is through a college degree. We sell this narrative to 18 year-olds (novice investors) and we make it really easy for them to invest in the model (government loans). If we wanted to create a bubble, I’m not sure you could have found a better way to do it.

So what happens if the bubble bursts? In the 2008 financial crisis, millions lost their jobs, their retirement savings, and their homes. That crisis bears many similarities to this one. Students take out and are given loans with little attention paid to their prospective ability to repay the debt.

And what was already a hot mess is reaching a boiling point in the midst of COVID-19 as the government continues to shut down businesses and create skyrocketing unemployment.

This is a crisis for millions of Americans, albeit one temporarily on hold as all federal student loan payments have been paused during the pandemic. There is, of course, an element of personal responsibility here. But these Americans do deserve some sympathy. These are people who were largely trying to do the right thing. They intended to work, not to be leeches on society. Many were taken advantage of and misled by higher education institutions, and they were poorly educated by our public schools that fail to teach basic financial literacy.

We cannot continue to shrug our shoulders at this situation. Unfortunately, most of the proposed solutions would only exacerbate the problem.

For years, progressives have been calling for the “cancellation” of student loans, and they’ve been calling for free tuition in higher education. And lately, the calls for loan cancellation have hit a crescendo as Senator Warren, President-Elect Joe Biden, and many other elected officials have floated the idea.

There are two problems we all want to address. The first is that college has become too expensive, and the second is that people with college degrees increasingly can’t find good jobs.

Instead of targeting the root cause of these two problems, cancelling student loans and taking full government control of higher education would merely devalue college degrees further. It would also allow higher education institutions to continue jacking up the price of a commodity whose actual value is diminishing—all on the taxpayers’ dime

These are the kinds of ideas that created the mess to begin with and are therefore the policies we need to move away from.

In the early 1900s, most professions did not require a college degree.

But in 1944, Congress passed the G.I. Bill, extending tuition and living assistance to veterans. This action exploded enrollment with over 8 million veterans signing up. The sudden boom led to states expanding college services with resources they had in a booming post-war economy.

Next came the National Defense Student Loan program, which did for civilians what the G.I. Bill did for veterans. The Higher Education Act of 1965 then set-up federal scholarships and low-interest loans for students. Finally, in 1978 Congress passed the Middle Income Student Assistance Act, which made all undergraduates eligible for subsidized loans.

A former education secretary warned that government aid for students would lead directly to an increase in college costs (known as the Bennett hypothesis) and his predictions came true. The Federal Reserve found that for every dollar in student aid, tuition increases 65 cents.

Ultimately, costs at public universities rose 213 percent between 1980 and 2018.

Progressives often try to blame these tuition increases on state budgetary cuts, claiming schools have had to raise their rates in response. But the claim doesn’t wash.

In fact, nine states have increased their per-student funding in the past 10 years and across all of them, tuition still increased. Furthermore, a Harvard study comparing higher education programs that accept federal aid to those that do not found that tuition at aid-accepting programs grew much faster.

All evidence points to government-subsidization as the real culprit behind rising tuition costs. And this is exactly what basic economics teaches us to expect.

The Basic Economics

The law of demand says that at higher prices, buyers will demand less of a product. And the law of supply says that at higher prices, sellers will supply more of a product. These two laws interact to determine the actual price of goods in a free market.

Normally, colleges would see the demand for their product drop if they raised their prices too high—which they have. Very few people could afford $30,000 for one year of school, and private lenders would be unlikely to lend that amount to borrowers for most majors. Therefore, in a free market, schools would have to drop their prices if they wanted to attract more students and stay open.

This isn’t happening because politicians used the federal government to interfere in the market. As is always the case with the government, they break it—you buy it.

There are many free market solutions to the student loan bubble that are equitable, grounded in sound economics, and within reach.

Employers can simply quit requiring college degrees for many positions and implement skills-based tests in their place. We can elevate trade schools and inform children on alternative career pathways. State lawmakers can remove regulations put in place to intentionally block new competitors from entering the market. Students and colleges can choose pathways that lower the costs of college. And the federal government should consider cutting the interest on student loan payments to give borrowers the ability to pay more of their principal.

But the reality is there’s no incentive for our society to pursue these things as long as there’s an endless sea of taxpayer dollars flowing to the colleges. In order for meaningful change to occur, and for higher education to actually become affordable, the federal student loan program must end.

In his book, Inside American Education, famed economist Thomas Sowell said,“The availability of federal grants and loans to help students meet rising tuition costs virtually ensures that those costs will rise.”

We can’t begin to really clean up this mess until we first cut the water off. Then, we could talk about true free market reforms.

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