The ongoing fallout over Nikola Corp. (NASDAQ: NKLA) may create some concern about the willingness of investors to pour money into special purpose acquisition companies (SPACs) and weigh further on what has been a down year for initial public offerings (IPOs).
The Phoenix-based designer and maker of battery- and hydrogen-electric vehicles and components finds itself in a tough position shortly after going public in June. The concern stems from a short seller report questioning the validity of the company’s battery and hydrogen fuel cell claims, resulting in the founder’s resignation on Monday.
Shares of NKLA are off 35% since the report. Nikola has disputed the claims.
SPACs at a glance
SPACs are essentially shell companies that don’t produce a good or provide a service. Often referred to as blank-check companies, SPACs are formed to raise capital through an initial public offering (IPO) for the purpose of acquiring or merging with another company in the future. Once an acquisition target has been found, a merger is transacted using the proceeds generated from the IPO. Investors can take shares in the entity, which is renamed to reflect the operating company acquired, or redeem their original shares in the SPAC at the IPO price.
The shell companies are normally established with a two-year time frame in which to consummate a deal or face liquidation. The IPO proceeds of a SPAC are held in an interest-bearing trust until an acquisition target is found, using the interest earned as working capital. An investor in a SPAC basically locks up their money for a while with the hopes of getting a large return on the back end when a deal is announced.
These investment arrangements have been around for a while and were often subject to fraud in the 1980s. Lacking a clear objective and without the heightened regulation in place today, the offerings frequently left many shareholders bilked.
However, the investment vehicle has gained prominence in the past two years among investors, with the larger investment houses underwriting the deals. Thus far in 2020, there have been 104 SPAC IPOs, generating more than $40 billion in proceeds, according to SPACInsider. Last year, there were 59 such deals valued at nearly $14 billion, representing more than one-third of all IPOs. SPAC deal activity in 2019 and 2020 represents more than half of all SPACs that have filed since 2009, counter to the broader market for IPOs, which has dwindled further during the pandemic.
Pitfalls of a nontraditional IPO
There are headwinds to SPACs when compared to traditional IPOs. The process can be drawn out if market valuations are high and deal flow is low. It takes time to find the right target and often requires vetting many takeout candidates before finding a fit. Also, investors in a SPAC vote on the proposed acquisitions, leaving the fate of a potential deal in their hands. SPACs usually receive a discounted valuation compared to the potential windfalls IPOs can bring in as one entity has taken on all of the risk.
Further, operational execution can become cluttered as managers from the SPAC are often appointed to the new entity’s board, meaning industry outsiders with a vested interest have a large say in how operations will run in the future.
Nikola went public in a reverse merger with VectoIQ Acquisition Corp., a SPAC created by former General Motors Co. (NYSE: GM) Vice Chairman Steve Girsky. Established in 2018, VectoIQ vetted more than 100 clean transportation companies before reaching an agreement with Nikola.
The combination provided Nikola with $230 million from the IPO and an additional $525 million, which was raised from institutional and other investors through a private investment in public equity (PIPE) in discounted share purchases of $10 per share plus a warrant in the new company that could be exercised post-merger. In Nikola’s case, that created about 23 million additional shares.
With funds on hand and in-kind manufacturing contributions, Nikola emerged with roughly $900 million in total capital.
GM wasn’t involved in the SPAC but the company agreed to take an 11% stake in Nikola earlier this month. The two announced an agreement with GM committing $2 billion worth of in-kind services to build Nikola’s battery-electric pickup truck and become the exclusive provider of fuel cells for its Class 7 and 8 trucks in North America.
Girsky replaced founder and Executive Chairman Trevor Milton on Monday, amid the controversy over allegedly false technology claims.
Other headwinds persist for Nikola shares. Several shares, including those held by PIPE investors, Milton and others, will see their lockup periods expire in December, potentially placing further downward pressure on the stock. Nikola’s shares have been tested in the past as original investors lined up to cash out.
Nikola’s market capitalization has dropped to roughly $10 billion, nearly one-third of its peak.
Why SPACs are likely here to stay
Proponents of SPACs see many positives. For starters, the acquisition target is taken out by one entity at a negotiated price. In an IPO, the company essentially offers itself for sale without having any price agreements or a guarantee from investors. That risk is often seen on deal roadshows where management pitches its company and expectations for future earnings and returns to potential investors, revealing all of its wares. If the deal collapses, the company can have a very public disappointment, suggesting shortcomings in its finances or its product or service offering.
The SPAC also allows an acquisition candidate to quickly sell when the company is doing well. Nikola was said to have saved at least six months in reaching a public listing. Some IPOs can have an on-again, off-again trajectory, taking years before they reach public status. The downside for investors in a SPAC is that there is an incremental level of risk inherent in the shorter courtship with a prospective takeout target, which may be representing a recent hot streak as indicative of future results.
Some recent successful SPACs include online sports gambling site DraftKings Inc. (NASDAQ: DKNG), Vivint Smart Home (NYSE: VVNT) and salty snack manufacturer Utz Brands Inc. (NYSE: UTZ). Many investors still have hopes for space travel company Virgin Galactic Holdings Inc. (NYSE: SPCE) even after multiple launch delays. Even the nation’s largest flatbed carrier, Daseke Inc. (NASDAQ: DSKE) has SPAC roots.
Activist investor Bill Ackman recently launched a blank check company, Pershing Square Tontine Holdings, raising $4 billion in capital. While a potential target hasn’t been announced, this is expected to be the largest SPAC ever.
The events at Nikola may cast a shadow over SPACs in the near term. It will be hard to imagine a conversation on the alternative to traditional IPOs without at least a mention of the recent noise surrounding the startup electric truck maker. However, with low interest rates forcing investors to seek higher yields elsewhere, a shaky backdrop for global equities and the traditional IPO market trying to shrug off COVID-19, the most recent hiccup for SPACs could be just that, a brief head-scratching moment in what will be a record year.