DuPont: A SPAC pullback is welcome and needed

DuPont Capital’s merger arbitrage managers weigh in on SPACs.

DuPont Capital’s Harris Arch views the prospect of a SPAC-driven market retreat positively as he expects inexperienced players to exit.

“Pullbacks are healthy; they get rid of the excess,” said Arch, co-portfolio manager for DuPont Capital’s merger arbitrage strategy.

The pause will be led by targets that went public too soon. “In the public market there’s a lot more criticism and they [poorly chosen targets] won’t do as well,” Arch said.

Managers like Arch say they do not know exactly when the frothy market action will fade but anticipate a sharp correction at some point. “When you see these deals fail, you’ll see some volatility in the market,” added Arch’s colleague Daniel Moore, SPAC co-portfolio manager at DuPont.

Founded in 1993, DuPont manages fund of fund products for leveraged buyout and special situation funds that are less than $1.25 billion in size, according to its website. The firm also invests in asset alternatives such as fixed income and public equity.

Merger arbitrage funds fall within the equity strategy and make money by buying the stock of a target announcing a takeover, betting that the share price will go up as the deal nears completion.

When it comes to blank check companies, DuPont’s strategy is to establish a position during a SPAC’s IPO offering before a target is found. This means the firm’s portfolio includes a host of premerger SPACs bought at approximately $10 per share. Those that announce merger combinations typically trade at higher levels, but that is not a given.

Arch and Moore have participated in SPAC deals for almost two years now. “We’ve been investing pretty heavily,” Moore said.

During this time, the duo has noted a few shifts in the SPAC market. “The quality of targets and sponsor management team has dramatically improved,” Arch said. “Companies previously were much smaller in size.”

Moore also highlighted the concentration of electric vehicle related SPACs last year. “We are starting to see a more diversified approach to this [target selection],” he said.

Historically speaking, SPAC proceeds were used to delever companies, but now the use of proceeds has diversified as has the universe of companies pursuing this strategy. Proceeds of SPAC deals are now also used on upgrades, especially in technology, Arch said.

Despite this evolution, for Arch, the current state of SPAC market is far from ideal – in part because it is not a structure that pursues earnouts. Earnouts, a common provision in transactions contingent on the target achieving specified financial metrics, helps to bridge valuation gaps between buyers and sellers.

“I’d like to see the SPAC market reformed a bit,” he said, while acknowledging that incorporating a component such as an earnout may be hard to achieve at this stage of the game.

“But whether you have this alignment or not you [as a SPAC sponsor] have done well in that initial stake,” Arch said, pointing to the lucrative 20 percent stake obtained by the SPAC sponsor in return of a nominal investment.

In the meantime, many market drivers will continue feeding the frenzy until a pullback, according to Arch.

“Everyone’s incentivized to do deals; if you are an underwriter you get paid for volume and sponsors for the share,” he said.

As a result, sellers are enjoying a strong autonomy. “There’s so much capital pounding on the doorstep,” Arch said.

Of course, SPACs’ 24-month investment deadline is adding to the flurry of activity. “If you don’t get a deal done, you probably won’t be able to raise a SPAC later,” Arch added.

Sellers like VCs are sitting on the driver’s seat “getting great valuations,” said Arch, but “we don’t know how they [targets] will do in a sharp market correction.”

The needed pullback will test the health of these targets, making a clear distinction between SPAC sponsor management teams that have benefitted their shareholders and those that have disappointed, according to Moore.

“Every SPAC management team we speak to says we have a proprietary network of deals,” Arch said. “Well, if all have proprietary, it’s not proprietary anymore.”