July 4, 2023 – In the 1980s, the emergence of the junk bond market revolutionized corporate finance and significantly impacted the capital markets. The catalyst behind this transformation was Michael Milken, a financier at the investment bank Drexel Burnham Lambert.
During this period, many established companies with low credit ratings faced difficulty accessing traditional sources of financing due to the high risk associated with their debt. Milken recognized an opportunity to fill this gap by creating a market for high-yield, high-risk bonds, commonly known as “junk bonds”.
Junk bonds offered much higher interest rates than investment-grade issues to compensate investors for the increased risk profile they carried. Milken’s innovative approach involved bundling these risky bonds into portfolios, providing diversification, and making them more appealing to institutional investors. This strategy enabled companies with lower credit ratings to raise significant amounts of debt capital for the first time.
Milken’s reputation and persuasive abilities attracted a wide range of investors, including pension funds, insurance companies, and other institutional investors hungry for higher yields. The junk bond market rapidly grew, allowing many companies to access capital otherwise unavailable to them. These funds were often used for a special purpose, including acquisitions, leveraged buyouts, and corporate restructuring.
However, the growing popularity of junk bonds raised concerns and criticisms. Detractors argued that the junk bond market encouraged excessive risk-taking, leading to the financial distress of some companies and contributing to a series of high-profile corporate scandals and bankruptcies. Additionally, the unprecedented growth of the junk bond market caught the attention of regulators, who began scrutinizing the practices of market participants.
In 1989, Drexel Burnham Lambert collapsed due to legal issues unrelated to the junk bond market. Milken was subsequently indicted for securities fraud, marking the end of an era and leading to tighter regulations surrounding the issuance and trading of junk bonds.
Despite the controversies and subsequent regulatory changes, the junk bond market had a lasting impact on the financial industry. It opened up new avenues for corporate financing, transformed the dynamics of mergers and acquisitions, and influenced the strategies of investors seeking higher returns.
Since their formation approximately four decades ago, junk bonds have become normalized within investor portfolios, and even obtained a more media-friendly label, rebranding as “high-yield bonds”.
The lessons learned from the rise, fall, and subsequent normalization of the junk bond market can provide a blueprint for the future of newer asset classes still in their formative stages.
One somewhat controversial new asset class still in its formative stage is the Special Purpose Acquisition Company (SPAC).
The modern-day SPAC, much improved from previous experimental iterations, became standardized in 2013. The previous year, zero blank check companies were issued, with $1.1 billion of SPAC IPOs subsequently issued in 2013.
The SPAC asset class was a backwater segment of the capital markets, trafficked almost exclusively by specialists. A decade ago, SPACs barely made page 19 of the news, let alone page 1.
Subsequent to its startup years, the blank check market slowly grew each year and became more accepted. By 2018, annual SPAC IPO issuance broke $10 billion for the first time. By 2019, issuance rose 30%, with more than $13 billion of blank checks issued. By 2020, the SPAC market had caught fire, growing more than 6-fold and moving from backwater to front-page news.
In 2021, SPACs were the talk of the town, and many business leaders from a myriad of industries were launching one or several blank checks into the market. Investors could not get enough.
Source: Accelerate
The combination of a rapid rise in interest rates, an equity bear market, and the poor performance of deSPACs, led to a rapid deceleration of SPAC IPOs in 2022. That year, blank check issuance dropped more than -90%, albeit from record levels. Nevertheless, the bear market caused investors to recoil, sponsors to move their SPACs to liquidate, and the blank check market to go from red hot to ice cold.
Currently, the SPAC market remains challenged, with sponsors seemingly losing interest amidst a still oversupplied, yet declining market. Year-to-date, there have been just 17 SPAC IPOs, raising approximately $1.8 billion. In comparison, at the height of the frenzy on March 2nd, 2021, $4.4 billion was raised across 15 SPAC IPOs that day.
That was then, and this is now. With (or perhaps without) the benefit of hindsight, that market could not handle anywhere near the peak of 720 SPACs holding more than $220 billion of investor capital. The market had grown more than 10-fold in size in just two years, and it burst at the seams.
Despite what the media may say, SPACs are far from dead. While the market remains active, it has and will continue to shrink. Year-to-date, 162 blank checks have matured, with 38 closing a business combination and 124 liquidating without a deal. The first half of 2023 featured a liquidation rate of 76.5%. In comparison, just two SPACs liquidated throughout 2020 and 2021.
Currently, there are 384 SPACs in the market, with 174 having announced a merger and 210 searching for a deal. However, 117 of these are what we call “microSPACs”, which have been heavily redeemed and retain less than $30 million cash in trust. MicroSPACs are the zombies of the blank check market, just plodding along and looking for seemingly any deal available, despite their bleak future. Net of these 117 microSPACs, there are 267 non-zombie firms still going and looking for a business combination. The current market capitalization of the entire SPAC universe stands at $36 billion.
Nevertheless, issuance has gone from boom to bust, as the oversupply issue works its way through the market. However, SPACs have proven themselves a valid and sustainable business model, cementing their place in the market.
While many deSPACs have failed or have traded down significantly, investors should not throw the baby out with the bathwater. There remain select blank check mergers, where a strong sponsor team combines with a high-quality business, that have a bright future. When used properly, the vehicle can create significant shareholder value over time. However, investors must be highly selective and supporting of only the highest quality issues.
Where do we go from here?
The emergence of the SPAC asset class over the past decade has similarities to the formation of the high-yield market in its first decade. A good idea taken too far resulted in too much issuance, followed by controversy and investor losses. Nonetheless, given high-yield bonds proved themselves to be a useful tool for corporations, investors, and business leaders, they emerged from the smouldering wreckage to become widely accepted in the market. They went on to achieve new heights over the subsequent decades.
Look for the SPAC market to follow a similar development arc to high-yield bonds. The asset class went through its initial boom-bust period and will take a while to recover. Slowly but surely, the SPAC asset class will continue to develop and grow in acceptance from here. In terms of the development of the market, we believe that the blank check market will continue to shrink over the near term. However, many sponsors are looking to the dearth of issues in the market come 2024 and are positioning themselves for an environment with far less competition.
We expect the SPAC market to normalize at around 100 issues representing a total market capitalization of around $20 billion, for an annual IPO rate of $10 billion per annum. We believe this will be the equilibrium point at which supply matches demand and where the market can adequately discern the quality from the junk. At this point, the asset class will be more rewarding for all those involved.
The Accelerate AlphaRank SPAC Monitor details various metrics on the current opportunity set while offering details on every individual SPAC currently outstanding. The Accelerate AlphaRank SPAC Effective Yield tracks the average arbitrage yield offered. The Accelerate AlphaRank SPAC Index tracks the price return of the SPAC universe.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). The Accelerate Arbitrage Fund may hold a number of securities discussed in this research. Visit AccelerateShares.com for more information.
