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Water Tower Research

Water Tower Research is a leading equity research firm that provides research on micro, small and mid cap companies.

Water Tower Research was founded by Wall Street veterans after witnessing a fundamental shift in the investment research industry with the result being a declining knowledge base among investors, a lack of awareness and a shrinking pool of fundamental research being conducted on companies across the small-cap and micro-cap spectrum. The same issues are now increasingly occurring in the mid-cap space. This sea change within the investment community is impacting not only the companies themselves but also current shareholders and potential investors. With significantly less active sell-side sponsorship by Wall Street, a substantial information gap has developed between companies and various constituents in the financial community. The net result is fewer channels for insight and information to flow between companies and investors.

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KEY HIGHLIGHTS

From feast to famine in SPAC IPO market.&nbsp;After a record-breaking year in 2021, in which 613 SPAC IPOs raised $162.5 billion of proceeds, the SPAC IPO market went into slumber mode in 2022 (along with traditional IPOs), with just 86 new SPACs, which generated ~$13 billion of funds. In fact, the major theme of the year was not how many SPACs came to the market, but how many exited. In this respect, 2022 saw 143 SPACs liquidations, an unprecedented number that was much higher than the total number of SPAC liquidations prior to last year.
Deal size shrinkage.&nbsp;There was a slowdown in deal flow too, but not nearly as dramatic as the drop in SPAC IPOs. There were 196 initial business combination (IBC) agreements in 2022 versus 238 the prior year. There were also 60 deal cancellations, reflecting the tougher economic and financial environment that characterized last year. However, the starkest statistic is the drop in deal value. In 2022, the average deal size plunged ~70% to $0.7 billion from $2.4 billion in 2021. While deal flow momentum picked up strongly in the final quarter of 2022, encouraged by pressing merger deadlines, the average deal size fell further to ~$550 million.
An annus horribilis for de-SPACs.&nbsp;De-SPAC values were crushed in 2022, with few places to hide amid the wreckage. In challenged financial markets, de-SPACs as a group were among the worst-performing investments, down by more than 70%, with only crypto-tied equities performing worse. Last year saw six bankruptcies among struggling de-SPACs.
Taking a peek at 2023.&nbsp;Our first SPAC Talk Focus of the year provides a more detailed review of 2022 and a peek at 2023. While predicting what might happen in the future often turns out to be a fool’s errand, we suggest that with the SPAC market undergoing an accelerated correction, it is conceivable the market will reach its equilibrium in 2023, Likewise, de-SPACs may be close to the trough of the disillusionment stage of the cycle. This may be the time to seek out the hidden gems in the wreckage.

SPAC STATISTICS


Source: WTR

SPAC HAPPENINGS IN DECEMBER 2022
Figure 1: IPO Pricings/Completed Liquidations


Source: WTR Research

Figure 2: IBC Announcements/Terminations


Source: WTR Research

Figure 3: De-SPACings


Source: WTR Research

SPAC/DE-SPAC RETURNS
Figure 4: Live IBCs (Initial Business Combinations)—Key Stats


Source: WTR Research

Figure 5: Top 5 Live IBCs by Share Price


Source: WTR Research

Figure 6: Bottom 5 Live IBCs by Share Price


Source: WTR Research

Figure 7: De-SPACs—Key Stats


Source: WTR Research

Figure 8: Top 5 De-SPAC Performers by Share Price


Source: WTR Research

BP has agreed to acquire de-SPAC Archaea Energy (LFG), a leading renewable natural gas producer for $4.1 billion or $26 per share in an all-cash transaction.
Figure 9: Bottom 5 De-SPAC Performers by Share Price


Source: WTR

SPAC TALK FOCUS
Looking Back at 2022 and Taking a Peek at 2023
The SPAC IPO Market – From Feast to Famine
Only 86 SPAC IPOs were priced in 2022, just one-seventh of the record-breaking 613 SPACs that came to market in 2021. These 86 SPAC IPOs raised a total of $13.4 billion in gross proceeds, representing only one-twelfth of the $162.5 billion raised in 2021, and lower than the $13.6 billion raised from the 59 SPACs IPOed in 2019. The average IPO size in 2022 was $156 million, the lowest since 2014. It should be said that the appetite for IPOs in general has waned significantly. The traditional IPO market was moribund in 2022, with only 32 IPOs above $40 million.
Figure 10: The State of the SPAC IPO Market in Context


Source: WTR

Meanwhile, the pending pipeline of SPAC IPOs has dwindled sharply during the past 12 months. At the start of 2022, 269 new SPAC formations were ready and waiting to tap the market for funds, but less than one-third eventually pulled the trigger last year. Although there were an additional 78 new S1 registrations filed in 2022, there were more than twice as many S1 withdrawals, with SPAC sponsors having second thoughts about moving forward with IPOs in a more challenging funding environment. By the end of 2022, there were just 76 live SPAC IPO registrations on file planning to raise $10.3 billion in gross proceeds at an average of $136 million per IPO.
Figure 11: SPAC IPO Pipeline Development in 2022


Source: WTR

IBC Deals – Flow Momentum Driven by Approaching Merger Deadlines
A consequence of the SPAC IPO boom, which began in earnest in 3Q20 before peaking in 1Q21, is many of the 510 SPACs that were IPOed in this nine-month period were approaching merger deadlines during 2022. Thus, it is perhaps no surprise to see strong momentum in SPAC IBC deal announcements, particularly in the final quarter of 2022. In fact, the 72 deals announced in the last quarter represent the second-best quarter in SPAC history and ~37% of the year’s total announced deal flow. One observation is that the momentum in deal flow has been accompanied by deal size shrinkage. In 4Q22, deals were valued at an average of approximately $550 million, around one-fifth of peak deal values evident in the second and third quarters of 2021.
Figure 12: New IBC Announcements and Average Deal Size


Source: WTR

There are several factors that may explain this, such as the economic reset that has occurred since COVID-19 from a low interest rate, low inflation environment to a rising interest rate, high inflation environment, which has contributed to general valuation compression. Another explanation is the heightened regulatory scrutiny SPAC deals have been attracting, particularly targeting very fanciful financial projections to justify the fanciful values that had been put on deals. It also reflects the intensifying pressure on SPACs to make deals irrespective of size and quality of the target, with the focus on simply getting to find a merger partner.
However, some of them have simply not worked out, resulting in the parting of ways. In fact, there were 60 deal cancellations in 2022 worth $85 billion in transaction value, compared with the $135 billion of transaction value in the 196 IBC announcements made last year. Among the deal cancellations, 26 SPACs have proceeded to liquidate, 20 have found new targets, and 14 are back in the SPAC pool searching for new targets.
Figure 13: SPAC IBC Deal Cancellations


Source: WTR


SPAC Liquidations – A Major Theme of 2022
Perhaps no statistic captures the magnitude of the decline in the SPAC market more than the number of SPACs liquidated in 2022. After all, a liquidated SPAC represents the failure of the blank check structured company to achieve its only mandated goal, which is to merge with an operating company within a specific timeline (typically two years although extensions are available usually subject to shareholder approval) or return the IPO proceeds plus any interest earned to public shareholders. Historically, SPAC liquidations have not been all that common to the extent that in the 20 years prior to 2022, a total of 87 SPACs had been liquidated. In 2022 alone, there were a total of 143 SPAC liquidations, of which 87 occurred in December. We estimate that SPAC sponsors have consequently returned ~$48 billion to public shareholders from their trust funds.
While there are other reasons behind the liquidations, such as the high cost of extensions, high redemptions, and the more challenging conditions for mergers, the key reason for the rush of liquidations, particularly since August, was the planned implementation of the 1% excise tax on share repurchases incorporated in the Inflation Reduction Act (IRA), which came into effect at the start of 2023. When the IRA was signed into law by President Biden on August 16, 2022, there was a debate over whether this new tax would be applicable to SPACs as the statute did not specifically address the tax with reference to SPACs. In the absence of guidance from the US Treasury stating otherwise, SPACs took their lead from legal and tax experts and presumed that the new law’s broad scope will likely cover many transactions beyond typical stock buyback plans, including redemptions of stock by SPACs. It is no coincidence that the bulk (127) of the SPAC liquidations that were affected occurred post-August 16.
Figure 14: SPAC Liquidations in 2022


Source: WTR

On December 27, 2022, however, the IRS released a notice containing important guidance on several issues pertinent to the IRA, including the application of the excise tax to acquisitive reorganizations, spin-offs and split-offs, and SPAC liquidations. In this respect, the notice indicated that complete liquidations (including liquidations of SPACs) are exempt from the excise tax, as are redemptions that occur in the same taxable year as the liquidation. However, redemptions of SPAC stock as part of a de-SPAC transaction would be treated as repurchases subject to the excise tax, subject to offset under a “netting” rule for stock (such as a PIPE) issued by the SPAC in the same taxable year.
While there is little doubt that 2022 would have still seen a record number of liquidations, had this guidance been available in August last year, we would probably not have witnessed the huge tsunami of liquidations that occurred in 4Q22 and December in particular, of which a sizable number involved accelerated liquidations brought about precisely to avoid the expected ramifications of the excise tax in 2023.
The SPAC Landscape – We Could See an Inflection Point in 2023
The SPAC market is in a different place from where it was a year ago. Entering 2022, there was a pool of 575 SPACs searching for targets. This pool continued to expand through 1Q22, peaking at 610 in March. As we enter 2023, the SPAC pool searching for targets stood at 386 and has been whittled down further in the opening days of the new year. As of writing, the number of SPACs searching for targets is 329, taking three new IBC announcements and five liquidations scheduled so far for 1Q23. All the developments highlighted above&nbsp;are contributing to a healthy correction in the oversupply of SPACs and moving toward more balanced supply/demand fundamentals.
Figure 15: Pool of Targetless SPACs Trending Down


Source: WTR

Given the SPAC maturity wall, we expect the correction to continue into 2023, at least through the first quarter. However, barring unforeseen events, it is possible that the SPAC market will find its equilibrium at some point this year.
Figure 16: Maturing SPACs in Search of Targets


Source: WTR

High De-SPACing Redemptions Offer No Redemption for De-SPACs
There were 102 de-SPACings completed in 2022, which was about half the corresponding number in 2021. But the key feature associated with the 2022 de-SPACings was the elevated level of redemptions by the merging SPAC public shareholders. Redemption rates had already begun to rise from 2Q21, but kept going through 2022. Redemptions in 2022 averaged 85%, with the median at 92%. The near full return of cash held in SPAC trusts has added financial pressure on de-SPACs at a time when access to alternative funds, notably PIPEs, has been severely curtailed.
Of the 102 de-SPACs completed in 2022, 34% have seen public SPAC investors redeem more than 95% of their shares. This percentage jumps to 56% for de-SPACs with redemption rates above 90% and to 68% for de-SPACs with redemptions above 80%. From an investment perspective, the corollary to high redemptions is a low float and exceptionally low in more than half the 2022 de-SPACs of less than 15%.
Figure 17: Elevated Redemptions Have Depleted Anticipated De-SPAC Cash Resources


Source: WTR

The De-SPAC Carnage
Last year will certainly not be remembered fondly by de-SPAC investors. De-SPAC values have been crushed as demonstrated by the performance of the only currently trading pure de-SPAC ETF (DSPC). The ETF lost 73% of its value in 2022.
Figure 18: De-SPAC Value Destruction


Source: WTR

Given the economic headwinds threatening the global economy, as inflation reared its ugly head again after a long absence, the financial markets were, with few exceptions, severely challenged in 2022, as monetary authorities around the world, led by the Fed, reacted by applying sharp interest rate hikes. Although, as Figure 19 demonstrates, crypto-related equities delivered the greatest value destruction in 2022, de-SPACs as a group were not far behind.
Figure 19: How D-SPAC Value Destruction Stacks Up


Source: WTR

One thing to note from the figure above is the performance of the pre-merger SPAC ETF SPC (CrossingBridge), which delivered a positive return last year. The strategy of this ETF focuses on purchasing shares of common stock and units of SPACs that are trading at or below their pro rata share of trust accounts with the intent of disposing of the shares prior to, or at the time of, a business combination. The outcome highlights the defensive nature of the SPAC arbitrage strategy employed by this ETF in the prevailing environment. Unlike de-SPACs, public investors in SPACs can always elect to redeem trust value with the added benefit of a shorter holding period and higher IRR ahead of a de-SPACing.
Moreover, there is potentially easy money to be made by the arbs as the capital raised by SPACs is held in trust and invested in short-term US Treasury Bills, so buying a SPAC trading at a discount to trust value is like buying a Treasury Bill at a discount with the certainty of being paid full face value on redemption. The bear market in SPACs, which is most emphatically reflected by an IPO market that has dried up because of the oversupply of SPACs searching for a limited pool of viable deals, has created a minimal risk opportunity for arbs as SPAC yields to maturity remain elevated.
Figure 20: Why SPAC Arbitrage Remains the Best Game in Town... For Now


Source: SPAC Insider

2023 May Be the Time to Start Looking for Hidden Gems in the De-SPAC Wreckage
Last year claimed six de-SPAC bankruptcies. One-quarter of the companies de-SPACed since the start of 2021 are currently trading below $1, which signals that we are likely to see more de-SPAC bankruptcies as 2023 progresses. However, as we opined in our SPAC Talk Focus on December 16, 2022, we are closer to, if not yet at, that inflection point. At some point, the value hunters, whether they be strategic or financial buyers, will look through the de-SPAC wreckage for hidden gems. Perhaps some of the $50 billion that public SPAC investors returned from the ~140 liquidations that occurred in 2022 could find its way back into the more promising de-SPACs. We may not have hit bottom yet, but as we begin 2023, it might be worthwhile to start doing some due diligence to discover those hidden gems.
DISCLOSURES
Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.  WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.  Robert Sassoon, who is the writer of this report, covers the Healthcare &amp; Healthcare Services and Emerging Growth &amp; Special Situations sectors for WTR. Mr. Sassoon and members of his household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.  Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.  In certain instances, including this report, WTR will write research covering non-clients. Readers should assume that WTR may seek to turn these non-paying companies into paying clients. Likewise, WTR may seek to transform these non-clients into paying clients of it or of its affiliate, which provides services such as presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services of WTR or an affiliate might offer to clients.  The manner of WTR’s potential research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly written compliance guidelines.  The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors or agents shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.  All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.

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SPAC Talk: What a Difference a Year Makes