Warning to Wall Street: SPACs may be out of control

New York(CNN Business) Reverse mergers were long reserved to the backwaters of Wall Street. Today, they've become the hottest way to go public.

Virgin Galactic (SPCE), DraftKings and Nikola have all gone public by merging with special purpose acquisition companies, or SPACs. Even Playboy is joining the SPAC craze. High-profile dealmakers including billionaires Bill Ackman, Richard Branson and even Billy Beane of "Moneyball" fame have gotten in on the act.

The latest rumor is that Michael Bloomberg, one of the faces of Wall Street, could bring his media empire public through a SPAC, which is also known as a blank-check merger. Although Bloomberg has said the report is "absolutely not true" and the company is not for sale, the buzz underscores the intense focus on these deals.

A staggering $54 billion has been raised by US-listed SPACs this year, according to Refinitiv. That is four times more than the next closest annual total. And 2020 isn't over yet. During the third quarter, SPACs accounted for nearly half of all money raised by US IPOs, according to Dealogic.

"It's SPAC mania out there. Everybody's got a SPAC," Chris Britt, CEO and co-founder of fintech startup Chime, told CNN Business.

Britt, whose company has seen its private market valuation spike more than 1,000% in 18 months, said he regularly gets calls from SPACs interested in bringing Chime public.

"We probably get a SPAC-a-week these days," he said.

But some fear the rise of these deals -- the number of US-listed SPAC IPOs is nearly triple last year's total -- is getting out of hand and could be an ominous signal of market euphoria.

"The last boom in SPACs was in 2007, so there is concern that this is a sign of exuberance," said Lindsey Bell, chief investment strategist at Ally Invest.

US stocks peaked in late 2007 right before the start of the Great Recession.

"I think the interest reflects the lack of growth opportunities in a market with stretched valuations," said Bell.

Despite the pandemic and the stimulus package failure in Congress, the S&P 500 is brushing up against record highs. Market valuations are near the highest level since the dotcom bubble 20 years ago.

SPACs have no assets or operations. They are publicly-traded blank checks that exist only to buy a private company -- often a fast-growing startup or a struggling older company -- and take it public.

'Speculation in all its glory'

Jim Chanos, the legendary short seller known for taking down Enron, warned Tuesday about the popularity of SPACs.

"We are now seeing speculation in all its glory come back," Chanos said at Grant's Interest Rate Observer's fall conference, according to Bloomberg News.

The billionaire pointed to research that shows SPACs are often busts. Less than one-third of SPACs since 2015 had positive returns, according to a July report by Renaissance Capital. That report also found that the median SPAC lost 36.1%, compared with a gain of 37% for traditional IPOs over that time span.

"That hasn't stopped people from getting excited and throwing money," Chanos said.

During a conversation last week with Hedgeye Risk Management, Chanos said some companies that couldn't "dream of passing" an underwriter's test are now easily going public. "The one thing I do know from my last 40 years," he said, "is that given enough time Wall Street will do a really great job of creating supply for people that want to pay up for questionable or worthless assets."

Britt, the Chime CEO and a veteran of Silicon Valley, said his company is committed to going public -- but most likely not through a SPAC.

"I would argue the area of SPACs is overheated," he said. "Given the volume, you're definitely not going to just have all-star companies doing SPACs."

From last resort to red hot

For years, investors have looked down upon reverse mergers. The thinking was that if a company couldn't go public through a traditional IPO, there must be something wrong with it.

"Companies have historically gone public via SPACs as a last resort," said Ally's Bell.

That stigma has diminished as well-known investors, CEOs and companies have entered in the space.

And in many ways, SPACs are a natural extension of a recent shift away from the cumbersome IPO process.

Slack (WORK), Spotify (SPOT) and Palantir have all gone public in recent years through another untraditional method: direct listings, which allow companies to avoid expensive underwriting fees and road shows. Unlike traditional IPOs and SPACs, however, direct listings do not allow companies to raise money.

"There have been criticisms of the IPO process: it's expensive, there is a level of unpredictability to it and perhaps companies' biggest fear is that they are leaving money on the table," said Kristina Hooper, chief investment strategist at Invesco.

For management teams worried about underpricing their IPO, blank-check companies offer a speedy solution because the price is negotiated in advance, and not left to the whims of the market.

"I look at it as a great innovation," Nasdaq CEO Adena Friedman said on CNBC Wednesday. "It gives companies a chance to say, 'Maybe I don't want to take a chance of not knowing how investors will value the company."

Embracing risk -- for better or worse

But the downfall of Nikola provides a cautionary tale about SPACs.

Last month, the electric and hydrogen truck maker was accused by a short seller of being an "intricate fraud" -- a claim the company disputed. A little more than a week later, founder Trevor Milton suddenly stepped down. And in late September, two women alleged they were sexually assaulted when they were teenagers by Milton, who strongly denied the allegations.

Nikola's share price is down more than 70% since peaking in early June.

"These vehicles are taking companies with limited track records or information available public," said Bell. "SPACs often have a higher risk profile than an IPO because you don't know what company the SPAC will ultimately invest in."

The fact that investors are rushing into SPACs is a reflection of the enormous amount of easy money being pumped by central banks. With interest rates near zero, investors are essentially being forced to bet on risky assets, including newbie stocks.

"It's causing investors to embrace risk," said Invesco's Hooper. "There is a level of exuberance around SPACs. They are the bright shiny penny of the moment."