Market Watch: Could the sector be rocked by a reduction in SPAC purchasing power?

You probably missed out on this rare celestial event, but early last month two parallel universes briefly collided with each other. The first event occurred in the art metaverse, a burgeoning giant of an industry where the price of a masterpiece is less due to its underlying beauty but more about what the market expects it will be worth to hedge-fund managers in the future. To fully understand what happened here, you need to go back a few weeks to the auction of a non-fungible token artwork (or NFTs as they’re happily defined and redefined all over Clubhouse), which sold at an eye-watering price of $69m at Christie’s. Whilst that may be palatable for some – particularly those holding a not inconsiderable amount of ETH tokens – what really caused consternation was just a few weeks later when another ‘artist’ (because the art world hasn’t fundamentally grasped the notion of ‘hacker’ yet) exploited a flaw in the NFT protocol. Specifically, the ERC721 smart contract framework for anyone who still has too much spare time post-lockdown. In so doing, said $69m artwork was essentially ‘sold’ to another user for just over 1 ETH, or $2,500 at the time. The fact that over a month later most of the art and crypto world are still scratching their (digital) heads as to how exactly this heist happened says as much about the complexities of the smart contract market as it does about the risks of overvaluing an (intangible) asset with real-world money. The second event, which brings us to the real reason why you’re reading this in EGR as opposed to, say, Art Monthly (or What Crypto) happened in that other over-speculated behemoth – otherwise known as a special purpose acquisition company. As a result of probably one too many alarm bells ringing at the US Securities and Exchange Commission (SEC) (and, as expected, a new Democratic team in control of House and Senate) a new accounting rule was passed that significantly changes guidance for SPACs. These SEC changes state that warrants, which essentially give investors the option to buy shares at specific prices in the future, will now need to be classified as liabilities instead of equity instruments in a company’s accounts. The fundamental implications to the financial markets are still yet to be fully understood, but to put it in a not-too-subtle way, the speculative valuation of SPACs has now been severely restricted. The fallout caused by the impact of these two seemingly distant universes may seem disconnected from gaming, but there’s an underlying thread that connects all worlds, and that is market sentiment.

Mutual synergy

It may seem reductive even mentioning it in today’s world, but surprisingly still one of the age-old drivers of M&A is not just fundamental analysis, in other words whether a buyer and a seller’s fundamental numbers resonate with a strategic merger, but whether – after buyer and seller have zoomed and exchanged heart emojis – it ‘feels’ like the right move given where the market is heading. This is not in any way meant to diminish the importance of mutual synergy, after all the need for both parties to pass a common ‘beer test’ is as crucial as having well-balanced books, but it has been a very key differentiator behind some of the most significant acquisitions we’ve seen recently. And building on this fallout narrative, if sentiment is impacted due to macro-economic changes, then the overall sale value changes drastically, and in many cases gets shelved indefinitely. Why does sentiment still have such an overbearing influence? Partly because sentiment is subconsciously tied to risk management, specifically managing the risk that a future asset price may not be as valuable as the present timeline thinks it is. And as we know from poker, it’s harder to process a seemingly small loss than a large win. Just how unbridled hubris has been occurring recently in bubble-driven markets such as art, NFTs and SPACs (and arguably crypto), when sentiment changes across one vertical there’s an almost immediate ripple effect across most asset classes. So, what does this mean for gaming and valuations? In the short term, the majority of transactions should continue unabated, as long as sale prices are tethered to sensible multiples of earnings and profits and, crucially, the money used to buy these assets is already in the bank. The dynamics will start to be felt – indeed they’re already happening – across transactions that are either (i) SPAC-dependent (ii) loan- or bond-financed, or (iii) leveraged. The wider effect on sale valuations will be determined on how much sentiment could be rocked by (the reduction of) SPAC purchasing power, cost of leveraged loans or bond raises, and closer to planet earth, the stock market prices. Because all these factors are influenced by sentiment, and they all build on each other. Still unsure? Let’s play out a hypothetical story just for kicks. The CEO of a mid-size gaming group (in the process of amassing a growing set of NFT-minted sports memorabilia as an investment asset-class) has a keen eye on a smaller business which is strong in product but still to break out in specific markets, most of which complement very nicely with the group’s existing territories. What’s also of interest is a dormant shell company which is publicly listed but not getting any action. A hypothetical bulb is planted in ear by a close friend in the private equity space, who suggests there is an opportunity to reverse IPO into this shell. So, the friend continues over sips of wine, let’s raise some cash – because there’s relatively low barriers to who can raise, and what for, in a SPAC.  Then, with this new vehicle, we will go public without all the fracas and with the newly injected cash from the raise, buy up that smaller asset with all this newly minted capital. Hell, why not make it two or even three acquisitions, they’re all going to be bought with future money anyway… Except that the SEC is about to take a very different view on how SPACs can raise money, or indeed be priced, and the investors can no longer just put money into such a vehicle without a very specific mandate. So the future buying power of the SPAC has now been restricted. What’s more, thanks to a sudden correction in the metaverse, those NFTs don’t really feel like such a liquid investment anymore. And like that, all of a sudden, ‘project back-pedalling’ kicks in… How could this have been done any differently? For starters, a more sensible view on what’s affordable from a buyers’ perspective. And from the sellers’ end – a more realistic expectation as to what the current market prices are. In fact – sellers beware – remember that an unusually large multiple figure from a press release usually means (i) a disproportionate amount of equity as opposed to cash (ii) a protracted earnout period; both of which depend on the future performance of both businesses. So, as the SPAC makers (and NFT markets) recalibrate their expectations over the coming months, expect some corrections in upcoming – and ongoing – acquisitions. Will buy-side activity slow down? Not at all, in fact quite the contrary – all hands are now to the pump to finalise the deals before the markets cool off. Thanks to a rare alignment, the M&A space just got a lot more exciting…