The Independent Market Observer

What About SPACs?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 24, 2021 3:18:37 PM

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SPACsToday's post was cowritten by Chris Stuart, senior investment research analyst.

The current hot investment story is SPACs (special purpose acquisition companies). Everyone is forming them. Cutting-edge companies like Virgin Galactic and DraftKings have gone public with a SPAC. Shaquille O’Neal (yes, the basketball player) is now on his second, and Paul Ryan (the former speaker of the House) is doing one as well. SPACs are being touted as the new, cool way for companies to go public and raise money. That’s great for the companies and certainly for the sponsors and the press. But is it also great for investors?

SPAC Vs. IPO

Stripping away the hype and the details, a SPAC allows a company to list its shares on the public market and raise capital from new shareholders. The effects are the same as doing a traditional initial public offering (IPO). As an investor, you could look at buying a SPAC like buying an IPO. Except you aren’t.

One problem is that you will not know what company you are buying the IPO of. SPACs are formed as blank-check capital-raising companies. Only when the capital has been raised will they identify a company to buy. It could be DraftKings. It could be Virgin Galactic. On the other hand, it could be Utz potato chips. When you buy the SPAC, you just don’t know what’s behind door #3.

Another problem is that your ownership in that IPO is likely to be significantly diluted. The sponsors of the SPAC (the people who organize it) typically take a large share—often 20 percent—of the company at a much better price than the SPAC shareholders get.

SPAC transactions differ from traditional IPOs and have distinct risks associated with them. For example, sponsors may have conflicts of interest, so their economic interests in the SPAC may differ from shareholders. Investors should carefully consider these risks. In addition, while SPACs often are structured similarly, each SPAC may have its own unique features, and it is important for investors to understand the specific features of any SPAC under consideration.

Why Are SPACs So Hot?

Despite these concerns, SPACs are hot. There are almost 300 underway this year, with almost $100 billion raised. Why is that? Is it for the investors’ advantage—or someone else’s?

From an investor’s point of view, a SPAC offers access to an experienced management team that presumably can find a good company to buy, negotiate favorable terms, and get the transaction done. The management team has every incentive to get it right. It can make a lot of money and, of course, its reputation is on the line. In this sense, it is kind of like buying into a startup.

Just like a startup, though, the team has to perform—and it has to have a good target market. These are the two requirements for a SPAC to succeed: a team that can find and acquire a good company and a good company that is willing to be acquired.

What’s In It for Companies?

Which brings us to the next question: why would a company want to go the SPAC route, giving up that share to the SPAC sponsors, rather than simply doing a traditional IPO? Two reasons. First, a SPAC is both simpler and more certain. Rather than try to sell the company to a vast pool of investors at an uncertain price, there is one agreement for a negotiated price. Because of the greater simplicity, this is also a faster process, which can be important. For a company, this is an easier although likely more expensive way to go public.

Second, the disclosure requirements for a SPAC are typically less onerous, which can be appealing for a company that may be in the development stages. From an investor perspective, however, there is simply less information available.

So, from a company perspective and a sponsor perspective, a SPAC can make a lot of sense.

But Do SPACs Make Sense for Investors?

As an investor, maybe not so much. First, that management team bet. Shaq may be a great businessman, but that is not what he is primarily known for. Are all of the management teams raising this capital really that exceptional?

Second, they better be, because of that significant dilution coming from the sponsor’s share. The sponsor may (indeed, should) make up for that dilution by adding value somehow. But that is an assumption, not a fact.

Third, right now, many different sponsors and SPACs are competing for a limited number of great companies, which will drive the prices up and limit the sponsor’s ability to add value by negotiating. Compare this with an IPO, where you know what the company is and have a better idea of the price. This dynamic makes SPACs riskier.

Fourth, even among the great companies available, those companies have to disclose less information and have more negotiating power than they would in the IPO process. This situation raises the risks for the investor.

In the end, with a SPAC there is the prospect—but not the guarantee—of an exciting company at a great price. But this has always been a hard game, and it is getting harder.

Those risks may seem theoretical, but they are real. While newly launched SPACs (pre-target acquisition) tend to hold up fairly well, studies have shown postmerger returns to be disappointing. Renaissance Capital examined the performance of 313 SPAC IPOs from 2015 to late 2020 and found that SPACs with completed mergers delivered an average loss of nearly 10 percent, well below the average return for traditional IPOs, which had an average return of 47 percent over the same time. This number is concerning and certainly not what the hype would imply. Moreover, not all SPACs work, with at least one major bankruptcy.

Just a Marketing Tool?

The hype is great. But at the end of the day, SPACs are simply a capital-raising tool, designed to serve the interests of the companies trying to access the public markets and the sponsors. They are not designed specifically for investor benefit and present the same risks as a traditional IPO, plus a number of their own. They are also, right now, a marketing tool. Investors should be very aware of that as they evaluate their options.

Check out the background of anyone recommending a SPAC. Learn about the SPAC sponsors’ backgrounds, experience, and financial incentives; how the SPAC is structured; the securities that are being offered; the risks associated with an investment in the SPAC; plans for a business combination; and other shareholder rights by carefully reading any prospectus that may be available through the SEC’s EDGAR database. Further, investors should consider the investment’s potential costs, risks, and benefits in light of their own investment goals, risk tolerance, investment horizon, net worth, existing investments and assets, debt, and tax considerations.

Can a SPAC be a good investment? Certainly. Can it be a bad investment? Yes, indeed. The point is that it is an investment, just like any other. Caveat emptor.

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