At the moment, everyone seems to be talking about SPACs (special purpose vehicles). Former professional basketball player Shaquille O’Neal is on his second SPAC, and so is former House speaker Paul Ryan. And with state-of-the-art companies like Virgin Galactic
What’s behind door # 3?
By removing hyper and detail, SPAC allows the company to list its shares in the public market and raise capital from new shareholders. The effects are the same as with the traditional initial public offering (IPO). As an investor, you can look at buying SPAC as buying an IPO. Except you’re not.
One of the problems is that you will not know which company you are buying an IPO from. SPACs are formed as capital raising companies with a blank check. Only when the capital is raised will they identify the company to buy. It could be DraftKings. It could be Virgin Galactic. On the other hand, it could be chips from Utz. When you buy SPAC, you just don’t know what’s behind door # 3.
Another problem is that your ownership of that IPO is likely to be significantly diluted. SPAC sponsors (the people who organize it) usually take a large share – often 20 percent – of the company at a much better price than SPAC shareholders receive.
SPAC transactions are different from traditional IPOs and involve different risks. For example, sponsors may have a conflict of interest, so their economic interests in SPAC may differ from shareholders. Investors should consider these risks carefully. In addition, although SPACs are often structured in a similar way, each SPAC may have its own unique characteristics, and it is important for investors to understand the specific characteristics of any SPAC under consideration.
How do SPACs succeed?
Despite these concerns, SPACs are hot. This year, almost 300 are in progress, with almost 100 billion dollars collected. Why is that? Is it in favor of investors – or others?
From an investor perspective, SPAC offers access to an experienced management team that is likely to find a good company to buy, negotiate favorable terms, and complete the transaction. The management team has every incentive to do it right. He can make a lot of money and, of course, his reputation is on the line. In that sense, it’s like shopping at a startup.
However, just like a startup, a team must perform – and it must have a good target market. These are two requirements for the success of SPAC: a team that can find and acquire a good company and a good company that is willing to be acquired.
Do SPAC make sense for companies?
Which brings us to the next question: why would a company want to go through SPAC, giving up that stake to SPAC sponsors, instead of simply conducting a traditional IPO? Two reasons. First, SPAC is both simpler and safer. Instead of trying to sell the company to a large number of investors at an uncertain price, there is one deal on a negotiated price. For greater simplicity, this is also a faster process, which can be important. For the company, this is an easier, though probably more expensive, way to enter the market.
Second, SPAC disclosure requirements are usually less demanding, which can be appealing to a company that may be in the development stage. From an investor perspective, however, less information is simply available.
So, from a company perspective and a sponsor perspective, SPAC can make a lot of sense.
Tough game for investors
As an investor, maybe not so much. First, that management team bets. Shaq may be a great businessman, but that’s not what he’s primarily known for. Are all the management teams that raise this capital really that exceptional?
Second, they would be better off, because of that significant dilution that comes from the sponsor’s share. The sponsor can (indeed, should) compensate for this dilution by adding values in some way. But that is an assumption, not a fact.
Third, many different sponsors and SPACs are currently competing for a limited number of great companies, which will increase prices and limit the ability of sponsors to add value to negotiations. Compare this to an IPO, where you know which company it is and you have a better idea of the price. This dynamic makes SPAC more risky.
Fourth, even among large companies available, those companies must disclose less information and have greater bargaining power than they would have in the IPO process. This situation increases the risks for the investor.
In the end, with SPAC there is the possibility – but not the guarantee – of an exciting company at a great price. But this has always been a tough game and it’s getting harder.
These risks may seem theoretical, but they are real. Although newly launched SPACs (pre-target acquisitions) are usually fairly well maintained, studies have shown that the return after the merger is disappointing. Renaissance Capital examined the performance of 313 IPACs for SPAC from 2015 to the end of 2020 and found that SPACs with a completed merger yielded an average loss of almost 10 percent, well below the average yield for traditional IPOs, which had an average return of 47 percent of the time. This number is worrying and certainly not what the hype would imply. Moreover, not all SPACs work, with at least one major bankruptcy.
Look Beyond the Hype
The hype is great. But in the end, SPACs are simply a fundraising tool, designed to serve the interests of companies trying to access public markets and sponsors. They are not designed specifically for the benefit of investors and pose the same risks as a traditional IPO, plus a number of their own. They are currently also a marketing tool. Investors should be very aware of this as they assess their options.
Check the background of everyone who recommends SPAC. Learn about the origins of SPAC sponsors, experience, and cash incentives; how SPAC is structured; securities offered; risks associated with investing in SPAC; business combination plans; and other shareholder rights by carefully reading any prospectus that may be available through the SEC EDGAR database. Further, investors should consider the potential costs, risks and benefits of investing in light of their own investment objectives, risk tolerance, investment horizon, net worth, existing investments and assets, debt and taxes.
Can SPAC be a good investment? Certainly. Could it be a bad investment? Yes, indeed. The point is that it is an investment, like any other. Caveat emptor.