SPACs are not a great investment opportunity for most investors

David Peartree and Patricia Foster
BridgeTower Media Newswires

The recent surge of interest in SPACs, a unique type of company listed on the stock exchange, has caught the interest of investors and the attention of the SEC. Here we take a closer look at who may benefit from investing in SPACs, who may not and why we believe most retail investors should be wary of SPACs as an investment opportunity.

SPAC stands for “special purpose acquisition company,” a neutral description to describe a very unconventional company. Ordinarily, a company offers some type of goods or services and achieves some level of success in commercial operations before turning to an initial public offering (IPO) to raise capital for further growth. By contrast, a SPAC will go through an IPO without having any commercial operations. A SPAC initially has no business purpose other than to raise cash from investors with the aim of eventually acquiring another business through merger or acquisition. A SPAC’s prospectus may identify the industry that the SPAC will target but not the actual company being targeted by the SPAC.

Because a SPAC does not have to specify its target acquisition when it goes through its IPO stage, SPACs are also referred to as “blank check companies.” SPACs can be thought of as pools of cash that are listed on an exchange. Investors are essentially buying into a management team on the belief that management will find a worthy target to acquire. Usually, a SPAC has a short window of 18 to 24 months to find a suitable target or return cash to its investors.

Although SPACs have been around for several decades, the use of SPACs has surged over the past two years, in large part because they offer an easier path to the capital markets for start-up companies. After the SPAC acquires the target company, that company then takes the place of the initial SPAC in the stock market listing. In 2020, SPACs raised over $83 billion, which is more than the total amount they raised over the preceding 30 years. So far in 2021, SPACs have raised well over $100 billion.

Very recently, SPACs have come under closer scrutiny by the SEC concerning the adequacy of their disclosures. SPACs have indeed helped many new companies gain quicker access to the capital markets. And the sponsors of SPACS have done very well in many cases, but it is becoming evident that their early success may be coming at the expense of subsequent investors.

The sponsors of SPACs are often large investment banks, private equity firms or their respective alumni. They invest relatively small amounts of capital, generally up to about 20% of the equity in the SPAC in the pre-IPO stage. Along with their initial investment these early investors may also obtain warrants, the right to buy additional shares of the company at a predetermined price at some future date or event. The early investors also may have the right to redeem their shares at the IPO price plus interest. These stock rights allow the early investors to realize returns that can be several times their initial investment.

Too often, however, SPACs are not such a great deal for subsequent investors. A recent study published by two law professors from Stanford University and New York University suggests that much of the early success realized by the initial investors may come at the expense of the subsequent investors who buy in after the SPAC has acquired its target company.

In most cases, a large percentage of the early investors cash out when the SPAC announces a merger with a target company. Over two-thirds of the proceeds from the earlier IPO are paid out to shareholders who redeem their shares when a merger is announced. That means that most of the IPO cash is no longer available to fund the new company and new money must be raised from new investors post-acquisition. By the time the merger takes place, an average of 90% of initial SPAC investors have sold out their positions.

The pre-merger phase of a SPAC runs from the initial IPO to the consummation of the merger with a target company. That’s when most of the money is made. Most SPACs are marginally profitable between the period from their initial IPO to the announcement of a merger. However, between the announcement of a merger and the closing of the deal, SPAC investments can be wildly profitable. The study found that the mean return to the sponsors of SPACs was about 400%. The authors conclude, “Sponsors thus tend to do very well even where SPAC investors do quite poorly.”

Post-mergers returns are far less favorable. These are the returns earned by the new investors who have largely replaced the initial SPAC investors. For the years 2019-2020, the years of heaviest SPAC activity, the average annualized return for 12 months post-merger is -35%. For a longer-term perspective, the study looked at post-merger SPAC returns since 2010. The study compared SPAC performance to the Russell 2000 Index, a common benchmark for U.S. small company stocks. Since 2010, SPAC returns post-merger have consistently underperformed the Russell 2000 Index, a benchmark that, by the way, significantly underperformed the total U.S. stock market over that period. Even in their best year, the average return for SPACs post-merger underperformed the Russell 2000 by 10%. In some years, SPACs underperformed by 40% or more.

SPACs are another example of investments that can work very well for Wall Street insiders but can be deeply disappointing for the typical retail investor. Let the buyer beware remains an iron law of investing.

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David Peartree is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by David Peartree and Patricia Foster. Patricia Foster is a securities law attorney whose experience includes representation of clients in various sectors of the financial services industry, including, broker-dealers, investment advisers, and investment companies. The information in this article is provided for educational?purposes and does not constitute investment or legal advice.