Even if you do not follow investing news particularly closely, you may have noticed that SPACs are everywhere this spring. Celebrities from Colin Kaepernick to Jay-Z have brought new attention to an already rising trend.
But as the U.S. Securities and Exchange Commission recently warned: “Just because someone famous is involved in a SPAC doesn’t mean it’s right for you.” First it is important to understand what SPACs are, why they are having a moment in the sun, and what risks you may take on if you jump aboard the SPAC train.
What Are SPACs?
A special purpose acquisition company, usually shortened to SPAC, is an alternative way for private companies to go public. A SPAC raises money in an initial public offering. The SPAC does not, itself, make goods or offer services; this is why you will sometimes hear SPACs called “blank check” companies. After the company goes public, the SPAC’s leadership looks for a promising private company to merge with. Assuming the SPAC shareholders approve the deal, the SPAC and the target company merge. The target begins trading publicly without having to go through the traditional IPO process.
Most SPACs are formed by private equity funds, financial institutions or groups of investors. Individuals can sponsor a SPAC too, as long as they meet the SEC’s definition of an “accredited investor.” The individuals or organizations that form and direct a SPAC are called the sponsors. For the sake of the following explanation, I will discuss a singular sponsor, but more than one person may be directing a particular SPAC. The sponsor makes an initial investment, called the promote. This initial investment may be relatively small, but it guarantees the sponsor access to a large portion of equity in the target company after the SPAC goes public. A sponsor can generally expect a 20% stake, though this is a convention rather than an inherent part of the SPAC deal structure.
Once the SPAC is set up, the sponsor can take it public. The SPAC’s IPO involves issuing “units” to investors, usually at $10 each. Units often consist of one share of stock in the SPAC and a warrant to buy additional shares or fractions of a share later. The money the SPAC raises in its public offering goes into a trust. The newly public SPAC has two years to identify an acquisition opportunity. The sponsor negotiates a merger and then brings the potential deal to the shareholders. If the shareholders approve it, the merger – also called a de-SPAC or business combination – will bring the target company public.
As part of the de-SPAC process, existing shareholders have a choice. Before the merger, they can redeem their shares to get back their initial investment (plus whatever interest the money accrued while in trust) or sell their shares in the stock market. Or they can swap their SPAC shares for shares of the merged company. If the sponsor does not find a deal that the shareholders approve by the two-year deadline, the SPAC is liquidated and shareholders get their money back, again with interest.
Why Are SPACs Suddenly Popular?
SPACs are not new; in fact, they have been around in their current form since 1993. What is new is their popularity. Venture capitalists once derided SPACs as “bottom feeders,” and except for a small blip in the early 2000s, they were not a widespread way to take a company public.
That began to change about four years ago. In 2017, 34 SPAC IPOs collectively raised a bit more than $10 billion. In January 2021 alone, SPACs raised almost $26 billion. That enthusiasm has continued so far this year. On Feb. 10, The Wall Street Journal reported that SPACs had raised $38.3 billion since the start of the year, compared to only $19.8 billion raised in traditional IPOs during that time. By mid-March, that total had reached $87.9 billion. Reuters reported on March 9 that SPAC merger volume had surpassed $170 billion for 2021, compared to $157 billion for all of 2020.
Some observers have suggested that SPAC enthusiasm may be a bubble. Charlie Munger, the vice chairman of Berkshire Hathaway, recently said of SPACs: “I think the world would be better off without them.” Regardless of your evaluation of the SPAC model on its own merits, the recent SPAC boom creates reasons to proceed with caution. The huge popularity of SPACs means a lot of them are looking for companies to merge with before their two-year window closes. Sponsors may lower their standards for acquisition targets in an environment where they have a lot of competition. Sponsors have an incentive to make some sort of deal, even a subpar one, to avoid losing their upfront costs. But it is possible that SPACs could one day level out into a long-term alternative to traditional IPOs for companies looking to go public.
Until recently, fewer companies were going public at all. Between 1997 and 2017, the number of listed companies fell steadily from about 8,500 to about 4,500. Even private companies that eventually went public had tended to stay private for longer. The median age of a company going public hovered between 10 and 12 years for the entirety of the 2010s. Recently, however, new companies have moved toward going public faster. In this environment, a SPAC can offer several advantages, especially to a startup.
First, a SPAC may help a company avoid leaving money on the table. Professor Jay Ritter of the University of Florida has estimated the average increase in stock price on the first day of trading for traditional IPOs in the past three years has landed between 20% and 40%. Venture capitalist Bill Gurley pegged the figure at around 31% in 2020. Part of this is due to market volatility. It is also partly due to investors expecting an IPO to go up substantially in its first day of trading, with valuations priced accordingly. In contrast, in a SPAC merger, the target company can negotiate a value it thinks is accurate. Some SPACs also raise additional equity financing when the merger closes through a private investment in public equity, or “PIPE,” deal. This gives the target company access to funds beyond those raised in the SPAC’s IPO.
Going public via SPAC is usually quicker than the traditional IPO process, too. The target company can go public in less than two months after finalizing the merger agreement. Traditional IPOs take at least four months, and often longer. The deal also is not public until both the target company and the SPAC sign. Traditional IPOs are made public as soon as the company files its registration with the SEC. If the IPO falls through due to market conditions or other factors, the company’s disclosures remain public. Consider the implosion of WeWork’s planned public offering in 2019, including its much-maligned prospectus, subject to public scrutiny and criticism. In a SPAC merger, if negotiations break down, everything happens behind closed doors. (In late March, WeWork agreed to go public – this time via SPAC merger, at a fraction of its valuation as of early 2019.)
Companies focused on technological advances may find SPACs particularly attractive. In a SPAC merger, a target company can provide future projections, which is not permitted in the traditional IPO process. The SEC also requires executives to observe a quiet period ahead of a traditional IPO. A SPAC merger carries no such restriction. This allows companies like those focused on space, autonomous vehicles, robotics and other innovative products to try to interest investors before they can demonstrate a track record of profits. If SPACs remain popular, they may encourage companies to go public sooner than they would have otherwise. Of course, projections are not promises. On average, companies that go public with little revenue have performed poorly. But SPACs offer a way for forward-looking companies to make their case with potential investors.
Are SPACs Good Investments?
As with traditional IPOs, there is no blanket answer to whether investing in a SPAC is a good idea. Past performance does not guarantee any particular future result, for a company or an industry. But looking at the past few years of SPAC deals can give potential investors some big-picture information about the pitfalls they could face.
There are three main parties invested in a SPAC: sponsors, pre-merger investors and post-merger investors. Sponsors, on the whole, have done quite well. Data from JPMorgan Chase indicates that over the past two years, sponsors have earned a 648% return on average. They also take on relatively little risk. If the SPAC is liquidated with no merger, they could lose their upfront costs. Or if a sponsor holds on to shares that eventually fall below not only their initial value, but the threshold that would cover the sponsor’s initial investment, that sponsor may not come out ahead. But both of these outcomes are, for now, rare. Sponsors have almost always done well.
In contrast, buy-and-hold investors who bought shares after a merger made an average of 44% for the same period. This return may seem substantial, but it lags the return of a standard market index fund over the same period. A rising market lifts all boats; it does not mean a post-merger SPAC investment is particularly attractive. As Terence Kawaja, the founder and chief executive of Luma Partners, told The New York Times, “Everyone’s a genius in a rising market.” And since sponsors do not have a fiduciary duty to the company’s shareholders, the sponsor only needs to find a deal that the shareholders will vote to approve, not necessarily one where the valuation of the target company is accurate.
Pre-merger SPAC investors, as a group, have done a bit better than post-merger investors, if not as well as sponsors. That said, they are taking on some risk in signing a blank check, relying mainly on the reputation of the sponsor. SPAC founders these days are as likely to be a famous athlete like Alex Rodriguez or Shaquille O’Neal as a well-known venture capital investor. While celebrities offer name recognition, it is less clear that all of them have the skills to identify and negotiate a good merger target.
Pre-merger investors do have the opportunity to redeem their shares for cash. Their main downside potential is forgoing other opportunities while their initial investment remains in trust. As some observers have noted, investing in a pre-merger SPAC is similar to holding a default-free convertible bond. It may or may not be the best use of capital, but the downside is limited by the SPAC’s design.
For post-merger investors, or even for pre-merger investors who choose to hold on to their shares post-merger, the upside is murkier. Unlike a traditional IPO, a SPAC merger does not necessarily make a lot of data about the acquisition company public right away. Performing fundamental analysis is possible, at least when investing post-merger, but it is not always easy. Accurate forecasting is especially difficult for a company that has never been profitable. Granted, lack of profitability is not unique to SPACs. In 2020, 80% of traditional IPOs represented companies with negative earnings at the time they went public. But potential investors need to stay alert to the risks. Historically, post-merger returns have been disappointing. Certain well-known success stories, such as DraftKings and Virgin Galactic, are the exceptions.
These high-profile outliers may mean that some investors are turning to SPACs out of fear of missing out or other fallacious thinking. After all, counter-examples are also available. Nikola Motor Company, which makes autonomous trucks, was celebrated when it went public via SPAC merger in 2020. Yet only three months later, fraud allegations led the founder to resign and shareholders to file multiple lawsuits. The company’s stock recently traded at a fraction of its June 2020 peak.
Many individual investors may also see a “cool” factor in getting to invest early in startups through a SPAC deal. Yet the advisory firm Renaissance Capital found that the average post-merger returns from SPAC IPOs completed between 2015 and 2020 fell short of the average aftermarket performance for traditional IPOs for the same period. In essence, investors – especially post-merger investors – may be paying a premium for that cool factor.
Investors should also note that the SEC is subjecting SPACs to new scrutiny. In September 2020, then-SEC Chair Jay Clayton noted that the commission was watching SPACs closely, with an eye to ensure that shareholders received the same disclosures available to traditional IPO investors. In March 2021, the SEC Investor Advisory Committee held a meeting focused on the expanded use of SPACs. While no regulatory changes have arrived yet, the SEC reportedly has focused on the safe harbor protections SPAC mergers enjoy in offering predictions of future growth – protections unavailable to traditional IPOs. The commission also issued a warning to investors to be particularly wary of SPACs with celebrity sponsors. Potential SPAC investors should stay alert for regulatory shifts in the months and years to come.
The current widespread enthusiasm for SPACs is likely to cool, but it is possible that SPACs could remain a viable alternative to traditional IPOs for companies planning to go public. Like any other investment, a particular SPAC may be more or less attractive. Before investing, take time to perform due diligence on the SPAC’s sponsors and specific terms, as well as on the acquisition target if it has been announced. And remember to maintain a well-diversified portfolio and to limit company-specific risk. Do not let enthusiasm, whether for a particular company, celebrity sponsor or the concept of SPACs in general, derail your long-term investing focus.