SPACs: Blind investing or investing blind?

This article appears in the October 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Special purpose acquisition companies (SPACs), also known as “blank cheque companies,” are publicly traded and normally have a two-year window to merge with a private company and take it public. SPAC investors constitute two very different risk profiles. Is either profile right for your clients?

SPACs are considered a more efficient way for companies to go public than traditional IPOs because they’re:

• less expensive to issuers — they avoid the new-issue price run-up and SPAC costs are paid by investors at the time of the merger;
• a faster path to market with fewer regulatory requirements;
• a way to go public for complex or unique businesses (e.g., DraftKings and Virgin Galactic); and
• a path to private equity for retail investors.

SPACs are variations of blind pools. After gaining notoriety in the 1980s (see The Wolf of Wall Street’s Stratton Oakmont), blind pools tended to acquire conservative businesses with reliable cash flows, like property holdings, to offset the risk shareholders assumed by speculating without knowing the targets. Today, SPACs bring substantially higher-risk businesses to market.

SPACs have come to dominate the U.S. initial public offering (IPO) market, going from 5% of all IPOs in 2014 to 55% in 2020 and 64% through August 2021, according to SPAC Analytics. They’re also powering investment banking activity.

The SPAC process involves two types of investor: those who buy SPAC IPO units pre-merger, and those who stay with the merged company or buy shares in the aftermarket.

The first group gets their capital back and retains rights that could be valuable if the acquired companies are successful — low-risk participation with potential upside. Their time horizon is the two years during which SPACs must find a merger; proceeds wait in low-risk assets like T-bills.

The second group invests in the acquired company, which may not have an operating record. This group usually consists of hedge funds and/or institutional investors, which replace redeeming SPAC shareholders. Time horizons can be long and risks extreme for acquired companies in untested markets.

According to Stanford University’s Michael Klausner, a small group of hedge funds and large institutional investors — known as the SPAC “mafia” — hold 87% of pre-merger and 70% of total post-merger shares. And the “smart” money sells after deal announcements: Klausner found the median rate of units redeemed before merger completion was 73%.

The winners, therefore, are the SPAC IPO issuers. Their typical 25% stake comes, effectively, with a carried interest of warrants and rights participation. Three months following mergers, successful sponsors had a mean return of 400%; 12 months post-merger, the mean return dropped to 187%, according to Klausner.

The bottom line: SPAC sponsors do well and merger shareholders do poorly.

The Canadian SPAC market is tiny compared to the U.S. In the first six months of 2021, although 47% of financings were capital pool companies or SPACs, they accounted for less than 10% of capital raised compared to IPOs, according to CPE Analytics.

In July, Portage Fintech Acquisition Corporation, backed by Power Corp., raised US$240 million in a Nasdaq-listed SPAC. Portage CEO Adam Felesky told the Financial Post that his SPAC’s prospective advantage may be in having Canadian pension funds as private investment in public equity participants. I hope clients’ pension plans aren’t left holding the bag.

Six SPAC-related ETFs trade in North America (see Table 1). Pre-merger SPACs offer lower risk despite uncertain target acquisition, while post-merger companies present an array of potential risks, forcing investors to rely more on the reputation and skill of the managers. SPCX and ARB focus almost entirely on pre-merger SPACs; SOGU, which shorts post-merger companies, may also be interesting for SPAC skeptics. SPACs have gained notoriety with high-profile celebrity participation. But as we can see, the buyer should beware.

Table 1: SPAC-related ETFs

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.