SPACs became very visible in 2020, with 219 SPACs raising $73 billion, outpacing traditional IPOs, which raised $67 billion. There is a mystique about investing in SPACs. We’ll try to demystify SPACs by explaining their structure, their investment considerations, and identify benefits and drawbacks.
SPACs are speculative investments with high risks with returns that often favor the founder, however, new structures are emerging that may enhance returns.
Continued Growth In 2021
Growth continues in 2021, with SPACs acting as an alternative way to take a private company to the public market. Its IPO process is different. The SPAC raises capital through its IPO to acquire an operating company which, more than likely, is not known. Subsequently, the SPAC acquires the target company, and after the shareholder approves the deal, the company becomes a listed stock.
From an investor’s perspective, you can invest in the SPAC once it goes to the public market after the merger combination is publicly listed or any time in between those events. As with any speculative investment, there is skepticism about investing in SPACs. Therefore, we believe a deeper understanding of its structure can help us decide one way or the other if this kind of investment belongs in our portfolio.
Third Generation of SPACs
SPACs are not new, having been around since the early 1990s. The first generation helped smaller companies who could not go the traditional IPO route of going public. However, sponsors received favorable terms, hurting investor returns and inflicting reputational damage. The SPAC structure reemerged in the early 2000s but faced competition from venture capital firms while the traditional IPO means to go public remained a preference.
The returns for SPACs still tend to favor the sponsors who play a dual role in organizing the structure. The pandemic, the economic downturn, and the volatile market in early 2020 spurred substantial growth in the SPAC industry. The high quality of sponsors, target companies, and increased SEC regulatory scrutiny on insider pay structures stimulate investor interest and provide better returns. Some SPAC experts see a positive difference in the SPACs today.
What Is A SPAC?
A SPAC is a special purpose acquisition company, sometimes referred to as a “blank check company.” Blank check companies are an appropriate term at the development stage. Initially, the SPAC doesn’t have a specific business plan or purpose and is highly speculative.
Creating a SPAC begins with a sponsor forming a corporation to go public in an initial public offering (IPO), working with an underwriter. A SPAC IPO shares few characteristics with a traditional IPO, and we will contrast how they are different.
You may be thinking, why would I buy shares in a company without a business plan or purpose? Asking this question is valid. The quality of the sponsor is the first clue as to the quality of the SPAC. Sponsors have come from large private funds (e.g., hedge funds), former S&P 500 CEOs, senior executives, and individual or group of investors.
SPACs have organized around a specific, often “hot” industry in the latest round of announcements such as emerging energy, electric vehicles, and health technology. The sampling of winners are DraftKings, Virgin Galactic, Repay Holdings, QuantumScape, and Vivint Holdings. Nikola was a success initially, but its CEO had to step down. Notable SPAC sponsors with substantial experience are legitimizing the SPAC market.
A Select Group Of Sponsors:
Chamath Palihapitiya, Social Capital Hedosophia series*
Bill Foley, Trasimene Acquisition Corp.
Bill Ackman, Pershing Square Tontine holdings
Michael Klein, Churchill Capital
Omar Ishrak, SPAC Compute Health Acquisition
*See below our discussion of Chamath Palihapitiya and the Hedosophia series
Stages of A SPAC
Before the IPO, the sponsor invests capital, paying a nominal price for the shares and warrants. Post-IPO, the sponsor will have about a 20% interest in the SPAC. These shares are called “founder shares.” As the sponsor, they receive a lower price as their compensation for the SPAC’s work.
Sponsors tend to get more favorable returns for SPACs than some investors as they play a dual role in organizing the structure and finding the right target.
At the time of the IPO, the sponsor can buy more shares and warrants but at the fair market value. The SPAC IPO sells units to public investors who will receive with each unit consisting of a share and a warrant. Potential investors should scrutinize the information in 10K and 8K reports filed with the SEC; and learn about the sponsor, company, risk factors, and management team.
In a SPAC IPO, the price is typically set at $10 per share and has no relationship to its value. It will trade with a temporary stock symbol until the merger combination reflects the company. The IPO proceeds go into a trust invested in safe Treasury securities until the SPAC, and its sponsor identifies a private company for its merger combination.
The Time Between IPO And Merger Combination
Most SPACs have a two-year window in which to find a private company for its combination. Once the SPAC identifies the initial business combination opportunity, there will be negotiation with the target company, and shareholders get to redeem its shares or vote on approving the merger.
If the SPAC does not complete the merger because it did not find a target company, the SPAC liquidates, and the shareholders receive the IPO proceeds. Shareholders can redeem their SPAC common shares for cash at a shareholder meeting to approve a combination. They have to elect redemption two days ahead of the meeting.
A Few Findings
Research by Michael Klausner found that over two-thirds of SPAC stockholders tender their shares for redemption. They analyzed 47 SPACs through its stages from issuance at $10 per share to post-merger. A few findings:
- The $10 share value drops to $6.67 per share due to dilutive costs.
- Underwriting fees for a SPAC IPO is typically 5%-5.5%, less than that of the traditional IPO.
- When factoring in other costs, median dilution for investors could be as high as 50.4%.
- Shareholders who redeem shares pre-merger earn higher median returns of 11.6%, though below 31.3% returns for sponsors.
- The longer investors hold on to their post-merger equity, the lower their returns.
Post-merger combination occurs after the announcement of the target company. The SPAC is still trading but on its pre-merger stock symbol. There is a transition period to prepare the company to communicate with existing and new investors, developing investor presentations as they complete the transaction. This period is readying a private company for the public limelight, which can be overwhelming and demanding.
In the traditional IPO process, the company and bankers allocate shares mainly to institutional investors. The IPO stock is not yet trading in the public market until pricing. Once priced, it will begin trading in the secondary market. In a SPAC IPO, the stock is first trading as a blank check company and then transitions to a company post-merger.
Investing In SPACS
I want to share my experience in investing in SPACs, specifically Chamath Palihapitiya and his Social Capital Hedosophia series. Palihapitiya has been a sponsor of six different SPAC IPOs, ranging from IPOA through IPOF. His plans are for 26 SPACs through IPOZ. That may prove ambitious even for him.
Why did I pick these over other SPACs?
Chamath Palihapitiya has an impressive background, from being an early executive of Facebook to a successful venture capitalist with a $1 billion net worth.
It is not solely his wealth but his ability to articulate where disruptive technologies are going. He is thoughtful about people on Main Street, may consider politics in the future. He has significant relationships with Silicon Valley. Thus far, I invested in all of the IPO letter stocks, except IPOA, the shell company that became Virgin Galactic. His SPACs have raised a lot of capital and are at different stages.
How Have They Done?
Three of the SPACs (IPOA, IPOB, and IPOC) have found their target companies, transitioning to companies.
By far, IPOA’s conversion to Virgin Galactic (SPCE) has been quite a star, rising over 140%.
IPOB is now Open Door (OPEN), an online home-selling business. Its shares are down 14.9% since it began trading post-merger as OPEN.
IPOC is now Clover Health Investment, a Medicare insurer. Its stock is down 18.7% as CLOV. It hit a speed bump last week when short-seller Hindenburg Research reported that it is under an active Justice Department investigation. Clover Health responded to Hindenburg’s report here.
IPOE has more than doubled from its initial IPO price. This SPAC will merge with Social Finance, better known as SoFi, an online lender and Robinhood competitor. It has a high capitalization of near $9 billion, well over the median amount for SPACs of $500 million in 2020.
Neither IPOD and IPOF have found their merger target but are trading above their $10 initial price. IPOD is up 65%, while IPOF is up about 50%.
Understand The Risks
Like newly issued shares in a traditional IPO, it is too early to judge the investment merits in the short-term. I have faith in this sponsor, and his ability to seek quality merger candidates in growth areas. However, it is up to the investor to learn what the risks are and if you can tolerate them.
You can consider how to minimize their risks by diversifying with a SPAC ETF. In the interest of full disclosure, my SPAC investments are relatively small, less than 1% of my portfolio. Young investors who have shown interest in investing in SPACs and other areas should read our letter.
1. Buy At The Ground Level. There is a chance for smaller investors to join institutional investors to participate in an exciting industry and company at an earlier time at the ground level. It depends on the SPAC and its sponsor. This opportunity typically doesn’t exist for the retail investors to get the stock at the IPO price who potentially pay a much higher price.
2. Low Price Point. At the initial stage, the shares are the same at $10 per share, a desirable price point for retail customers.
3. Different Stages To Invest. Investors can buy SPAC shares at the IPO price, participate before the merger deal is announced, and after the deal’s completion of the deal when the merged company is listed. Shareholders can opt to redeem their shares before the approval vote for a merger.
4. There Are Many SPAC Choices. SPACs vary by sponsor, industry, and company. With many SPACs in the market, there are choices with better terms or structures for investors. Bill Ackman’s Pershing Square Tontine Holdings is the largest SPAC in 2020, has positive attributes that may serve as a better model for future SPACs.
Different Structure, New Model?
Pershing Square SPAC’s structure deviates from other SPACs by eliminating the sponsor’s 20% “promote” at lower prices for the founder, special warrant incentives to keep shareholders from redeeming shares, and buying smaller interests in private companies, rather than one operating company for its SPAC. This may reduce risk or improve returns.
5. Investment returns vary for SPACs with potentially higher returns at certain stages. According to Tim Jenkinson and Miguel Sousa’s research, they found a 7.6% median return when investors buy shares shortly after the IPO and sell it soon after announcing the potential merger.
6. Diversification. To minimize risk, you may consider buying a SPAC ETF, with a diversified pool of SPACs. There are a few new ETFs to investigate.
1. These Are Speculative Investments. Investors need to be more cautious given more significant risks. At the blank check company stage, you are investing blindly. Your reliance is on the sponsor, so you need to understand the founder who may not have a lot of experience in the field. Before investing, you should learn about their track record, previous successes as investors or senior management, and access to target companies.
2. Underperformance For Many SPACs. Like most traditional IPOs, long term stock performance is usually low or negative returns. That is true for SPACs. Not every stock becomes a Virgin Galactic, whose shares appreciated 146% in the year after going public. On average, SPAC transactions underperform the equity market. Klausner’s research on tracking 46 SPACs, found median negative returns of 14.5% after three months, 23.8% after six months, and a detrimental 65.3% after 12 months.
3. Few Quality Target Companies? Many SPACs are looking for quality target companies in a handful of hot industries. At some point, SPACs may have challenges finding outstanding companies for their combination and may settle for lower quality.
Investing in SPACs has been an exciting area in the financial markets. We hope we helped you better understand SPACs and their investment considerations. It is a speculative investment with high risks and returns that often vary depending on its stage, the sponsor, the target company, and the industry.
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With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.