What to Make of SPACs?

From reading the headlines around SPACs (Special Purpose Acquisition Companies) it is clear that as an investment they mean many different things to many different people. For hawkish investors like Jeremy Grantham, they are a “reprehensible instrument, and very very speculative by definition".   For market pundits, the opportunity for colourful analogies arises such as comparison to the South Sea Bubble, when blank cheque companies first made their debut and led to one of the most extreme examples of speculative mania. For some retail investors, SPACs are a potential get rich quick scheme as evidenced by internet forums dedicated to SPACs and social media videos with captions telling investors that a SPAC bringing an electric vehicle manufacturer to market will be the next big thing. For SPAC promoters and underwriters, they represent a new golden age for deal making. The number of SPACs being launched continues to hit record numbers with more SPACs being launched in 2021 thus far than all of 2020. This has understandably turned many investors away from the space. It also does not help that SPACs are complicated and opaque.

It is quite easy to critique SPACs as a construct and has become fashionable in many professional investing circles to do so. But what are they and why has has SPAC activity exploded over the past year? Many journalists, such as Matt Levine, have written excellent in-depth exposés that make a lengthy explanation redundant.

In short, SPACs are an elaborate structure to take private companies public. A SPAC is formed by a sponsor, presumably with investment acumen and capital markets expertise, who puts up the “risk capital” that goes to pay the investment bank underwriters, lawyers, and other expenses in exchange for founder shares which the sponsor purchases for a nominal amount and typically results in the sponsor owning 20% of the shares outstanding after the SPAC IPO. The SPAC issues shares in an IPO at $10 to external investors, who also typically receive warrants that give them the right to buy an additional share at a fixed price, typically $11.50 per share. In a SPAC IPO, the shares and warrants are combined but then trade separately shortly thereafter once SPAC shares begin to trade in the secondary market. In addition, SPAC shares have voting rights on any proposed business combinations and the $10 cash per share is held in trust, providing a “put option” for an investor to take back their $10 if the deal does not go through or they decide not to participate. In theory, SPAC IPO investors and investors buying SPACs on the secondary market at a price close to $10 have very low risk of losing money if they take cash instead of participating in a transaction.  SPACs that trade below $10 are viewed as an arbitrage opportunity by event-driven hedge fund investors since the SPACs are ‘money good’ for $10. Up until then SPAC investing  is a relatively straightforward and investor friendly proposition given the sponsor takes most of the risk.

That all changes once the acquisition of a target company is announced which introduces significant risk, rewards, and conflicts. For deals that are well received by the market there is typically a frenzy of trading following the announcement, or even before in some cases based on rumors. In addition, through a Private Investment in Public Equity or “PIPE” for short, the sponsor has the ability to raise additional capital at much lower prices than the $10 IPO price; this results in dilution of the original SPAC investors that participated in the deal. PIPE investors get in cheap as a concession for supporting the deal and competition is fierce to participate. Often PIPE investors secure their allocations by supporting the SPAC sponsor with risk capital in the SPAC’s early days. This creates a classic insider vs. outsider dynamic where the majority of profits are realized by institutional investors at the expense of ordinary investors. That being said, all investors, retail or otherwise, retain their $10 put prior to the business combination closing, so presumably have less downside than they otherwise would have in making speculative investments.

As to why SPAC activity has exploded, this is difficult to attribute to one particular thing. One of the primary drivers is the current market environment of elevated valuations, which creates an incentive for private companies to go public. Another cause is the high level of participation in markets by retail investors, a cohort of which is prone to speculation. This is partly evidenced by the shift of SPACs to “growth” from “value” companies. Finally, there is a real economic incentive at work for private companies to go public given the public markets have a lower cost of capital and give growth companies the ability to scale more quickly by tapping the capital markets. Despite these benefits, many venture capitalists and rapidly growing companies in the private markets have avoided IPOs due to onerous listing requirements and road shows, which some would argue has stood in the way of the public getting access to promising early-stage investments. Going the SPAC route eases some of this burden.

So what should the takeaway be for investors interested in SPACs? Simply put, avoid speculation, and ensure that you find yourself on the right side of the table when investing in SPACs. Several alternative investment managers run by experienced portfolio managers have been successful by following an arbitrage framework and enhancing returns by participating in sponsor economics in exchange for helping to bring SPACs to market (the right side of the table).

To use a mining analogy, it is generally better to sell pickaxes and shovels during a gold rush, then to mine for gold. The SPAC sponsors and the institutional investors that support them are selling the pickaxes here. Whether the ordinary investors that hold SPAC shares post business combination are also able to strike it rich remains to be seen.

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