IN BRIEF

• Over the past year, a flurry of SPAC listings and the involvement of many celebrity names have not only attracted huge amounts of retail money but have also triggered questions of potential froth in the market.
• In essence, SPACs offer retail investors opportunities to invest in firms before they go public, an option otherwise open only to private equity investors or hedge funds. An investment in a SPAC can be seen as a bet that the sponsor will successfully find a suitable business to buy within 24 months.
• Those putting their money into SPACS should be aware that it comes with significant risks – one of which is that a SPAC has to deploy its funds to make an acquisition within a limited timeframe, usually two years. This time pressure may result in a less-than-ideal acquisition being made, translating to poor returns for investors. There is no way to be sure what a SPAC will eventually invest in, or if an acquisition will prove to be profitable.
• It is important for investors not to overinvest in SPACS or speculate excessively in them. To reduce risk, investors should do as much research as possible and assess a SPAC’s founders, and their track record, as a great deal hinges on their ability to identify good acquisition targets.

Slowly, and then all at once

While SPACs – or special purpose acquisition companies – have risen to prominence over the past couple of years, it is not at all new. In fact, SPACs have been around for decades. These investment vehicles are having their moment in the sun as businesses and investors alike rush to cash in on the IPO wave.

First, some definitions. SPACs are publicly listed shell companies or blank cheque companies that are set up to raise cash in an initial public offering (IPO), which will be used to merge with or acquire a private company, thereby taking the latter public. The private company then takes the SPAC’s place in the stock market and trades with a new stock ticker. It’s like Pacman ate a ghost, but instead of dying, it transforms into something else entirely.

SPACs offer an alternative for private companies to go public without having to go through the traditional IPO process, which is often elaborate and expensive and typically involves many roadshows amid extensive efforts to drum up investor interest. Even then, the company is unsure about how much it will garner until the day before its IPO. By contrast, marriage with a publicly listed SPAC is simpler, quicker, potentially cheaper and certain.

But SPACS are by no means costless. It also involves a middleman who launches the SPAC IPO and takes on the task of finding a private company to merge with. SPACs are typically led by teams of seasoned executives with experience in private equity and venture capital, and expertise in a particular target industry or a track record in investing. The middleman, or the sponsor, negotiates the terms of the merger and raises additional funds if necessary, to complete it. Typically, the sponsor has two years to find a target company and close a deal, failing which they will have to return the money to investors, with interest.

The mechanics

SPAC founders, known as the sponsors, are a group of investors who set up the SPAC to pursue a deal – usually targeting an industry or market segment in which they have expertise. Potential merger targets are not disclosed during the SPAC IPO process. As a result, investors often rely heavily on the reputation of SPAC sponsors when choosing which SPACs to invest in.

The sponsors are compensated for their efforts via founder shares, known as the “promote”, which is tied to the amount of SPAC capital raised, usually 20% of the SPAC’s total equity.

Typically, units in a SPAC are offered to public investors via the SPAC IPO. Each full SPAC unit consists of two parts:

• Shares of common stock that can be redeemed for cash before the completion of the SPAC merger should the investor choose not to participate any further; and
• Warrants that gives holders the right to buy more shares in the future at a certain price, often at a premium to the current stock price at the time the warrant is issued. This is effectively a call option offering potential further upside to investors.

The SPAC unit trades as is on the exchange for some time after the IPO. Thereafter, the unit will split into its common stock and warrant components and these will trade separately with their own unique tickers.

SPACs are typically priced at a nominal US$10 per unit in the IPO. When these units, common stock and warrants begin trading, their market prices may fluctuate. These fluctuations bear little relationship to the ultimate economic success of the SPAC. After all, investors are buying shares of a shell company – there is no existing underlying business.

The SPAC IPO proceeds are typically held in a trust account. SPACs generally invest the proceeds in relatively safe, interest-bearing instruments, but this may not be true all of the time.

Once the SPAC sponsor has identified its target company and the merger has been announced, management will perform further due diligence and negotiate the terms of the merger. SPAC sponsors may also raise additional capital through debt financing or investments from outside equity investors, known as private investment in public equity (PIPE).

The deal is then brought to SPAC shareholders for a vote. Typically, if more than 50% of shareholders approve the business combination and less than 20% vote for liquidation, the merger is approved, and the target company becomes public and assumes the SPAC's listing on the stock exchange but under a brand-new ticker. SPAC investors who kept their shares will become shareholders in the post-merger company.

SPAC shareholders may choose to dissent, vote against the merger and redeem their shares for cash, plus interest. Importantly, for retail investors who bought shares in the SPAC after the IPO on the open market, they are only entitled to their pro rata share of the trust account and not the share based on the price at which they bought the stock.

For instance, if an investor bought 100 shares on the open market for US$15 instead of the nominal US$10, his or her share would still be worth US$1,000 (100 shares multiply by US$10) and not US$1500. Even if holders of the SPAC units redeem their common stock, they can still keep the warrants, thus retaining the right to participate in the upside of a successful post-merger company in the future.

If a SPAC fails to find a suitable target or reach a deal within an allotted timeframe, the SPAC is liquidated and all capital plus interest is returned to the SPAC shareholders while the warrants become worthless.

Benefits of SPACs

There are a few reasons why private companies would choose to go public via a SPAC rather than the traditional IPO route.

For the most part, a merger with a SPAC allows a company to get access to capital more quickly than a conventional IPO. A SPAC merger can be closed in mere months versus a more involved and tedious IPO process. For perspective, registering an IPO with the Securities Exchange Commission (SEC) in the US can take up to six months. This is even before factoring in the time taken for underwriting and investor roadshows. By contrast, a SPAC merger would have been easily completed within those six months.

At the same time, merger with a SPAC is lean process. For instance, the company does not need to negotiate with underwriters, conduct investor roadshows or prepare a comprehensive prospectus to generate investor interest just to raise capital. In a traditional IPO, the company would typically engage an investment bank to advise and run this process, usually for a significant fee.

For companies that are still fairly young, without an extensive track record, SPACs are particularly attractive because they allow companies to present forward-looking guidance to SPAC sponsors and potential investors, which are typically not allowed in a traditional IPO process.

Meanwhile, for retail investors, buying shares of a SPAC is one way to participate in the acquisition of a private company and gain exposure to potentially high-growth businesses at an early stage of their development. The traditional IPO route seldom allows retail investors to gain early access to these high growth opportunities. In fact, access to companies at the pre-IPO stage is usually only available to private equity investors or hedge funds.

In addition, during an IPO, investment banks typically allocate early shares of the company to their big institutional clients. The average investor can always buy shares of newly listed companies in the secondary market, but often at a steeper price as these newly listed shares typically experience a large “pop” during initial trading.

Surging interest

2020 was the indeed year of the SPACs. And this is expected to continue in 2021.

The economic disruption and tighter financial market conditions triggered by Covid-19 underscored the inherent benefit of being publicly listed. For one, listed companies are well-positioned to access capital in public markets that can help provide liquidity support and shore up solvency. In 2020, the sudden decline in demand due to the synchronous and widespread shuttering of businesses and shelter-in-place mandates stressed companies’ cash flows, pushing many to the brink of collapse, except those which were able to raise capital quickly.

Listed companies could access public debt and equity markets and were able to raise capital through issuance of common shares, convertible preferred stock, debt and so on – options that were not readily available to private companies which largely depended on credit lines and relationships with banks. The capital raised prevented bankruptcies and helped operations continue, essentially allowing companies to bide their time until containment policies were loosened, and economies reopened.

While many saw the benefits of having access to public capital, going public through a traditional IPO, as mentioned earlier, is a tedious process. In this case, SPACs offered an attractive alternative to gain access to public markets quickly.

It’s little wonder, therefore, that the number of SPAC IPOs rose to a record 248 in 2020, more than four times the number in 2019, raising US$83.3 billion in gross proceeds. The pace of SPAC IPOs does not seem to be slowing down this year, after a record-setting 2020. This year looks to set a new record high – so far, around 298 SPAC IPOs have already been announced as at 3 April 2021, quickly surpassing 2020’s total and raising US$97.1 billion. Over the past two years, SPAC activity has contributed about 30% of IPOs and 10% of equity capital market deal value, according to Dealogic data.

A steady supply of private companies looking to go public is just one side of the equation. SPAC IPOs would not necessarily happen without strong investor demand for such investment vehicles. For the most part, 2020 offered the necessary conditions for the explosion of SPAC interest.

• First, 2020 was undeniably the year of growth stocks and was a crushing year for value and cyclical plays, which slumped under the weight of the economic downturn. Covid-19 accelerated secular growth trends including digitalisation, e-commerce, proliferation of electric vehicles, the increased usage of cloud technology, commercial application of genomics and the like. The information technology, health care and consumer discretionary sectors were key beneficiaries of the growth mindset that dominated the investment landscape. SPAC sponsors merely fed the demand of investors who were increasingly seeking growth opportunities, by targeting mergers with companies operating within these fast-growing sectors.
• Second, increased retail participation in the markets further boosted demand for non-traditional, high growth companies. For retail investors, SPACs offer convenient access to potentially high growth businesses that are still in the early stages of development or those operating in seemingly niche industries with lack of comparable players. SPACs that had merged with sports betting, electric vehicles and space technology companies elicited tremendous investor interest, which caused the prices of these SPACs to skyrocket from just the mere mention of a merger. Such buoyant demand stoked ever more supply, which could explain the SPAC explosion. Indeed, SPAC sponsors, private companies and investors alike are looking to strike while the iron is hot.
• This flurry of risk-taking behaviour was in part the result of interest rates being lodged at rock bottom levels for a relatively long period of time. The Fed funds rate is expected to stay at close to zero for the next three years if the Federal Open Market Committee’s (FOMC) infamous dot plot is to be believed. Investors have continued to reach for riskier options in search of returns amid the lower for longer interest rate environment. To some degree, the SPAC explosion is the manifestation of such risk-taking behaviour. In any case, investors in the SPAC IPO will still earn some interest on their funds as they wait for the sponsor to locate a potential target. SPACs also provide some downside protection because of the right to redeem their shares if they do not approve of the resulting deal.

Does it pay to invest in SPACs?

The next question is, does the performance of SPAC stocks measure up to the hype over a longer period of time?

Indeed, there is a wide dispersion in stock performance of companies listed through SPACs. While some high-profile SPACs like DraftKings and Virgin Galactic have performed reasonably well, other companies like Nikola Corp have experienced an extremely volatile run since its listing, wiping out almost all the gains clocked after the announcement of the merger.

Comparing the De-SPAC Index – an index that tracks the performance of a group of 25 companies that became publicly listed through mergers with a SPAC such as Skillz Inc, Nikola Corp, DraftKings Inc, Clover Health Investments Corp and many more – with the S&P 500 index, we find that the performance of SPAC-listed companies broadly tracked the S&P 500 index and even outperformed the market benchmark late last year, before facing turbulence in 2021 and sliding meaningfully lower in the first quarter, largely driven by the violent rotation out of growth stocks and into value.

Granted, the index comprises just 25 companies, which may not be wholly representative of the market. Also, growth stocks are typically long-term plays, in which case only time will tell which of these fairly young companies would grow to be the next Amazon or Apple. Conclusions derived from a rather short time series might be misleading, especially as performance tracking of this market segment is a relatively recent endeavour. Still, one might glean from the above example that these stocks are volatile and such wide dispersions in performance means there is no proven or quick way to locate winners.

Relying on specialised research, we also gather that SPAC mergers have not exactly yielded strong outperformance relative to companies that listed on public exchanges via traditional means. In fact, work by advisory firm Renaissance Capital, which specialises in IPOs, found that the average returns from SPAC mergers completed between 2015 and 2020 fell short of the average post-market return for investors from an IPO.

More recently, rising long-term bond yields and the rotation into value have dulled the appeal of SPACs, with the IPOX SPAC index – which tracks a broad universe of SPACs before their mergers – sliding some 21% from the peak touched in February. Still, the index remains up about 49% since the beginning of the benchmark at end July 2020.

So, what are the risks?

Investing in a SPAC, prior to any merger announcement, might be considered a speculative trade. After all, investors are literally buying shares of a shell company, which has no commercial operations, does not produce any cashflow and neither manufactures products nor sell goods or services. The SPAC’s only asset is the money raised in its own IPO.

At the time of the SPAC IPO, investors know almost nothing about the private company that the SPAC is targeting. They may know the broad sector of interest, but details beyond that are scant and the sponsor is not be obligated to pursue the target in the specified industry. The only meaningful information that investors can rely on is the reputation of the SPAC sponsor.

One reason why Pershing Square Tontine Holdings became the one of the biggest – if not the biggest – SPAC was largely due to the backing of billionaire Bill Ackman, a famous investor. Investors, familiar and confident in Bill Ackman’s tried and tested investing prowess through his hedge fund Pershing Square, had invested in droves and bid up the share price of his SPAC.

Recently, SPACs have attracted more than just famous investors as sponsors. Celebrities began to join the bandwagon. For example, Tennis star Serena Williams joined a SPAC’s (Jaws Spitfire Acquisition Corp) management team, aiding in the effort to locate an acquisition target within the consumer discretionary sector. Basketball stars Shaquille O’Neal (Forest Road Acquisition Corp II) and Stephen Curry (Dune Acquisition Corp) have also made waves becoming members of the management teams for various SPACs. Celebrity involvement increases public attention on SPACs, attracting even more retail money. This has led the SEC to issue a statement cautioning investors against making investment decisions solely based on celebrity involvement. “It is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment,” said the SEC. Due diligence is important, but might be difficult when information is scant. Given that the SPAC does not have an operating history to evaluate, reviewing the business background of SPAC management and its sponsors is utterly critical.

An investment in a SPAC is essentially a time-limited bet that the SPAC will be able to find a suitable, quality business to merge with successfully, within 24 months. As with all speculative trades, this comes with opportunity costs.

First, devoting capital to a two-year hunt for an attractive company to take public means foregoing other market opportunities during the life of the SPAC. Even though SPAC investors typically earn interest from parking their funds with a SPAC, the yields earned on relatively safe, interest-bearing instruments pales in comparison to directly owning equities. For instance, 10-year US Treasury bonds paid less than 1% in 2020, while the S&P 500 index returned some 16% over the course of the same year.

Second, there is always the risk that the hunt for a good company may not yield favourable results. For one, the SPAC may not be able to find a suitable opportunity at the end of two years. While investors will receive their capital and accrued interest upon the liquidation of the SPAC, the returns on their investment is very likely to be paltry relative to other potential investments that SPAC investors could have deployed their capital into. For those who bought shares of the SPAC in the open market after the IPO at more than the US$10 nominal price, they will face a loss.

Conversely, the SPAC may potentially locate a company to merge with, but there is always a risk that the target lacks sound fundamentals. The latter is a real risk considering the incentives built into the structure of the SPAC as it relates to the sponsor.

Essentially, the economic interests of sponsors may differ from shareholders. In terms of compensation or sweat equity for locating the acquisition and closing a deal, SPAC sponsors are typically paid 20% of the total equity raised during the SPAC IPO. This dilutes the ownership of common shareholders and does not necessarily create strong incentives for sponsors to find the best acquisition target.

Towards the end of a SPAC’s two-year lifecycle, sponsors may become impatient to close on an acquisition, and may do so without proper due diligence or without negotiating the best deal, just so that they can avoid returning capital to shareholders. In fact, the incentives are lined up such that sponsors would want to find a company quickly and get a deal done, regardless of the performance of the post-merger company.

This risk is mitigated somewhat by the ability of SPAC shareholders to vote against a merger or redeem their shares for cash if they are unhappy with the deal brought by the sponsors. But this does not necessarily fully nullify the risk.

Some SPACs have sought to address these conflicts of interests by reducing the sponsor’s percentage ownership of the total equity raised and imposing lock-up periods on sponsor shares, preventing the sponsor from vesting those shares until a certain share price is reached.

But these protections are not standard practice as yet. Widespread adoption could improve the long-term appeal and viability of SPACs as an investment opportunity. As such, it is important for retail investors to assess the specific features underlying an individual SPAC to truly understand the terms of their investment.

Too big to ignore

The boom in SPAC issuance over the past couple of years has often been cited as an example of frothy conditions or signs of irrational exuberance in financial markets, although we note interest in SPACs has somewhat dimmed since the rapid rise in long-term bond yields alongside the violent rotation out of growth stocks. Nevertheless, the sudden growth in this particular fund-raising structure has caught regulators’ attention.

As mentioned earlier, the SEC has already issued a warning to retail investors interested in ploughing funds into dubious SPACs with celebrity backing. The regulator has also opened an inquiry into the listing scheme.

Even in Singapore, SGX has launched a consultation on SPACs, with several proposals to mitigate the risks of excessive dilution for long-term investors and safeguards to ensure economic interests of both the SPAC sponsors and investors are aligned. These include a larger minimum capitalisation size for SPACs listed in Singapore, a longer timeframe – about three years – for SPACs to find an acquisition target and close a deal, making warrants undetachable from shares and limiting capital redemption rights to independent shareholders who voted against the business combination.

Ultimately, the size of the SPAC market is just too big to ignore. And with the rapid rise of retail participation, it is almost inevitable that regulators will get involved to ensure that the public is well-informed about the risks of such instruments and may well seek safeguards to protect the interests of ordinary retail investors. Until then, buyers beware.

Do your homework

There are many episodes in history when an investment craze with unclear fundamentals, turns sour and causes significant misery for investors who get caught up in the exuberance – either for fear of missing out on the latest fad or with hopes of making a quick buck. The SPAC-craze is no different.

Those putting their money into SPACS should be aware that it comes with significant risks. One of which is that a SPAC has to deploy its funds to make an acquisition within a limited timeframe, usually two years. This time pressure may result in a less-than-ideal acquisition being made, translating to poor returns for investors. Also, exuberant sentiment and strong IPO cycles may increase the likelihood that companies of questionable fundamentals, which are not ready to go public, may still do so.

As such, it is important for investors not to overinvest in SPACS or speculate excessively in them. Recall how those who had overinvested in dubious internet companies during the dot.com craze of the late 1990s, suffered sizeable losses when the bubble burst in 2000.

There is no way to be sure what a SPAC will eventually invest in, or if an acquisition will prove to be profitable. To reduce risk, investors should do as much research as possible and assess a SPAC’s management team, and their track record, as much hinges on their ability to identify good acquisition targets.

Devoting capital into the hunt for the next unicorn also involves high opportunity costs. It means foregoing owning other listed equities or other financial assets during the life of the SPAC.

Ultimately, for investors, they will have to decide if making this trade-off is worthwhile.