SPAC at Sea: Shunned by the media, opportunities are sizeable

By Davis Donley 

SPACs, or special purpose acquisition companies, have become one of the hottest trends in the financial markets as they offer a unique alternative to traditional IPOs. A SPAC is a blank check company formed solely to raise capital through an initial public offering (IPO) and acquire an existing company. After their IPO, a SPAC places the money raised in an interest-bearing trust account. Investors with expertise in a particular industry or business sector generally form SPACs and prioritize pursuing deals within their circle of competence. SPACs generally have two years to complete an acquisition or must return funds to investors. Essentially, SPACs are publicly traded companies with no commercial operations and provide retail investors with early access to privately held companies, which have historically only been available to institutional investors. 

SPACs have existed since 1993, often as a last resort for small companies to raise capital—only in the last year have they become mainstream. Before 2020, SPACs were looked upon unfavorably, often being compared to penny stocks and pump-and-dump schemes. However, SPACs have gained prominence as big-name investors from Wall Street and Silicon Valley, such as Bill Ackman and Peter Thiel, began using them as a means to take companies public. 

SPACs follow a three-stage life-cycle, which is crucial to understanding their risks. The first stage of a SPAC comes post-IPO, when the company’s only asset is $10 in cash per share. The SPAC generally trades at net asset value ($10 per share), which is a company’s total assets minus its liabilities. Thus, before a merger target is announced, the price of SPACs remains close to this $10 floor. Investors can take advantage of merger arbitrage opportunities in SPACs by purchasing shares for less than $10, as this is essentially getting cash at a discount. The second stage for a SPAC occurs when the merger is announced, and the price of shares can swing based on investor perceptions of the deal. It is common for SPACs to increase in price when a unique merger target is officially announced. While SPACs have two years to complete their merger, in 2020, merger targets were announced on average only 4 to 6 months after the SPAC’s IPO. The third stage for a SPAC occurs after the merger is completed (when the stock no longer trades as a blank check company) and the shares fluctuate based on the new company’s outlook. Post-merger, the private firm takes the SPAC’s place on the stock exchange. The SPAC ticker symbol and stock name adjust to reflect the newly traded public company. 

In 2020, 248 SPACs went public and raised a combined $83 billion, dwarfing the $12 billion total proceeds from SPACs in 2019. The incredible growth in the number of SPAC IPOs has only increased in 2021 as 298 IPOs through April raised a combined total of around $100bn. With celebrities such as A-Rod, Shaquille O'Neal, and Colin Kaepernick forming their own SPACs, investors question whether a bubble is forming. At first glance, it is easy to dismiss all SPACs as a speculative frenzy. 

Euphoria in SPACs peaked in February 2021 as investors chased young companies amidst low interest rates. As bond yields increased, SPAC prices have fallen dramatically as higher bond yields provide investors with an alternative to place their cash and means investors are less willing to pay as much for speculative, high-growth stocks. As many companies merging with SPACs have low present cash flows, the majority of which will be from future years, a rise in bond yields and the subsequent application of a higher discount rate reduces the present value of SPAC merger targets. 

Numerous news outlets proclaimed “the end of SPACs” as the high-growth companies they targeted will have much lower valuations in a higher interest rate environment. Before March 2021, speculative fervor was at its peak as numerous SPACs traded for large premiums over their net asset value ($10) with no merger target announced. While it is unlikely that SPACs without targets will return to their lofty prices, it is premature to dismiss SPACs as an investment vehicle. When purchased for $10 a share, SPACs offer an interesting asymmetric risk vs reward structure. After a merger proposal, shareholders have two options—redeem their shares for $10 plus accrued interest or hold their shares of the post-merger company for the long-term. 

SPACs incorporate numerous guardrails into their structure, which news outlets repeatedly overlook in their analysis. Because investors’ money is placed into escrow immediately—and earns a small amount of interest while waiting for a merger—the downside risk for SPACs is largely eliminated. Essentially, $10 per share acts as a SPAC’s floor because the blank check company always holds $10 worth of cash in an interest-bearing trust account. Moreover, before a merger is completed, SPAC investors can redeem their shares for $10 plus any interest accrued. In a worst-case scenario for an investor who buys a SPAC at $10, a deal never materializes and the investor fails to earn the market’s 5% to 10% return, but instead only receives interest from the trust account. Ultimately, the greatest risk for early SPAC investors is opportunity cost. However, the potential upside from a good merger candidate makes the risk seem well worth it, given that downside pre-merger is fairly protected. However, investors must take note that their shares cannot be redeemed at $10 post-merger is completed; risks post-merger are SPAC specific. 

Another advantage SPACs provide over IPOs is that they allow retail investors to purchase shares at the same time as institutions and accredited investors. In recent months, the IPO and DPO (Direct Public Offering) markets have seen Roblox and Snowflake go public, providing excellent returns for institutional investors, but not so much for retail investors. Online games company Roblox had its reference price set by the New York Stock Exchange at $45 for its direct listing. However, trading started at $70 for retail investors. Since Roblox’s DPO, retail investors who purchased on the first day of trading have not received any profits, but institutional investors experienced a quick 52% pop on their shares. Similarly, Snowflake offered excellent returns for institutional investors who could purchase it for $120 a share in its November IPO as the stock now trades at $236. However, the stock began trading for retail investors only at $235, so they have only received a minuscule gain. SPACs help even the playing field between retail and institutional investors as both can pick up shares at the net asset value of $10. SPACs function as a good alternative to IPOs in that they allow retail investors early access to private companies with high potential growth prospects.

While SPACs possess inherent guardrails mitigating downside risk before the merger, SPACs have shown poor shareholder returns post-merger due to share dilution. Researchers at Stanford University discovered that “although SPACs issue shares for roughly $10 and value their shares at $10 when they merge, by the time of the merger, the median SPAC holds cash of just $6.67 per share.” The dilution embedded in SPACs stems from three sources—warrants, founder shares, and an underwriting fee. A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed price until the expiry date. In the case of SPACs, issued warrants allow investors to buy the underlying stock of the post-merger company for $11.50 per share, with a five-year expiration date. Ultimately, when investors exercise their warrants the number of shares outstanding increases, thus making each share worth less. The second cause of dilution is that SPACs pay an underwriting fee based on IPO proceeds. 

The third cause of dilution and poor post-merger returns in SPACs is that sponsors—the investors behind the SPAC who seek out a target—compensate themselves with a “promote” consisting of shares equal to 25% of the SPAC’s IPO proceeds, or 20% of post-IPO equity. The greatest risk in SPACs over the long-term is this big sponsor “promote” which dilutes the company’s shares. The SPAC sponsor is incentivized to find any target before the SPAC deadline as their shares from this “promote” have zero cost basis and sell for pure profit. 

The massive profits SPAC sponsors receive from this “promote,” regardless of the quality of the company they merge with, led to an explosion in the number of SPACs hitting the market. Today, there remain hundreds of SPACs chasing deals of significant size in the same industries. This will inevitably mean that standards will slip and that weaker companies will be brought to market. Moreover, hundreds of SPACs competing for a limited supply of private companies means that these private companies can ask for higher valuations. The sheer number of SPACs is leading to some SPACs overpaying for their merger targets. 

Due to the risks in SPACs and the fervor from retail investors, it is easy to dismiss all SPACs as speculative investments. To be sure, many of these companies merging with SPACs will fail over the long term, as SPACs pull from venture capital, and venture capital is inherently speculative. The electric vehicle SPACs in particular appear to have lofty valuations with little to no current revenue or competitive advantages. Despite the risks inherent in SPACs such as dilution, there remain a few ways in which they offer themselves as sound investments. 

Amidst the February and March crash in SPAC prices, merger arbitrage opportunities have emerged. Pre-merger SPACs trading below their $10 net asset value are safe, risk-free investments as they can be redeemed at $10 plus accrued interest upon merger completion. Investors can think of it as purchasing a $10 bill for less than $10. Furthermore, if these SPACs trading sub-net asset value announce exciting merger targets at attractive valuations, they may increase in price. Purchasing shares of SPACs sub $10 offers 0% downside before their merger is completed as the investor can either sell them for a profit if the price increases or have their

shares redeemed. 

Overall, many companies targeted by SPACs are speculative growth stocks trading at high multiples. However, there are unique cases in which SPACs acquire high-growth companies at reasonable prices, which provide long-term shareholders excellent returns. For example, Draftkings, a popular sports betting company, went public via SPAC in April 2020 and returned 526% from its SPAC IPO price of $10. Furthermore, QuantumsScape, a Bill Gates-backed company that makes solid-state batteries, returned 395% from its SPAC IPO. 24 SPACs have been completed in 2021, and despite merger dilution and the founder “promote,” they have returned 35.2% on average from their SPAC IPO. 

The financial media tends to label all SPACs as poor investments, with a select few which prove good long-term holds. This provides opportunities for the proactive investor who is willing to do their due diligence. As renowned investor Peter Lynch famously said, "The person that turns over the most rocks wins the game.”