How special purpose acquisition companies (SPACs) work, what their performance has been, and what are the ways to invest.
Topics covered include:
- How much money has been raised in SPAC initial public offerings and who are some of the better known sponsors
- What are the benefits of a SPAC acquisition compared to a traditional initial public offering
- How SPACs work from the initial IPO to the acquisition of a private company
- How have SPACs performed so poorly
- How a new SPAC ETF is structured
- An intriguing way to invest in SPACs that potentially could outperform
Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 318. It’s titled “What are SPACs, and should you invest in them?”
The Boom in SPACs
Recently on the Money For the Rest of Us Plus member forums we’ve had an ongoing discussion on SPACs. SPACs is an acronym for Special Purpose Acquisition Companies. These are non-operating publicly-listed companies, sometimes called blank check companies, whose purpose is to identify and purchase a private company, allowing that private company to be publicly listed. They are extremely popular right now.
In 2020 so far there have been over 53 billion dollars in the U.S. raised in SPAC initial public offerings, according to SPACInsider. In other words, a new special-purpose acquisition company is created; their shares are made public with the idea of eventually purchasing a private company, and helping that company go public and have publicly-traded stock that trades on a stock exchange.
If we combine the amount raised in 2019 and 2020 with, again, 53 billion dollars raised in 2020, combined, there have been more raised in SPAC IPOs since 2003. So effectively, more raised in the past two years than the prior 16 years combined.
SPACs are getting bigger. The average SPAC IPO brought in 379 million dollars in 2020, versus 231 million last year, according to SPAC Insider.
There have been a number of prominent individuals that have gotten involved in SPACs. For example, former NBA basketball legend Shaquille O’Neal, along with three former Disney executives and one of Martin Luther King Jr.’s sons are planning on launching a SPAC that targets technology and media companies. It’s a SHAQ SPAC.
Other prominent figures that have plans to lead SPACs or are already doing so are former U.S. House of Representatives Speaker Paul Ryan, and Oakland Athletics executive Billy Beane, who was featured in the film and book Moneyball. Billionaire hedge fund manager Bill Ackman raised the largest SPAC in history, 4 billion dollars, in July.
Now, when we had the discussion on the forums on SPACs, I was skeptical, and I continue to be skeptical, but having spent a number of hours researching them, they’re more complicated than I realized. And they’ve changed from where they were back in the ’80s and ’90s, where there were some fraud issues, and they just weren’t great vehicles. Things are better now, but there are still problems.
Former SEC Chairman Arthur Levitt said “I have never found any blank-check investment vehicle attractive, no matter what the reputation or what the sponsor might be…. They are the ultimate in terms of lack of transparency.”
We’ll see what he means by that because in this episode we are going to take a closer look at SPACs, how they work, what their performance has been, how to invest in them, including an intriguing way to invest in SPACs that I’m considering.
Why Do SPACs Exist
Now, why do SPACs exist? A primary reason is the reverse mergers that occur with SPAC with a publicly-traded company purchasing a private company is in some ways a simpler and easier way for private companies to become publicly-traded, compared with doing their own initial public offering. One reason—the appetite for IPOs varies.
There are sometimes when markets are more receptive to IPOs, and that’s when a lot of private companies/startup companies want to go public. Other times, no so much. With a SPAC, it’s already public, so it’s a way for a private company to become public without having to go through the roadshows and much of the paperwork and legal hassle of going public.
Another reason is often when a startup goes public and there’s an initial public offering, there’s a lock-up period for existing shareholders. It’s not necessarily great press for a newly public company to have its founders selling a lot of their shares. With a SPAC, they have the cash already raised, and it’s easier for founders and other principals of the private company to be able to liquidate more of their shares in the company.
How SPACs Work
How then do SPACs work? Well, SPACs also need to raise capital, so they do an initial public offering. It’s usually combined with one common share, plus a warrant or a fraction of a warrant. And what a warrant is—it gives the holder the right to buy more stock at a fixed price, at a later date. It’s an incentive for SPAC holders to potentially get more shares of the company once that target is identified.
The initial public offering is held for the SPAC, and at least 85% of those proceeds need to go into an escrow account for future acquisitions. In practice, it’s closer to 97% of the proceeds, with 3% held in reserve for underwriting fees for the initial public offering, operating expenses for the SPAC to cover due diligence costs, legal, accounting, etc.
Most of the money goes into this Escrow account, which is then invested in government bonds. So before the acquisition, it’s a fairly risk-free investment. Most of the time, the SPACs are issued at a IPO price of $10/share. In theory, it should stay about $10/share, because it’s just an Escrow account invested in government bonds, and shareholders of the SPAC—they don’t know what the potential acquisition target will be. In practice, we’re seeing SPACs sell for more than the IPO price, because holders believe the management team of this SPAC is going to identify a very attractive company, that will be profitable to the SPAC’s shareholders. So sometimes they can bid up the price of the SPAC. For example, that SPAC that Pershing Square (Bill Ackman’s company) came out in July is trading about 20% above its IPO price.
The SPAC sponsors have a specified period to identify a potential target. Typically, it’s about two years. And if they’re not able to identify an acquisition and close an acquisition, then the trust is liquidated, and the money in the escrow account is returned to shareholders.
If the SPAC sponsors do identify a potential target firm, then they make an announcement; it’s called the announcement date. Then the SPAC shareholders are notified that there’s a potential acquisition target. At that point, the SPAC sponsors perform additional due diligence, they negotiate the structure of the acquisition, the SEC has to review the terms of the acquisition because the private company will be made public, and then there’s a proxy vote for the shareholders of the SPAC. They are deciding on two issues—whether they approve the acquisition, or disprove it, they don’t want the SPAC to go forward with it.
The second thing that they’re voting on is whether they want to liquidate their shares in the SPAC. They have an opportunity to get out at the net asset value of the trust, which is the value held in the Escrow account divided by the number of shares outstanding.
If more than 50% of the shareholders approve the acquisition and less than 20% of the shareholders vote for liquidation, then the transaction is approved, and the target firm is listed on the stock exchange. If more than 50% approve it, but more than 20% want their money back, then the SPAC is also liquidated.
The SPACs typically target companies about two to four times the amount that they raised in the initial public offering. So the SPAC doesn’t have all the money to purchase the company. Once they have identified a target, they will bring in outside equity investors, typically from buyout firms, in what are known as PIPs (Private Investment in Public companies), and they might raise debt financing to complete the acquisition.
Downsides and Risks with SPACs
Now, one of the downsides to these acquisitions is they’re not cheap. The sponsors, the management team—they get stock worth 20% of the cash raised in the SPAC IPO. If there’s an acquisition, they effectively get 20% free stock. So there’s a dilution for the existing shareholders, and that’s one of the criticisms of SPACs—this management team gets what’s known as a promote, 20% of the SPAC, and then ultimately, 20% of the target company once it’s publicly-traded.
One of the interesting things about the Pershing Square SPAC that came out, Pershing Square Tontine Holdings—it was issued at $20/share, and there isn’t this 20% promote. Pershing Square is buying a billion dollars’ worth at the public offering price, and also has some warrants that they can get, so the dilution is about 6% according to Ackman, not the 20% of a typical SPAC.
One reason that SPACs are more attractive right now is interest rates are low. So as an investor in SPACs, we earn essentially government yields, but the opportunity cost is low because there are not necessarily higher-yielding investments that are any more attractive. And these are relatively low-risk until the acquisition is announced because it’s just invested in government bonds.
Now, there is uncertainty about what the acquisition will be, and how it will do. There are clearly some risks for SPACs. Potentially given how much money has been raised, future returns could be lower. There’s a lot of competition among the SPACs. Jay Ritter—he’s a finance professor at the University of Florida—said “The fact that there are so many SPACs out there searching for mergers certainly allows an operating company to play them off against each other.” In other words, SPACs potentially pay more for these private company acquisitions, and if you pay more for something, your potential returns in the future could be lower.
There’s also some regulatory scrutiny. SEC Chairman Jay Clayton said “One of the areas in the SPAC space I’m particularly focused on and my colleagues are particularly focused on is the incentives and compensation to the SPAC sponsors. How much of the equity do they have now? How much of the equity do they have at the time of the IPO-like transaction? What are their incentives?” Because again, most SPACs—they get 20% of the company for free. And then, there is the potential for fraud.
One of the apparently more successful SPACs this year was a company called Nikola, which makes or plans to make electric and hydrogen-powered trucks. They were bought by a SPAC and Nikola became public in June. Share price went from $10, which is what the SPAC was trading at, to $95/share. Huge jump.
In early September, General Motors announced a two-billion-dollar deal to work with Nikola to produce the Nikola Badger electric pickup truck. But two days after that deal, Hindenberg Research, a short seller, released a report claiming that Nikola faked its technological achievements, including its unveiling of its semi-truck, the Nikola One, that when it was rolling downhill, it wasn’t doing under its own propulsion. It was just rolling downhill from gravity.
The stock got crushed. It’s now selling for about $20/share. The SEC is investigating, there’s been other accusations. But that’s just one of the things with SPACs. They’re typically just buying one company, and as an investor, you get to decide whether you want to participate in that. But after the company goes public, things can happen.
Let’s take a closer look at the performance of SPACs. There are a number of interesting studies. A more recent one was by Goldman Sachs, who looked at the stock performance of 56 SPACs that have announced mergers with target companies since the start of 2018. They’ve found that SPACs tended to outperform the overall market, be it the S&P 500 or Russell 2000, by 1% to 6% in the first month to quarter following the announcement of the deal. But afterward, these SPACs tended to lag the overall market.
The Financial Times analyzed SPACs over the last few years and found that the majority of them trade below $10/share (the IPO price). There have been a few successful ones that are notable. DraftKings has done very well, Simply Good Foods has done well. But most have not.
This comprehensive study I’ve found was by Johannes Kolb and Tereza Tykvova. And they looked at the performance of SPACs that went public between 2003 and 2015. They were looking at a measure called “buy and hold abnormal returns”. They were adjusting their particular SPAC for its size and the industry it was in and then compare the long-term performance. They’ve found that most under-performed.
And they actually also compared these SPACs to initial public offerings, private companies that went public in the traditional way. They’ve found that these SPAC firms underperformed by 59% to 96% on average benchmarks. Whereas the IPOs underperform anywhere from 34% to 45%. But significant underperformance.
The longer the timeframe that passed—36 to 60 months—the worse SPACs did. Most underperformed the overall market.
One of my favorite quotes I’ve found on the underperformance of SPACs was in a Financial Times article where they wrote “The poor investment record of many SPACs is a reminder than when Wall Street pushes a new product, clever financiers invariably find a way to shift most of the risk onto ordinary investors—even if a new generation of SPAC founders believes they will avoid the problems of the past.”
This is an underperforming segment of the stock market. But more and more high-profile names are issuing SPACs because there’s a demand for them right now. Individuals want to invest in them. And if you’re sponsoring a SPAC, you believe that you have the skill to identify an attractive acquisition target, negotiate a successful acquisition price, and if you’re able to do that, you get 20% of the company for free. What a great way to profit from your influence and your name, and hopefully, your investment acumen. But even if post-IPO the company doesn’t do well, you still have made a lot of money.
How to Invest in SPACs
How then to invest in SPACs? One way is to research individual SPACs and decide which one you want to invest in. A paper by Kristi Marving, Tereza Tykvova, and Milos Vulanovic found that the SPACs that did better tended to have founders who were serial entrepreneurs. They’ve had experience running companies, bringing them to market, identifying companies. They tended to do a little better. Still, as we saw, most SPACs underperform.
There is an exchange-traded fund that just came out. It’s the Defiance NextGen SPAC Derived ETF (SPAK). It seeks to track the performance of the Indxx SPAC & NextGen IPO Index. The challenge with this—and this is from an article in Barron’s—is that the index is comprised 80% of SPACs where there’s already been a merger, so the private company is public. And we’ve seen that once the company goes public, most underperform. So only about 20% are in SPACs that haven’t made acquisitions yet.
You can invest in this ETF, but I think there’s a better way to invest in SPACs. This was identified by two academics, Tim Jenkinson and Miguel Sousa. This is a 2015 paper titled “Why SPAC investors should listen to the market.” They point out that because most SPACs trade near their IPO price up until the acquisition date, that once the acquisition is announced, the target a company identified, some SPACs will jump more in price than others. Some won’t jump very much at all, which suggests that the investors aren’t terribly receptive to the acquisition. They separated the universe of SPACs that announced acquisitions into Good, where the stock jumped in price, and Bad, where it basically languished. They’ve found that the good ones tend to do better than the bad ones.
But the idea that I liked was they modeled buying the SPAC on the first day of trading after the IPO and then selling it one week after the announcement date. So don’t wait until the SPAC acquisition has been approved, but just wait a week after the target has been announced. That’s when the due diligence is occurring, and they’re getting ready for the proxy vote, negotiating the final details. That strategy, based on their modeling, did about 12% on an equal-weighted basis, and 11% based on the value/size of the deal. So it had double-digit type returns.
The median return for the SPACs that made up that portfolio was about 7.6%. The worst lost 5.6%, and the best returned close to 300%. But it’s an interesting way because by investing in SPACs right after the IPO it’s invested in government securities, so there’s not a big risk that they’re going to fall significantly. And it’s a way to get a diversified portfolio to potential buyout candidates, without waiting around to see how they perform. You just wait for a week after the announcement date, and then sell.
Now, again, this is a 2015 paper. It could be that there’s so much appetite for SPACs right now that many more are trading above the IPO price, and then when the deal was announced, then it falls back closer to the $10/share. I don’t know. This would be an interesting experiment, to see how they do. But the bottom line is, historical, most SPACs have trailed the market, partly because they just didn’t identify the right company, or the SPAC paid too much for it, or the overall performance was weighed down by that 20% dilution because the sponsors got 20% of the company for free.
We’ll be hearing a lot more about SPACs, because more and more prominent people want to cash in on this potential free money, and everybody thinks they’re a great investor before they actually buy something. It’s afterward, to see how it does—that’s when things get a little more challenging, as we’ve seen with Nikola and some of the other newly publicly-traded SPACs, which we’ve seen most trade below the IPO price as time goes on. They just don’t do that well.
That’s our overview of Special Purpose Acquisition Companies.
Federal inquiries, allegations of sexual assault, a resignation, and billions on the line: Here’s everything you need to know about Nikola and its founder’s controversial last 5 weeks by Isabella Jibilian—Business Insider
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