SPACs: What to Know About Special Purpose Acquisition Companies

Do special purpose acquisition companies, or SPACs, have a place in your portfolio, or should you steer clear?
Jan 7, 2022

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When a house party gets a little too rowdy, it’s only a matter of time before the police take notice. And when that party’s happening down on Wall Street, it’s the Securities and Exchange Commission that gets the call.

Such appears to be the case for special purpose acquisition companies, or SPACs. But what does enhanced regulatory scrutiny mean for retail investors? Are SPACs inherently very risky products to avoid, or might there be a place for this particular asset class in your portfolio?

Here's what you need to know about them.

What is a special purpose acquisition company or SPAC?

A SPAC is a company that doesn’t actually do anything — it has no operations, which is why it's often referred to as a "blank-check" or "shell" company. It's one way for a company to become a publicly traded entity, aside from traditional initial public offerings or direct listings.

How do SPACs work?

A SPAC is formed by a management team known as the “sponsor,” which then sells shares of the company in an IPO. Investors buy the shares knowing that they’re looking ahead to the next step: finding a private company that actually does have operations.

Once the SPAC is a public company, it usually has two years to use the cash it raised to find and merge with the private “target” company. If the SPAC can’t find a target company within two years, it will be liquidated (i.e, it will have to return the money to shareholders), and the sponsors will be out the high cost of fees required to execute an IPO.

Assuming the SPAC does complete a merger, though, it takes on the operations of the target company and retains its own status as a public company. And voila, that target company effectively goes public without having to go through a lengthy, costly, regulatory-laden traditional IPO process, and the investors in the original SPAC have the opportunity to own shares in the merged company.

Why did SPACs surge?

According to SPAC Analytics, SPACs raised over $161 billion in proceeds in 2021 — more than the amount raised between 2003 and 2019 combined. Iliya Rybchin, a partner at global management consulting firm Elixirr, says that a confluence of events from the past few years likely contributed to this surge, including deregulation, excess available capital and a volatile stock market.

Plus, according to Rybchin, SPACs can be a really, really sweet deal for sponsors — and here's why.

While liquidation is certainly a risk, it's also somewhat rare. Since 2009, only about 10% of SPACs have had to liquidate. What's more, if the SPAC successfully finds and acquires a target company, the sponsors often get to own 20% of the merged company for a much lower price than the average investor would have to pay for the same equity.

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Additionally, SPACs have gained popularity with endorsements from celebrities (though the SEC has warned that doesn't make them a good investment). Rybchin says celebrity interest in SPACs is likely for two main reasons: The first is the fact that it's easy money. A celebrity can essentially convert their brand equity into actual company equity via SPACs. The second is that with an unprecedented number of options on the market, SPACs need a way to stand out from the crowd — something that comes pretty easily to celebrities.

What did the SEC do and why?

During this explosive growth period, the SEC became concerned that SPACs could be using their structure to avoid disclosing all risks to investors or boast projections that are rosier than reality.

In an April 8, 2021 statement, the regulator warned that if this was indeed happening, it raised “significant investor protection questions” and reiterated the fact that SPACs have just as much securities law liability as traditional IPOs. This comes on top of the SEC’s long-standing warning that a SPAC’s sponsors could potentially put their own interests above their investors’.

Then, on April 12, 2021, the regulator presented new accounting guidance for SPACs. And while that may sound minor, it quickly had a significant impact.

The change put added stress on accountants working on SPAC deals and led to a slowdown in the market, says Yelena Dunaevsky, managing editor of the American Bar Association’s Business Law Today and vice president of transactional insurance at insurance and consulting firm Woodruff Sawyer. And, she continues, this may be exactly what the SEC wanted, considering how big the market had become.

But the SEC’s concerns aren’t necessarily a SPAC-specific issue, says Dunaevsky.

“I think it might be overreaching to say a sufficient amount of information is not being disclosed,” she says, adding that most SPAC teams take the extensive regulatory filings and disclosures extremely seriously.

“It all comes down to the fact that the SEC is trying to protect the investors. And like in any market, there could be some bad actors that are not following the rules and are not disclosing everything they should be disclosing or are being overreaching in their projections, but that’s not new.”

In September 2021, the SEC instructed auditors to further tighten accounting guidelines for SPAC shares. And more accounting and disclosure requirements are likely as the SEC targets April 2022 for additional amendments surrounding SPACs.

Should you steer clear of SPACs?

Like all investments, investing in SPACs requires thorough due diligence. The problem is, that due diligence looks a lot different than it does for evaluating companies that actually have operations to evaluate. That’s because you’re not investing in a company that makes things or sells services — you’re investing in an idea.

According to Rybchin, a SPAC can be boiled down to a thesis about a way to create value in the future with funds raised in the present. And the best place to start your due diligence is that thesis, she says. Do you believe in or agree with the SPAC’s big idea, or is it too lofty? Additionally, you could take a close look at the SPAC management team. Do they have a strong track record of successfully finding, acquiring and growing companies, or are they new to the SPAC game?

Anish Ailawadi, global head of investment banking at Acuity Knowledge Partners, headquartered in London, also urged investors to do their homework.

“You do need to exercise proper financial diligence, which is to an extent limited in a SPAC because you don’t have commercial operations,” says Ailawadi, adding that investors need to consider their own financial situation and risk appetite before investing in SPACs.

“Exercising a bit more caution, just like you would do in an IPO, would definitely make sense,” he says.

So, if you don’t have the risk tolerance to invest in an idea that isn’t backed by any historical operational metrics, SPACs might not be for you. Likewise, if you don’t yet have a highly diversified core portfolio of stocks, bonds and cash, it may be wise to get that in place before ever considering investing in a SPAC.

Did you miss the boat on SPACs?

With SPAC headlines waning, you may be worried you missed the chance to add them to your portfolio. But if you look at the data, you may have actually dodged a bullet, not missed an opportunity.

In the short-term, SPACs are attractive. According to data compiled by Elixirr, investing in SPACs outperformed investing in the S&P 500 in the latter half of 2020, and by December, the outperformance was significant. But this is looking at the earliest stages of a SPAC — the post-IPO period. From there, the SPAC still must find a target to acquire, merge successfully and start operating as a real company. And that, Rybchin says, is where the rubber really meets the road.

“In theory, yeah, SPACs are doing well. Everyone’s like ‘yeah, you guys are gonna go buy a clothing company!’ Then in reality, they go buy that clothing company, and they can’t deliver the efficiencies, the synergies, the cost savings, the growth,” she says. “You can no longer hide behind the veil of your thesis.”

Elixirr data shows that between 2010 and 2019, average one year post-merger returns for earlier SPACs consistently underperformed the Russell 2000 index. 

“The explanation for this phenomenon is simple. Investors rush into a SPAC on the promise of big returns from famous SPAC founders,” Rybchin says. “However, we have found many of these SPAC leaders are not as hands on as they once were, do not have support to operate the acquired businesses and many of the promised benefits are never realized.”

So, if you’re kicking yourself for not buying into the SPAC hype, maybe a change of attitude is in order. It’s more likely you avoided jumping on a bubble that was bound to burst. Looking ahead to a world that isn’t dominated by SPACs, you may want to follow the tried-and-true advice of financial experts: Put your money away in highly diversified, low-cost index funds, make regular contributions through a dollar-cost averaging strategy and focus on the long-term, rather than chasing the types of investments making headlines.

Tiffany Lam-Balfour contributed to this article.

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