What’s a SPAC? And should I invest in one?

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ROBERT POWELL

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Many investors are salivating over the latest way to presumably great rich quick — the special-purpose acquisition company or SPAC.  

But the only folks making money on SPACs today are investment banks and sophisticated investors — not those saving for or living in retirement. And given that, as well as many other reasons, experts offer this unequivocal advice: Don’t invest in SPACs — an investment that one high profile money manager said in a recent webinar should be illegal.

So, just what the heck is SPAC? A SPAC is “corporation that raises money through (an initial) public offering to pursue a future acquisition” of a private operating company, according to Robert Huebscher, the founder and CEO of Advisor Perspectives and author of How SPACs Destroy Wealth. They are sometimes called “blank-check IPOS.” 

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The SPAC is led by a sponsor, and it has a board of directors and a management structure. And, typically, the sponsor, board and management have worked together before in the industry they intend to target for an acquisition, Huebscher said in an interview. “For the typical investor, this is not a good deal.”  

Others agree. “The less people saving for or living in retirement know about SPACs the better,” said Robert Johnson, a professor at Creighton University’s Heider College of Business. “It is my strong belief that the biggest principle that investors should follow is only investing in things they understand. If you violate that principle you can get into trouble.” 

The aforementioned money manager, by the way, was none other than Jeremy Grantham, the chief investment strategist of Grantham, Mayo, & van Otterloo. Read Jeremy Grantham: “SPACs should be illegal.” 

Here’s how it works. The investor buys the initial public offering (IPO) shares at a standard price of $10. In addition, they get rights and/or warrants that they can usually exercise at $11.50, according to Huebscher. The sponsor also receives what Huebscher described as a “misaligned” incentive: 20% of the post-IPO equity at essentially no cost, in addition to other financial kickers.  

The funds are held in trust and invested in short-term government securities and the SPAC must purchase a private operating company within two years or return the funds raised to investors. Once a transaction is announced, wrote Huebscher, the IPO investor can redeem their shares at $10 plus interest and they get to keep their rights and warrants. But if you don’t redeem your shares you’ll face the risk of dilution, said Huebscher.  

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No other entity in a SPAC transaction, he wrote, is exposed to that risk. The sponsor, redeeming shareholders, underwriters and legal counsel, private placement investors and shareholders in the target company will not suffer a certain loss through dilution. 

But what’s good for the sponsor and the private company going public — i.e., DraftKings and Nikola — isn’t always so good for the IPO investor.  

Here’s the laundry list of reasons to avoid SPACs: 

You’re flying blind 

Most times you know what you’re investing in. That’s not the case with SPACs. SPACs raise funds before they identify the company they intend to acquire, according Huebscher.  

“Essentially, you are investing in an enterprise founded to simply raise capital in order to buy another company,” said Johnson. “You can’t possibly know what you are investing in.” 

And that can create all sorts of problems if you’re trying to be prudent with your asset allocation. “SPACs are ill-defined, said Stephen Horan, a managing director with CFA Institute. 

SPACs make it difficult to allocate assets prudently 

Because investors know little about what underlying SPAC investments will be made, it makes it difficult to know how the rest of the portfolio should be structured to accommodate the investments that ultimately make up a SPAC, said Horan. 

“In addition, the underlying investment is cash until the investments are made,” he said.  “So, maintaining your asset allocation and rebalancing requires a bit more work as the SPAC makes its acquisitions.” 

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No transparency  

SPACs are not publicly traded companies, said Horan. And that means “there is less transparency and disclosure that investors of publicly traded companies enjoy,” he said. 

Others agree. Grantham noted, for instance, that SPACs escape regulatory oversight and encourage the “most obscene type of investing.”  

Risk and costly underperformers 

For his part Johnson said SPACs are one step removed from IPOs. And that means “SPACs are inherently riskier than IPOs,” he said. 

To be sure, studies have shown that the average initial public offering outperforms the broader stock market. But the average investor doesn’t get the average return in IPOs, said Johnson.  

“While the average return earned by IPOs may outpace the broader market, the average is driven by a few superior performers,” he said. “The median IPO return is lower than the broader market.” 

And complicating this, he said, is that many of the hot new issues — that is, where demand for the shares exceeds the supply of the shares — have exorbitant returns that skews the averages. 

Others, meanwhile, have demonstrated that SPACs, which accounted for about half the IPO volume in 2020 (about $80 billion from 237 IPOs), don’t perform well postmerger as a public entity. Read A Sober Look at SPACs by Michael Klausner of Stanford Law School and Michael Ohlrogge of the New York University School of Law.  

Huebscher said an IPO SPAC investor makes about 11½%, including that which they might make with warrants and rights, provided they redeem their shares. But  the typical SPAC investor who does not redeem their shares is going to suffer about a 33% loss, said Huebscher. The fact that the sponsor gets a hefty 20% stake for committing no capital is a perverse incentive that will erode at returns right away, said Huebscher. 

Another factor that lowers the potential returns is this: The fact that a SPAC has to find a company that it can acquire and buy at a cheap price is a hefty task, said Huebscher.  

Klausner and Ohlrogge also found that SPACs don’t have a lower regulatory burden than IPOs; don’t have greater price certainty when they go public than an IPO; and aren’t a “poor man’s private equity.” 

Plus, the researchers found — contrary to research by others — it’s more costly for a SPAC to go public than for an IPO. Authors posting on the Harvard Law School Forum on Corporate Governance website said SPACs allow a private company to essentially complete an IPO with an intact public shareholder base at a lower cost than a traditional IPO.  

In a recent post, Deloitte noted that SPACs have been used for decades as alternative investment vehicles but they have recently come into vogue as seasoned investors and management teams have turned to SPACs to mitigate the increased market volatility risk of traditional IPOs. 

You’re not getting access to hot IPOs and SPACs 

Odds are high too that you, the average investor, aren’t getting access to the hot IPO or SPAC deals. Indeed, many of those hot new issues are allocated to a brokerage firm’s best clients and are often unavailable to clients with lower portfolio balances, said Johnson. 

Johnson said investors would be wise to remember the Groucho Marx quote (“I refuse to join any club that would have me as a member.”) when given access to an IPO and/or SPAC and refuse to buy any IPO and/or SPAC that they can access. 

Recency bias 

Johnson also suggests that investors — when it comes to SPACs in the current environment — are suffering from behavioral finance adherents call “recency bias.” In essence, investors tend to overweight the most recent results and dismiss results further back in the future. “My contention is that investors’ recency bias is becoming even shorter and shorter in terms of longevity,” he said. “That is, investors see the bull market of the past nine months and have a strong risk appetite. They forget the pain of the sharp market correction earlier in the year.” 

Johnson’s advice to investors: Develop a more longer-term memory. “Embracing higher risk endeavors in bull markets can be hazardous to one’s wealth,” he said. 

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Exceptions to the rule 

To be fair, there are some exceptions to the rule that SPACs aren’t a good investment for retirees and preretirees. SPACs can be structured in a way that the incentives are properly in line, said Huebscher. 

And that would be Bill Ackman’s SPAC, Pershing Square Tontine

Among other things, Ackman removed the incentive for initial investors to redeem their shares and isn’t taking a 20% equity stake, said Huebscher. 

So, aside from investing in Pershing Square Tontine, are there times to consider investing in a SPAC? 

Yes, said Huebscher. But only if you’re “totally confident” that you’re getting the same deal as the hedge funds investing in the SPAC IPOI and you redeem your shares . And that, for the average investor, might be a tall order. 

“I suspect that there will be very few (investors) who will have that opportunity,” said Huebscher. “So, the simple advice is to avoid SPACs.” 

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