The rise of SPACs, or Special Purpose Acquisition Vehicles, has exploded this year. In fact, the SPAC issuance for 2020 alone is greater than the previous 10 years!
So, what’s the craze about SPACs? For what it’s worth, SPACs has tended to have a bad reputation, purely from a fundamental perspective, as we will explore later.
The goal of the article is create awareness around SPACs, specifically, how to invest in SPACs, how to buy SPAC stocks, SPAC vs IPO and the various SPAC resources you can use to help your research.
What is a SPAC?
According to a post in Harvard Law School Forum, Special Purpose Acquisition Companies (SPACs) are companies formed to raise capital in an initial public offering (IPO) with the purpose of using the proceeds to acquire one or more unspecified businesses or assets to be identified after the IPO.
Commonly known as blank check companies, SPACs provide an alternative way for companies to be listed. To put in simply, a “shell” company is listed with the sole purpose of seeking to acquire an unlisted company.
This results in the combined business being listed, which is an alternative method to bring companies to the market vs the commonly known Initial Public Offering (IPO) process.
Why are SPACs so popular?
There are a few reasons that drove the rising popularity.
First, given the pandemic, traditional IPO process such as book building and roadshows are significantly more difficult, which lead to companies seeking alternatives to be listed in the public market. SPACs are one of such options.
Secondly, the concept of SPAC’s net asset value (NAV). Generally, SPACs allow public stock investors to redeem their shares close to its NAV, which essentially means that there is a lower floor in investing in SPAC. We will revisit this later.
Finally, SPACs are especially popular with concept stocks. Traditionally, these companies are pre-profit and increasingly pre-revenue companies, who are selling the visions of the companies. For example, Nikola (NKLA) was infamously one of those stocks that emerged from a SPAC that has no product or significant revenue in the near term.
More importantly, SPACs’ increasing popularity is also correlated with what
SPAC vs IPO
One of the key differences between a traditional IPO and SPAC IPO is the speed of execution. Because SPACs are created as a blank check company, financial statements and other regulatory filings are significantly simpler, hence can be prepared in a quicker fashion.
It is also worth mentioning that generally traditional IPOs receive much more investor scrutiny than SPACs.
This make sense since traditional IPO tend to already have a pre-determined business model. In contrast, a SPAC may or not may not find a deal during its lifetime, which is usually around 24 months.
Finally, up and coming pre-revenue and pre-profit companies may find it easier to raise capital via SPAC. Technically speaking, whenever a company decides to merge with a SPAC, the discussion on valuation is pre-determined by both parties.
In the case of traditional IPO, it’s typically a supply and demand issue across the entire market. It should be clear why these group of companies prefer SPACs relative to IPO.
Convincing one investor is generally easier than two!
How to invest in SPACs smartly
There are a few ways investors can gain exposure to SPACs. For simplicity, we will discuss about gaining exposure via stocks and warrants. We exclude options in this discussion for now. Our goal here is to create a framework of understanding about SPACs investing.
The key difference between investing in stocks and warrants within the SPACs world is that stocks are less risky relatively. We mentioned earlier that SPACs are usually given a 24-month window to seek a deal or business combination, or else it will be wind down.
For stock investors, there will be typically a redemption value close to the issuing price (usually $10 per share). This means there is a downside protection, as the SPAC sponsor will agree advance to buy back any outstanding stocks should a deal not crystalized.
On the other hand, should any deal not be realised and the SPAC decides to wind down, the value of warrants goes to 0.
Hence, why warrants are perceived to be a leveraged and riskier bet. Obviously, the upside is greater for warrants relative to stocks.
What to look for in SPACs
Broadly, there can be two types of SPAC investors. First, being before any business combination. And the second being after.
For investors interested in pre-deal SPACs, it’s scrolling through its prospectus to understand what type of business are they aiming for and the background of the management team.
The latter part is especially important, given pre-deal SPACs investors are essentially betting heavily on its management team. For what it’s worth, a Google search about the management team is strongly encouraged. Additionally, the management team and board’s composition tend to provide clues as to what type of company they will be looking to merge with.
For investors getting in after the deal has been announced, the focus is then shift to the analysis of the post-merger company. In general, this tend to work in favor of fundamental investors when it comes to analysing businesses.
As for most SPACs today, the post-merger company tend to include fairly subjective (sometimes overly optimistic) projections about its future revenue/profitability. Consequently, investors should be wary about this.
Pros and cons of investing in SPACs
For SPACs stocks investors, one of the most attractive part is its redemption value should the SPAC decides to unwind. In essence, this is providing downside protection, if invested early, as the redemption value is usually close to IPO price, usually ~$10.
With the current low yield environment, SPAC stocks can be attractive to some investors give this feature. This doesn’t apply to SPAC warrant investors, unfortunately.
Turning to the risk, SPAC tend to attract companies who are of higher risk and an unproven business model. While there are some successful companies (so far) such as DraftKings (DKNG) that emerged from SPACs, the case of Nikola Motors (NKLA) has definitely served as a reminder that SPAC investing is not a no brainer!
The other important consideration that investors are not talking enough is what the market terms the “promote” or founder shares. In broad terms, this is a highly lucrative structure for the sponsors/founders of SPAC.
Typically, this structure allows the sponsor to free equity equivalent to 25% of the IPO cash contributed, or 20% of the enlarged equity. Obviously, these are only vested once a deal has done.
Because the incentives are so lucrative, some may argue that SPAC sponsors would be willing to do any deal, just to get that.
This issue has definitely raised some eyebrows in the institutional investors’ space, but it’s almost non-existent in among retail investors.
Free SPAC resources
In summary, history shows that mania creates panic, which creates FOMO at the end of the day. The SPAC mania is not an exception.
At present, we observe that most SPACs lack the longer term fundamental story, but do sometimes provide the asymmetric risk return profile for short-term traders.
We find this space refreshing, as it brings a whole new host of companies that were previously only available for private investors. But, investors has to be even more cautious, now that SPACs are going (have gone) mainstream.
“Be fearful when other are greedy. Be greedy when others are fearful” – Warren Buffett