A special purpose acquisition company (SPAC) is a stock you can buy that doesn’t have an underlying business. You might think of investing in a new SPAC as being more interested in the jockey than the horse. SPACs are newly public companies that raise money—which is why they’re also known as shells or blank checks—which is then used to buy a private company, effectively taking that company public while avoiding the traditional IPO process.
SPACs went from relative obscurity in early 2020 to the financial equivalent of celebrity status in 2021, alongside short squeezes, Bitcoin, and crowdsource-sentiment algorithms underlying the buzziest exchange-traded funds. But do SPACs offer meaningful value, or are they just another risky fad?
SPAC issuance has grown dramatically in the 2020s
Source: statista, 2/26/21. 2021 data is through February.
An alternative to traditional IPOs: pay now, find out later
When you buy a SPAC, you’re essentially giving your money to the SPAC’s founder, or sponsor, without knowing exactly how the sponsor will invest it. The sponsor may be an individual or a group. Sometimes the sponsor will specify a target industry, while in other cases, the sponsor has free rein. Much of the appeal comes from retail investors’ ability to get in on the ground floor, to buy SPACs at or near the initial price, while they don’t have that opportunity in highly sought initial public offerings (IPOs).
In a typical new SPAC transaction, the investor pays $10 for a unit consisting of a share in the SPAC and a detachable warrant, which represents the right to buy shares at a specific price on a specific date. Warrant terms can vary but, in most cases, the exercise price is $11.50, which the investor must pay when delivering the warrant to obtain another share.¹ The sponsor then typically has two years from the initial investment to use the investor’s cash to buy a business. So the targeted company, instead of raising cash through an IPO, gets money that’s been previously raised by investors signing a “blank check.”
What’s good about SPACs?
Perhaps the most favorable aspect of SPACs is that investors have the right to redeem the share for $10, while keeping the warrant, if an announced deal seems unfavorable. Investors also get their money back after two years, with interest,¹ if the sponsor hasn’t acquired during that period. In this sense, SPACs behave a little like convertible bonds. Investors who buy at the initial offering price and hold to maturity are assured, barring a default, of recouping their principal, while the SPAC’s attached warrant (like the embedded option in a convertible) expires worthless in this type of scenario. It must be stressed that investors who pay more than the SPAC’s initial price are not assured of recouping their entire investment; for example, an investor who pays $12 for a SPAC unit before a deal is consummated may only count on getting back $10 (plus interest) at the end in a typical situation.
Because investors who buy a SPAC at its initial offering price get something of a free look, with interest, it shouldn’t be surprising that many of them redeem their shares either after the two-year period or just before an announced transaction is completed. Investors with long-term horizons hope that the SPAC may merge with a company on attractive terms and add value, leading to substantial returns in the subsequent months and years. But according to a study done between January 2019 and June 2020, the percentage of holders redeeming when mergers took place was 58% (mean) and 73% (median), and over a third of merging SPACs had redemption rates of over 90%.²
Dilution: the unpleasant secret of SPACs
The problem with so many redemptions is that they drain the cash initially made available to help the acquired company grow. They also mean that SPAC holders who stay with the deal find their shares backed by substantially less cash than at the initial investment. The study draws a hypothetical 100-share SPAC in which half of the holders redeem just before a merger. This becomes especially problematic because sponsors typically get 20% of the shares while paying, not the investors’ price, but just a nominal fee. In the hypothetical deal, investors initially buy 80 shares while the sponsor gets 20, so 80% of the shares are backed by cash. But after the 40-share redemption, the sponsor owns 20 of the 60 total shares, meaning that only 67% are now backed by cash.² Clearly, higher redemption rates weaken the backing further.
For successful mergers, in which the price rises significantly after the SPAC turns into an actual operating company, the originally attached warrants are likely to be exercised, typically at a price of $11.50,² well below the probable trading price of the shares in such an instance. This also causes dilution, although investors who bought initially and held may not mind that arbitrageurs are likely to buy detached warrants and hedge them by selling the stock short. But the study still finds that between sponsorship dilution, underwriting fees, and warrant exercises, in the median deal, investors and target companies share in effective costs of just over 50%.
Performance: recent history isn’t necessarily representative
There are many stories of recent big returns in SPACs, including a gain of over 150% for investors in Collier Creek’s acquisition of the well-known snack company Utz Quality Foods (both now merged to form Utz Brands).³ But in another study released in 2020, from the beginning of 2015 through September 2020, only 93 of 313 SPACs completed mergers. Despite generally favorable market conditions, the common shares of these 93 merging SPACs had an average loss of 9.6% and a median loss of 29.1%, and only 29 of the 93 had positive returns.⁴ The authors of “A Sober Look at SPACs” acknowledge that SPACs with high-quality sponsors have tended to outperform, but also that post-merger prices in their study fell on average by a third or more.
SPACs have gone from obscurity to celebrity status: Is 300-year-old history repeating itself?
According to Barron’s, “baseball executive Billy Beane of Moneyball fame, former astronaut Scott Kelly, 15-time NBA All-Star Shaquille O’Neal, and former Speaker of the House Paul Ryan have one thing in common: They are all involved in SPACs.”⁵
Students of history may be reminded of London in 1720, when “innumerable joint-stock companies (the forerunners of SPACs) started up everywhere … the Prince of Wales became governor of one company, and is said to have cleared 40,000 (pounds sterling) by his speculations.”⁶ This comes from Charles Mackay’s iconic Extraordinary Popular Delusions and the Madness of Crowds, originally published in 1841. Perhaps the most famous story, though likely apocryphal, from Mr. Mackay’s book is of a “man of genius” who convinced investors to deposit £2,000 for equity in “a company for carrying on an undertaking of great advantage, but nobody to know what it is.”⁶ The man of genius set sail after collecting the deposit and was never seen again.
Those investigating SPACs should consider their initial lack of transparency as well as the potential conflicts of interest, incentives, and compensation of SPAC sponsors. The evidence cited above has shown SPAC investing to be generally unattractive for individual investors, as SPACs have tended to underperform the market and eventually fall below their initial price. There's also risk for the target companies, which may have their acquisition rejected by SPAC shareholders.
Are SPACs worth it?
Despite the concerns mentioned here, certain SPACs may have benefits. Some are run by highly successful investors such as Bill Ackman, whose $4 billion Pershing Square Tontine Holdings has been praised as a more investor-friendly structure than most SPACs have offered, particularly by forgoing the 20% sponsor stake.⁷ And yet because of the considerable risks involved, having an experienced investor vet the target company is a critical step. But even with the most robust due diligence, the significant costs, along with the relatively blind faith associated with buying in, make SPACs inappropriate for the average investor—and speculative at best for investors deeply familiar with particular sponsors and their targets.
1 seattletimes.com, 2/8/21. 2 “A Sober Look at SPACs,” corpgov.law.harvard.edu, 11/19/20. 3 spactrack.net, 2/26/21. 4 nasdaq.com, 10/1/20. 5 barrons.com, 12/13/20. 6 Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay, 1841. 7 cnbc.com, 7/22/20.