SPACs: the next big thing

They’re hot stuff in the US, but these investment vehicles have a mixed record

If Jay-Z, Shaquille O’Neal or Serena Williams got involved in a special purpose acquisition company (SPAC), would you? “Yes” has evidently been the answer given by retail investors in the US, where interest in SPACs has hit fever pitch.

A SPAC starts life as a listed shell company set up by founders or sponsors. It then attracts funds, which are held in trust and later used to merge with an unlisted company, effectively taking that company public. SPAC shareholders then get a stake in the newly merged public company as well as warrants to buy further shares.

The merger has to take place within the two years after the SPAC is created; if it doesn’t happen, the money has to be returned to investors. Shareholders are in the dark about what company the sponsors have their eyes on until just before the acquisition.

In short, SPACs are a fast-track vehicle for companies to go public.

“One rough way to think about SPACs is that they are a way to do tomorrow’s initial public offerings today,” as Bloomberg’s Matt Levine puts it.

While the popularity of SPACs is new, the investment vehicle is not. It was invented in 1993 by banker David Nussbaum.

SPACs have surged in popularity for a number of reasons.

They preserve capital at a time when interest rates are at rock-bottom. “Retail investors say, ‘I can park my money there and if I change my mind I can get it back,’ ” says Jun Bei Liu, a portfolio manager at Australia’s Tribeca Investment Partners.

SPACs trade like any other security – at a premium or discount. Theoretically, then, an investor could buy a pre-merged SPAC at a discount and return the shares just before merger, banking a return that may or may not be better than what you get from government bonds.

SPACs have been coined the “poor man’s private equity” because they provide everyday retail investors with exposure to the kind of investment previously reserved for the investment elite.

“Some of these investments are hard for retail investors to get their hands on, so an experienced SPAC manager can find those high-quality investments and bring them into the listed environment,” says Liu.

Who makes the money

The claim that SPACs democratise access to the IPO market might be overstated.

“The characterisation of SPACs as poor man’s private equity is off the mark,” according to a recently published paper by Michael Klausner (Stanford University), Michael Ohlrogge (New York University) and Emily Ruan (Stanford University). SPAC shareholders are overwhelmingly large funds, not retail investors.

“A SPAC typically sells shares to one set of investors in its IPO and another set of investors when it comes time to merge. Nearly all pre-merger shareholders exit at the time of the merger, either by redeeming their shares or selling them on the market. In effect, a SPAC pays IPO investors generously to get the SPAC up and running as a public company so that other investors can later buy shares once a target has been selected to bring public.”

SPACs also reward the sponsors handsomely relative to regular shareholders, and at considerably less risk.

At the point of merger, known as the “promote”, sponsors receive shares worth 25% of the proceeds from the IPO, or 20% of outstanding shares following the IPO. This proportionately dilutes the value of the shares held by other investors.

Moreover, the promote also creates misaligned interests between the sponsors and regular shareholders. The upside incentive for sponsors and shareholders are the same, but the downside incentives are not.

“If the SPAC gives up more than it receives in a merger, and the post-merger shares decline in value, the SPAC shareholders lose while the sponsor still gains,” says the paper.

“As a result, especially as the two-year life of a SPAC nears its end, and a sponsor’s options for consummating a merger narrow, the sponsor has an incentive to enter into a losing deal for SPAC investors if its alternative is to liquidate.”

SPAC results have been mixed, but Liu believes past performance isn’t a representative sample. “Most of the money hasn’t been deployed, because most investment has taken place in the last 12 months.”

At the end of the day, whether a particular SPAC makes good investment sense will depend on the fidelity of the sponsor and the due diligence they undertake when looking for a company to take public.

“Celebrity involvement in a SPAC does not mean that the investment in a particular SPAC or SPACs generally is appropriate for all investors,” reads a bulletin from the US Securities and Exchange Commission.

Whether SPACs follow the same trajectory here as they have in the US is yet to be seen. At the time of writing, the Australian Securities Exchange (ASX) was yet to give SPACs the green light.