SPACs: Odds Still Favor the House, Unless You Know the Rules

With the S&P 500 posting historic returns in President Joe Biden’s first 100 days, there’s been nothing short of combustion in the U.S. stock market. Out of a crucible of fiscal and monetary stimulus, low interest rates, baby boomer money and a massive Bitcoin onslaught, a smarter and faster investor has emerged. Armed with a smartphone and connected through popular social networks like r/WallStreetbets, influencers like “Roaring Kitty” prove that investors who bet against the establishment can win big. And the hottest new method is betting on SPACs, or special purpose acquisition companies.

A picture of a series of cubes stacked up to get taller as they go to the right, with the word SPAC on them.
Source: Dmitry Demidovich/ShutterStock.com

The betting started with a slew of “gamma squeezes” like Gamestop (NYSE:GME), AMC Entertainment (NYSE:AMC), and meme stocks. Now, there’s another way to bet against the house: SPACs. But despite their populist appeal, the real winners in SPAC investing aren’t the long-term shareholders. They’re early, fast-money arbitrage players.

Here’s what you need to know. And how to trade like an insider.

Meet the Pied Piper

SPACs are “blank check companies” — shell companies listed on a stock exchange whose sole purpose is to acquire a private company and take it public without going through the traditional IPO (Initial Public Offering) process. Led by a who’s who of billionaire investors and celebrities including Bill Ackman, Shaquille O’Neal and even former House Speaker Paul Ryan, a record 248 SPAC IPOs were completed in 2020, raising $100 billion in proceeds. That’s more than 7 times the $13.6 billion raised in 2019. It’s also more money raised by SPACs in a single year since the first blank-check company was founded in 2003.

The numbers are big for a reason. SPACs weave into the Pied Piper narrative of Wall Street as corrupt and inefficient, blazing a cheaper, faster, and more certain path to the financial markets than a traditional IPO. That’s been the populist cry of Chamath Palihapitiya, whose 14 SPAC investments prove that individual investors can circumnavigate “the process of going public that is true brain damage.” Chamath’s 2021 performance has been a mixed bag.

Hits like Social Capital Hedosophia Holdings Corp V (NYSE:IPOE) and Arclight Clean Transition (NASDAQ:ACTC) are up 39% and 47% respectively this year, versus an 11% rise in the S&P 500. Underperformers like health insurer Clover Health (NASDAQ:CLOV) and Social Capital Hedosophia Holdings Corp IV (NYSE:IPOD), which has not yet announced a merger target, are down 39% and 21% year-to-date.

Give Them What They Want

Despite being potentially disruptive to the Wall Street establishment, SPACs appear well aligned with retail investors — and appeal to two key sentiment shifts. First, they offer certainty. In a more speculative market where prices swing wildly and company valuations are subjective, SPACs afford their private company targets an assured path to the capital markets.

SPAC investors are also promised certainty via a capital structure that allows them to cash out at any time. SPACs raise cash in an IPO and place the funds into an interest-bearing trust fund account — the purpose of which is to cover expenses associated with the de-SPAC transaction (the transition from empty shell company to the acquired business). They have two years to search for a target private company to merge with, and bring public. If a SPAC can’t take over another business in two years, it dissolves and returns the money to investors. To date, 361 SPACs have not announced a pending merger.

SPACs also appeal to a second sentiment shift among retail investors: a preference for early stage investing– that is, growth over value. As a result, SPACs allow investors to get in on ambitious growth names riding long-term secular trends. Examples include Momentus (NASDAQ:SRAC) in space logistics, Super Group Holdings (NYSE:SGHC) and DaftKings (NASDAQ:DKNG) in sports betting, and almost a dozen new electric vehicle SPACs. Most SPACs are long-term stories whose earnings growth and profitability are years in the future.

Who Picks up the Tab?

Given the market’s current appetite for growth, coupled with the valuation risks inherent in a public offering, it makes sense that so many nascent businesses are jumping into SPACs. But, that freedom and flexibility comes at a price. And its shareholders that are picking up the tab.

The first price SPAC investors pay-to-play: equity dilution. On the surface, SPACs look like a money-back guarantee. But, there’s value lost along the serpentine two-year route to bringing a company public. Along the way, SPACs give shares and warrants to individuals that do not contribute cash to the eventual merger. Those investors can redeem their shares for the purchase price, plus interest —plus the right to keep the warrants for free.

Fast Times With SPACs

SPACs offer these “detachable warrants” as a sweetener to attract cash from sponsors. But this structure affords those early investors another perk: a short-term arbitrage opportunity with little financial risk. The proof is in the redemptions. SPACs that merged between January 2019 and June 2020 had a redemption rate of 58%. That means the majority of sponsors and pre-merger investors chose to redeem their shares rather than participate in the merger with the target. They’re buying the IPO for the guaranteed redemption return plus free warrant option and have NO interest in the long-term performance of the de-SPAC company.

For these early pre-merger SPAC investors, redemptions are worth it — averaging 11.6% or more. But for investors viewing the post-merger SPACs as real businesses, these “free” securities dilute the value of their shares. To replace the cash lost by redemptions, SPACs raise money via a secondary offering, or PIPE (private investment in public equity), further diluting equity in the company. Some observers have cautioned against this conflict of interest. Ackman’s SPAC, Pershing Square Tontine Holdings (NYSE:PSTH), discourages fast-money action by its mandate: two-thirds of the warrants issued to shareholders are not detachable.

Rules of Play

The second price of SPAC investing — aftermarket performance — is difficult to calculate. Because a greater number of pre-deal SPACs are now hitting the market, there are more SPACs trading around their $10 redemption price. The average SPAC now trades at a 2.2% premium to its NAV (Net Asset Value). In January, 100% of SPACs were trading at their NAV.

But, with so many SPACs hovering around NAV, retail investors who want to play this space can still find opportunities.

One trick: do what the hedge funds do. Buy a basket of SPACs with relatively small downside risk and the potential for upside (if they pick the right targets). There’s a better chance that at least one finds a deal and that others move on deal chatter, offsetting the losses.

A second litmus test: look for SPACs of high-quality sponsors, which tend to produce better results, either due to less dilutive terms (e.g. lower promote fees by the parent or no warrants), or better post-merger performance from staying involved in the business. PSTH, for example, still trades at 20% above its redemption price.

There are good investments among pre-merger SPACs. My favorites are names with respected management that are still hovering around $10: Apollo Strategic Growth Capital (NYSE:APSG), Soaring Eagle Acquisition (NASDAQ:SRNGU) and Dune Acquisition (NASDAQ:DUNE). For investors that can get involved in the right names early enough, there may still be an upside opportunity in SPACs. Longer term, the jury’s still out as to whether cooling retail interest and tightening SEC regulations will close the SPAC IPO spigot. Exercise caution.

Stay tuned for more in this series, where I’ll provide an in-depth look at individual SPACs.

On the date of publication, Joanna Makris did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Joanna Makris is a Market Analyst at InvestorPlace.com. A strategic thinker and fundamental public equity investor, Joanna leverages over 20 years of experience on Wall Street covering various segments of the Technology, Media, and Telecom sectors at several global investment banks, including Mizuho Securities and Canaccord Genuity. 


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