Here’s how you can identify the risks as well as the opportunities in this decades-old—but newly popular—financial vehicle.
By any measure, the SPAC surge is remarkable. Special Purpose Acquisition Companies, or SPACs, raised $76 billion in equity proceeds in 2020—59% of total U.S. IPO capital raised. In the first six weeks of this year, they pulled in another $47 billion.
What accounts for this explosive rise in popularity? Should you consider SPACs as part of your overall portfolio? And how do they work, exactly? It’s a multi-part process, and some of the steps may be unfamiliar. What’s more, investors face a very wide dispersion in SPAC returns. In short, before you invest you need to identify the risks as well as the opportunities in this decades-old—but newly resurgent—financial vehicle.
SPAC’s post-COVID-19 surge
First, some basics. A SPAC, also known as a “blank check company,” is a corporation that raises money through a public offering with the intent to acquire a business or asset, generally by merger. When a SPAC initially raises funds, it has not yet identified its acquisition target (hence the phrase “blank check”). SPACs are designed to bring new companies to market much more quickly than in a typical IPO—in some cases in just a few months versus an average of around 18 months for an IPO.
The first SPAC appeared in 1993. Since then, the vehicle’s popularity has risen and fallen with equity market trends and regulation.
SPACs attracted new attention as the coronavirus pandemic, and related lockdowns, took hold in March 2020. Suddenly, IPOs looked vulnerable amid COVID-19 and a concomitant jump in market volatility. Emerging companies and venture capitalists began looking for alternative vehicles to bring companies public. And so the SPAC moved to center stage.
SPAC process and structure
How does a SPAC deal come together? First, the SPAC raises funds from investors. Typically, the goal is to acquire a business or asset through a merger, but it can also occur through a capital stock exchange, stock purchase, reorganization or asset acquisition. The SPAC then launches via an IPO. Generally, shares are initially priced at $10 with warrants attached, typically exercisable at $11.50. These warrants detach from the stock and can be traded separately after 45 days.
Once launched, the SPAC has two years to execute a transaction or liquidate and return funds to investors. In the meantime, the assets from the IPO are invested in a trust that generates interest, generally from short-term government securities. At any time during the two-year period, the share owners have the right to redeem their interest via the warrant at the IPO price plus any interest. The SPAC price may trade below the initial price (again, typically $10). When it does, it can create short-term yield opportunities for investors, who know they can redeem at the offering price.
When the SPAC identifies a merger or acquisition target, the management team creates a prospectus for the SPAC investors and seeks approval for the deal. All shareholders vote on the acquisition. Investors opposed to the deal can redeem their shares, plus interest earned, for cash while also retaining their rights and warrants. When a SPAC successfully merges, it usually takes the target company’s name.
After the SPAC IPO
Most acquisitions have a market value greater than the cash raised by the SPAC IPO. In such cases, the management team raises more cash via a private investment in a public equity vehicle, commonly known as a PIPE. At this stage, large institutional investors can commit significant investments in the deal, which is often not the case at the IPO. Historically, most deals average around 4x the IPO raise. Once the combination is complete, the SPAC winds down, its ticker changes to the acquisition target’s, and shareholders own equity in the newly floated company.
Not all SPACs are created equal—far from it. In fact, we see a significant dispersion of returns from post-merger SPACs (Exhibit). The mean 12-month return of high-quality, post-merger SPACs launched from January 2019 through June 2020 was more than 9.7% above the Russell 2000.1 However, the median return for the same group was negative 36.3%. Investors need to conduct thorough due diligence to assess a SPAC’s prospects.
The coronavirus bear market took a toll on post-merger SPAC returns, with a 12-month median return more than 36% below the Russell 2000. However, the mean return was 9.7% above the index.
SPAC risks to review
Investing in a SPAC offers several important potential benefits: easier access to the expertise of venture capital investing, downside protection via the warrant, an interest-bearing trust and a potentially uncapped upside. However, a few key risks need to be weighed.
Opportunity cost: What else could you do with the money you might invest in a SPAC? Waiting for a target acquisition may take some time and may not even occur within the prescribed two years. In 2020, deal incompletion was generally not a problem, but if equity markets are soaring during the waiting period, investors could miss out on potential gains elsewhere.
Management team: What is the quality and experience of the SPAC management team? Like any market trend, the boom in SPAC popularity has attracted a wide array of players. Choose carefully when picking a SPAC manager.
Valuation: Has the SPAC team correctly valued the target, is the PIPE significantly dilutive, and are the prospects for the target accurately and fairly represented? Unlike an IPO, a SPAC can give five-year forward projections for the target company’s prospects. IPOs are barred from making such a forecast. Some observers might see this as an advantage for SPACs, but others will wonder if the forecasts are reliable. In addition, Wall Street analysts do not issue recommendations on SPACs until after the transaction with the target business.
Potential bubble: Investors need to assess the possibility that the SPAC trend is becoming a bubble. Deal volume has been so outsized that 247 SPACs are currently looking for deals that must be completed in either 2021 or 2022, given the two-year expiration. For some, the need to find a deal is urgent. Of course, investors do not want to have the money they’ve invested sitting in cash for any longer than necessary. Some have suggested this wall of money that is looking for deals is simply unsustainable and will lead to SPACs acquiring targets at unrealistic valuations.
Could this become a systemic risk? In theory, a large amount of cash seeking a small amount of deals could lead to a scenario of seriously overvalued companies. A SPAC market collapse is possible. Today, many emerging companies are looking for investment, as evidenced by recent SPAC deal activity. However, if that demand disappears even as more retail investors participate in SPACs and levels of leverage increase overall, then the SPAC market would be increasingly vulnerable.
Should you invest?
In the current environment, investors with higher tolerance for risk, large cash holdings and well-diversified portfolios may find SPACs an attractive investment. A wider group of other investors may find opportunities too, but they’ll need to be careful and consider the risks involved. Another way to invest is through professional managers such as hedge funds. These mangers seek allocations to SPACs with strong growth potential, and also search for arbitrage opportunities where they can capitalize on market inefficiencies or dislocations driven by the unprecedented risk in activity.
As investors become more familiar with SPACs, we may see wider acceptance and adoption. But for now, SPACs are best suited for those with a clear understanding of their structure and their risks. Speak with your J.P. Morgan team to determine if this newly popular financial vehicle is right for you.
Originally published by Stephen Jury, Managing Director and Abigail Yoder, Vice President, J.P. Morgan