As ‘Blank Cheque’ companies explode in popularity, investors should be extra cautious of SPACs

No offence, but if you’ve never come across the term SPAC, you missed what was considered the hottest trend on Wall Street in 2020.

So it is time to catch up!

Traditionally, when private firms wish to go public — raise capital and list their shares on the stock market — they go through a process called an IPO, Initial Public Offering. Investment banks, in exchange for a handsome fee, help them with the process, which requires complying with regulatory requirements, due diligence and serious marketing efforts.

In recent years, however an alternative process has emerged. Instead of taking the conventional IPO path, many private companies prefer now to seek funding by being merged into a public shell company that has no operations but lots of cash. That shell company is called a SPAC — Special Purpose Acquisition Company — and it is established for the sole purpose of identifying a private firm (a “target”) and taking it public.

SPACs have tremendous momentum on Wall Street these days, and the numbers are staggering.

In 2019, 59 firms raised $13.6 billion (U.S.) using SPACs; in 2020 the number of firms increased to 248 and proceeds to $83 billion and during the first month of 2021, 82 firms have already raised $23 billion.

Some of the SPACs are organized by celebrity billionaire investors, and deals are often announced in hot sectors such as electric vehicles, renewable energy, cannabis and fintech. All of which just adds to the hype.

SPACs are appealing to private companies eager to go public but still at an early growth stage; in some cases even without any revenue. Choosing the SPAC path allows them to guarantee access to capital without the potential risk of an unsuccessful IPO.

For SPAC sponsors, the completion of a deal can be very lucrative. In one example, billionaire Alec Gores turned a $25,000 investment into $80 million in nine months. In another, former Citigroup banker, Michael Klein made $60 million on a similar size investment.

But what makes SPACs, which are often referred to as ‘Blank Check’ companies, so attractive for investors?

If you were one, here is how such an investment would have unfolded, step by step:

• You pay $10 per share to invest in a newly established SPAC. Your money, along with the money of others who bought shares, is deposited in a risk-free, trust account.
• For every 3 shares you buy, you get a bonus — the right to buy one additional share for $11.50 at some point in the future.
• Now the clock starts ticking, and the SPAC starts looking for a target company. If the SPAC fails to identify a target within 2 years, you get back your $10 per share, plus interest. If it finds one, the target is merged with the SPAC in exchange for the pool of funds in the trust account. At this point, you’d need to decide whether you wish to become a shareholder in the newly combined company. If you do, this would become a stock position like in any other company in your portfolio. If you don’t, you can request to get your $10 back, plus interest.

At first glance, SPACs look too good to be true. If you indeed buy shares at $10 apiece, this seems like the ultimate lottery ticket. You are facing significant potential upside, with no downside whatsoever.

But before you rush to buy shares of SPACs, there are a few caveats which you must consider.

• First, for small retail investors, it is extremely difficult to participate in a SPAC IPO and purchase shares at $10 apiece. In most cases, your first opportunity to buy shares is once the SPAC is listed on the market and trades above $10. It’s not uncommon SPACs will trade at hefty premiums — as high as 50 per cent even before identifying a target. So if you pay $15 a share, now you’re facing some serious downside risk as well.
• Second, most investors decide to stick to their investment after the SPAC completes the acquisition of the target firm. But recent research which analyzed the performance of 47 SPAC deals between January 2019 and June 2020, highlights poor results. Twelve months post-merger, SPACs had negative mean returns of 34.9 per cent. There are of course many success stories, mostly in the past 6 months, but the averages are lacklustre.
• Lastly, with so much money flocking to SPACs, it’s going to get harder and harder for sponsors to find high-quality companies who are ripe to go public. Goldman Sachs chief executive David Solomon raised his concern recently saying the SPAC boom is not “sustainable in the medium term.”

While in the U.S. the SPAC market is simply on fire, the scene in Canada is much calmer.

Rob Peterman, vice-president of Global Business Development at TSX, acknowledges the SPAC market is still fledgling in Canada. This is in contrast to the booming IPO market.

“2020 was a record year for IPOs in Canada, with 17 firms raising a total of about $7 billion (Cdn.),” he said in an interview earlier this week. “On the other hand, in the past 5 years, firms have raised using SPACs about $2.2 billion (CDN) in total at the TSX.”

SPACs are promoted aggressively among day traders and on internet platforms such as the now famed reddit chat room r/wallstreetbets. Before making an investment, convince yourself there are good reasons for paying more than $10 a share for a newly listed SPAC firm. And once a target is announced, do your homework and decide whether it is a solid investment which is worth sticking to. You can always claim your $10 back.

The SPAC market is too hot. And as such, it carries significant risk that investors cannot ignore.

Amir Barnea is a Montreal-based freelance contributing columnist for the Star. Reach him via email: amirbarnea.oped@gmail.com