Yet another interesting market trend for 2020 is the surge in blank-check companies. SPACs, or Special Purpose Acquisition Companies, are a little like those claw machines at the arcade. Maybe you’ll get pick up something great, maybe you’ll get something mediocre or maybe you’ll get nothing.
The trend isn’t stopping yet. 2020 has seen a surge in SPAC creations with basketball legend Shaquille O’Neal to former Speaker Paul Ryan now involved in SPACs, how are the prospects now looking for investors?
A SPAC Primer
SPAC stands for Special Purpose Acquisition Company. The company raises funds from investors, typically around $300M to a few billion and hunts for a partner company to merge with.
From a CEO’s standpoint it can be a quick way to get to a company to market with the prospect of a bigger fund raise and potentially less complexity than the IPO process. However, importantly SPACs vary in terms of their size, implicit costs, warrant terms and many other factors. Some elements of the SPAC process are consistent, but the exact nature of every SPAC is unique.
The Emerging SPAC Trade
SPACs have historically had two attributes that have set up a potentially interesting trade. First off you can generally cash out your shares if you don’t like the deal you’re presented with. Secondly, SPACs can rally on deal announcements before they happen.
SPACs generally invest their money conservatively until a deal is found. So, if the SPAC ends up buying a company you’re not interested in, then you can cash out your shares. This typically happens at around the initial offer price. This may offer downside protection. There’s still opportunity cost, of course, maybe it takes 3 years for a deal to fail to emerge. During that time, you could have earned a better return than effectively zero. Still, maybe you haven’t lost much in this scenario either.
The Potential Rally
The second scenario is the rally when the SPAC finds an attractive merger partner. In this case, a deal is announced which the market views positively and the value of the SPAC rallies above the offer price on the prospect. Here, the investor may make money. They can cash out at that point and enjoy a potential positive return. Remember not all deal announcements are viewed positively. A SPAC can trade down if the market doesn’t receive the deal well.
As such the trade is relatively straightforward. It offers the potential for heads you win, tails you don’t lose much. Buy buying a SPAC you have upside potential if a strong merger occurs, but your downside is often capped should no deal, or a deal you don’t like occurs. The market is starting to notice this as certain SPAC share prices are bid up above the offering price before deals are announced.
As with any trade of this nature there are risks. As mentioned above we now have hundreds of SPACs hunting for companies to merge with. That explosion in SPAC supply may mean that companies can shop around and attract better terms from investors, reducing the potential upside when a merger is announced.
Second, at least theoretically speaking, not all SPACs will necessarily give your money back in all circumstances. You should read the prospectus carefully. Historically funds have generally been returned without issue, but there may be certain clauses which could prevent the return of funds such as for investors. Such as for those with very large holdings, or if investors appear to collude to block a merger. Also, as shares of SPACs that have not announced deals are bid up, creates the increasing prospect of downside should no deal emerge.
The SPAC trend has been increasingly hot for almost a year now, maybe the better companies have found partners already, and the pickings are now less attractive. It’s also of note that the trading strategy outlined above may work for shares not necessarily warrants. A warrant will generally be worthless if no deal is announced, whereas shareholders can generally get receive cash back in that scenario. Warrants potentially have more upside too of course, but with warrants you typically have far more risk in both directions.
It appears that the overall markets for SPACs may become less attractive simply because of the explosion of supply. In 2019 it was reasonable to think that with around 59 SPACs looking for deals against 119 IPOs in the U.S. for the same year, there were potential good pickings for SPACs to find deals.
In 2000 there are hundreds of SPACs searching for partners, and perhaps more coming, well ahead of the IPOs occurring in most recent years. That doesn’t eliminate opportunities for SPACs. Maybe there are a large crop of companies that are SPAC ready, but not yet ready for an IPO, and maybe international companies expand the field materially. It’s possible too that the SPAC model proves far more attractive than the IPO equivalent, given a faster timeline, less regulatory hurdles and perhaps more realistic pricing of companies compared to IPOs.
Whereas in recent months SPACs themselves have been a relatively attractive asset class, investors may now want to be more selective in which SPACs they consider. Also, much like IPO activity, a bear market could dampened SPAC enthusiasm too.