By Philip Lieberman, Partner & Portfolio Manager at KJ Harrison
Since the first one launched in the early 2000s, special purpose acquisition companies – SPACs, for short – have largely occupied a small niche of the financial world. That changed last year. In 2020, more than 200 SPACs listed on U.S. exchanges, representing a market value of over US$60 billion. The buzz has continued into 2021, as several high-profile SPAC deals are buzzing. Predictably, this resurgence has prompted a corresponding wave in SPAC-focused market commentary – some of it balanced, but much of it in the hand-wringing vein, highlighting all the risks that SPACs raise for investors.
In our view, however, much of the concern is overblown. While the risks are real, they are not unique, and SPACs – properly incorporated into a sound capital allocation strategy – can provide several benefits to investors.
How they work
Before we explain why, let us look at how SPACs work. A promoter or management group, called a sponsor, raises money for a company that has nothing in it – no assets, no liabilities, just a shell whose sole purpose is to buy, well, something. What it is, exactly, investors do not know; that is why SPACs are often called “blank-cheque companies.” The capital raised is placed in a low-risk, interest-bearing account, and the sponsor then goes about the business of identifying an acquisition. Typically, they have two years to do so. If they are unsuccessful, the capital is returned. But if the sponsor does find a target, the penny drops, the acquisition is announced, and investors are given a choice: convert their SPAC shares into equity in the merged company, or get their original investment back, plus interest.
It is not hard to see why SPACs have enjoyed a rebirth in the COVID-19 environment: the economic recession has lowered business valuations and created buying opportunities. As well, market volatility can be anathema to IPOs, and SPACs are providing an avenue for private equity investors and others (for instance, so-called “unicorn” companies) to take firms public while mitigating market risk.
Friend or foe?
Still, at a casual glance, this scheme might seem downright scary for investors. At initial investment, traditional valuation methods are meaningless, because the company has no assets and no operations. It is also possible that unscrupulous or incompetent sponsors could abuse shareholders, buying any old company at an inflated valuation, pocketing their fees (usually in the 20% range) and leaving investors to pick up the pieces. And there are plenty of examples of SPACs that went on to trade at a substantial discount to their issue price.
It is important to remember, however, that those same kinds of risks apply to other financial vehicles, including traditional IPOs, private equity and hedge funds. And the investor’s mitigant is the same for SPACs as for the rest: due diligence.
Do your due diligence
Of course, you cannot perform due diligence on a SPAC’s assets or operations – it doesn’t have any – but you can carefully assess the management team. What is their expertise? What is their track record? Do they have one, or are they simply a bunch of financial engineers hopping on the bandwagon? Secondly, some SPACs identify the sector they are targeting right from the start, and this provides another opportunity for risk and opportunity assessment. Finally, when the SPAC announces its acquisition, it must conform to the same level of disclosure as that applied to IPOs, making traditional valuation and due diligence feasible.
Importantly, if investors are not satisfied with the acquisition, or if exogenous factors make the exposure unattractive, they are free to walk away with their original investment plus interest. That “call option” on M&A activity is one of the primary benefits of the SPAC model. And more generally, SPACs represent competition to the traditional IPO model – and competition, in our view, is good.
Of course, markets are frothy these days, and SPACs are not immune to the risks that accompany market hype. To us, however, that noise does not amount to a reason to avoid them. Ultimately, the job of investors is to cut through the noise, weigh opportunities against risks, and decide if there is real value. The key with SPACs, as with any investment, is to do your homework.