Nicholas Jasinski - Barron's
If you wait until a blank-check company completes its merger to invest, you’ve missed the bulk or all of the deal’s upside. That’s the core finding of a recent study of SPAC—or special purpose acquisition company—returns over the past five years.
The Edge Consulting Group, a research firm that counts money managers and institutional investors as clients as well as offering a service for individual investors, looked at 115 completed SPAC mergers from 2016 to the end of 2020. They found that 65% of their stocks had declined a month after their merger closing, and 71% were down a year later.
SPACs go public as cash shells, raising money from investors in the initial public offering to later put toward a merger with an operating company. SPAC sponsors come from diverse backgrounds ranging from hedge funds and private equity, to former CEOs and entrepreneurs, to entertainers and other celebrities. They’re the ones tasked with identifying a target private company and negotiating a deal to take it public via a merger with their SPAC.
SPACs have exploded onto the scene in 2020, thanks to a flood of liquidity, a frothy market, and an insatiable appetite among investors for new public companies. 248 SPACs raised $83 billion in IPOs last year, according to SPAC Insider, and another 118 have already gone public in 2021. Companies including DraftKings (ticker: DKNG), Nikola (NKLA), QuantumScape (QS), and Virgin Galactic Holdings (SPCE) have been among the highest-profile products of SPAC mergers.
SPACs usually have two years to complete their merger, or else return their trust cash to shareholders. At the time of the SPAC’s merger, shareholders also have the option to redeem their shares for a proportionate share of the SPAC’s trust—typically $10 a share. That puts a floor on their stock prices while sponsors are searching for a deal. But in 2020’s and 2021’s red-hot SPAC market, the vast majority of issues have traded at prices comfortably higher than their trust cash. That’s a product of rock-bottom interest rates, but also speculation that a given SPAC will be the next QuantumScape or Virgin Galactic.
Like any merger, it takes a few months between the announcement of an agreement and the actual closing of the combination of the two companies. There’s always a small chance that the deal won’t end up going through, but the odds are slim. In the meantime, the SPAC’s stock is effectively a proxy for the shares in the operating company, which they’ll convert to once the merger closes.
At the deal announcement, SPAC sponsors and the target company put out a detailed presentation of the agreed-upon terms, a discussion of the company’s business, and forecasts for its future growth. Putting aside the viability of those management estimates—lofty forecasts are the norm—it’s all the information that an investor has to assess the deal and the fundamentals of the soon-to-be-public company.
The SPAC shares should move to price that in immediately, with the months-later closing of the deal essentially a formality. Given the unfailingly bullish picture painted by the company and the hot market, SPAC stocks nearly always surge in the days after their merger announcement—doubly so for those with targets in popular areas like electric vehicles, video games, or online gambling.
It means the upside for SPAC stocks happens before the deal closes. The Edge found that the majority of SPACs have positive returns in the 12, six, or three-month periods prior to the closing of their mergers.
“However, the issue with investing prior to the business combination date is that the public is not provided with many options to conduct proper due diligence during these early stages,” reads the study. “Therefore, positions prior to the business combination date consist of a large amount of uncertainty, which only increases the earlier the position. Even twelve months prior to the business combination date, 36% of SPACs lose money while incurring very high levels of uncertainty, as the management team’s record of achievement may be the only factor to consider in place of proper due diligence.”
SPAC sponsors and the company can’t knowingly lie to investors, but remarks about future growth and far-out financial targets are protected by the standard disclaimer that actual results may differ materially from forward-looking statements. The incentive is to present a rosy picture so that SPAC shareholders vote in favor of the deal and a sponsor can earn their so-called promote. That’s a portion of the merged company, typically equal to 20% of the SPAC’s shares. A SPAC stock trading above its trust value is the surest way to get shareholders to vote in favor of the merger.
Once the merger closes, the company’s fundamentals should be what drives the stock. And that reality might be more challenging than the initial forecasts presented.
For a better chance of long-term outperformance, Barron’s has recommended that investors focus on SPACs where sponsors are best aligned with shareholders. That means a smaller upfront promote, and more compensation tied to the stock’s post-merger performance. It can be an earn-out, or share grants that vest at certain levels higher than the trust value after closing.
Hedge funds that invest in SPACs have the chance to bid on IPO allocations, getting in at $10 per unit. That’s a huge advantage in today’s SPAC market, where a large majority of SPACs trade at premiums to their $10 trust values.
But the pros also tend to diversify across numerous sponsors and SPACs, and stick with past winners. Chamath Palihapitiya, Michael Klein, Chinh Chu, Alec Gores, and others are serial SPAC sponsors who have raised several vehicles and completed multiple transactions. Private-equity firms and other institutions like TPG Capital, Fortress Investment Group, or Goldman Sachs (GS) also have dedicated SPAC units.
Investors can judge them on their past SPACs’ performance both pre and post merger. Big names from outside the SPAC world like Bill Ackman, Reed Hoffman, and Softbank’s Vision Fund also have pre-merger SPACs trading at hefty premiums to their trusts. They’ve been successful investors in other areas, and the market seems to be betting that experience will translate to their SPAC efforts.
Nonetheless, investing in pre-merger-announcement SPACs involves betting on the track record and pedigree of a sponsor and management team. That’s a different process and skill set than the traditional fundamental analysis that most investors big and small rely on, and one that inherently involves some degree of speculation.