Valuentum Exclusive Analysis for the Discerning Investor

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Image: Performance of the Defiance NextGen SPAC IPO ETF (SPAK), where “a 60% weighting is applied to IPO companies derived from SPACs and 40% is allocated to common stock of newly listed Special Purpose Acquisition Companies (“SPACs”), ex-warrants” has been roughly flat since inception in October 2020.  

By Brian Nelson, CFA

What a time to be an investor…ehem, speculator!

Cryptocurrencies, non-fungible tokens (NFTs), and now the boom in Special Purchase Acquisition Companies, more commonly known as SPACs. First, the good: We like that SPACs will create more publicly listed companies to improve investor choice because the number of publicly traded companies has been dangerously shrinking in recent years…but that’s really all we like about them.

A SPAC is just an instrument that facilitates a process for a company to go public. These “blank check” companies aren’t for individual investors, in our view, and they’re really not for financial advisors either. Hedge funds might find a place for them in their portfolios, but these “shell companies” just aren’t much to get excited about.

We’d only grow interested in the operating company that is taken public by a SPAC once that operating company can be analyzed appropriately within the equity valuation context--companies that have merged with SPACs such as Virgin Galactic (SPCE), Opendoor (OPEN), and Nikola (NKLA).

Until they bring a company public, SPACs are…well…not SPAC-tacular at all. They're just speculative instruments that can come with lots of risks, and investors should be careful not to be lured into something they don’t completely understand or aren’t absolutely comfortable with.  

What Is a SPAC?

According to some estimates, there were 248 Special Purpose Acquisition Companies (SPAC) that went public in 2020, raising more than $80 billion (up sixfold from a record high set in 2019). But what is a SPAC—and why all the interest? To get started, let’s take a look at a definition from the Securities and Exchange Commission:

“SPAC” stands for special purpose acquisition company, and it is a type of blank check company. SPACs have become a popular vehicle for various transactions, including transitioning a company from a private company to a publicly traded company. Certain market participants believe that, through a SPAC transaction, a private company can become a publicly traded company with more certainty as to pricing and control over deal terms as compared to traditional initial public offerings, or IPOs.

These types of transactions, most commonly where a SPAC acquires or merges with a private company, occur after, often many months or more than a year after, the SPAC has completed its own IPO. Unlike an operating company that becomes public through a traditional IPO, however, a SPAC is a shell company when it becomes public. This means that it does not have an underlying operating business and does not have assets other than cash and limited investments, including the proceeds from the IPO.

If you invest in a SPAC at the IPO stage, you are relying on the management team that formed the SPAC, often referred to as the sponsor(s), as the SPAC looks to acquire or combine with an operating company. That acquisition or combination is known as the initial business combination. A SPAC may identify in its IPO prospectus a specific industry or business that it will target as it seeks to combine with an operating company, but it is not obligated to pursue a target in the identified industry.  

Once the SPAC has identified an initial business combination opportunity, its management negotiates with the operating company and, if approved by SPAC shareholders (if a shareholder vote is required), executes the business combination. This transaction is often structured as a reverse merger in which the operating company merges with and into the SPAC or a subsidiary of the SPAC. While there are various ways to structure the initial business combination, the combined company following the transaction is a publicly traded company and carries on the target operating company’s business. 

The obvious problem for investors in SPACs is that they won’t know which company the SPAC will buy until the management team (sponsor) announces it--and they won’t know whether the operating company that is purchased will eventually be valued by the market at a price that makes the investment worthwhile.  

It’s like rolling the dice.

A SPAC often comes with warrants, too, which means that as an owner, you attain the right to purchase more shares of stock at a certain price in the future. This may be an enticing feature, but again, investors still don’t know what company will be acquired--and whether the numbers will end up in their favor in the future.

Unlike investing in publicly-traded equities such as Coca-Cola (KO) or Procter & Gamble (PG), for example, where you can assess the existing business, its historical financials, competitive advantages, net balance sheet position, future free cash flows, and management, with a SPAC, all one can really do is assess the management team.

Should You Roll the Dice?

Let’s say you’ve been following a management team for years and you think they have expertise in the right industry or business, a SPAC may be worth a roll of the dice. For example, you might get lucky and pick a top performing SPAC such as QuantumScape (QS), DraftKings (DKNG), Iridium (IRDM), Immunivant (IMVR) or Betterware (BWMX).

But these may be long shots.

If management doesn’t find the right deal in the allotted time outlined in the prospectus (usually 18-24 months), you would get your prorated share of the pooled money back, but it’s worth noting that if the SPAC went public at $10 per share but you bought shares at $12 per share on the market, you’d only get ~$10 per share back.

However, that’s not the worst that can happen. If management destroys value by buying a subpar entity, shares could end up being worth significantly less. It just comes down to whether you know and can count on management to find the right company and one that can generate sufficient economic value.

If you think management can--and you know their expertise inside and out--SPACs could be worth a shot. But if all you are able to judge management by is what you’re reading in the prospectus--and you haven’t been tracking their every move for years--then SPACs probably aren’t for you.

That, unfortunately, is probably the case for almost all of them, in our view.

Concluding Thoughts

According to some estimates, there were 248 Special Purpose Acquisition Companies (SPAC) that went public in 2020, raising more than $80 billion (up sixfold from a record high set in 2019). SPACs reached heightened levels of excitement in early February, but the performance of the Defiance NextGen SPAC IPO ETF (SPAK) has been roughly flat since it began trading October 2020.

Most of what investors have to go on when considering a SPAC is a thorough assessment of the management team, as SPACs go public as a shell (“blank check”) company with no underlying operating business. Some forward-leaning, “out of the box” management teams may be worth rolling the dice on, but for the most part, the great many of the SPACs out there probably aren’t worth your time.

Though we like the idea of more investor choice once SPACs take operations public (and new companies are listed), we’re not getting lured into the SPAC IPO boom. It’s not our style. Even diversified exposure to the SPAK ETF doesn’t sound great. We’ll be patient and evaluate the companies SPACs bring public through traditional equity analysis to see if opportunities present themselves.  

Prudence and care, first, always.

Related: AHCO, SBE, MP, RPAY, LPRO, MCAC, PLBY, DNMR, BFLY, CCIV, PSTH, SRNGU, SKLZ, DFHT, CERAF, SSPK, SPCX

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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, and IWM. Brian Nelson's household owns shares in HON. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.