Is Now a Good Time to Join the SPACs Hype? | Poshaan Daryanani
How do SPACs perform? Is investing in a SPAC riskier than buying shares in an established public company? Do SPACs have higher growth potential? If you have been asking yourself these questions following the recent hype with SPACs, this article is for you.
Before we jump into the pros and cons of investing in SPACs, let us recall how they work in the first place. SPACs have a simple model: raise funds from the public markets through an IPO of the SPAC (which is a “blank check” company formed solely to raise funds), then find a company to merge with.
However, despite the simple model, we think you should be aware of the potential pitfalls of investing in a SPAC before deciding to jump on the bandwagon.
What are the potential pitfalls of being a public investor in a SPAC?
In our humble opinion, there are 4 major pitfalls that you should be aware of before you invest in a SPAC. We will explore these risks within the pre-merger and post-merger stages of the SPAC.
1) High volatility due to speculation
Share prices of pre-merger SPACs typically have high volatility as prices fluctuate according to investor speculation. As SPACs are “blank check companies” with investors buying into SPAC IPOs not knowing ahead of time which private firm will be acquired with the funds they invest, huge speculation revolve around 1) the uncertainty as to which target company the SPAC will choose to merge with and 2) when the merger will happen.
A SPAC’s volatility and trade volume spike when the acquisition target is announced, as price discovery starts to occur and the risk/return profile increases (i.e. the risk involved increases but the potential for return is high too). For instance, Churchill Capital IV (NYSE:CCIV), saw its share price rise more than six times in February, from the beginning of December solely on hopes that it would move forward with a merger with electric-vehicle builder Lucid Motors. In such situations, be wary of ‘riding the hype’, especially if the merger is still in discussion as it could fall through at any time, causing the share price to plummet significantly.
2) Sole reliance on track record of Sponsors
In the absence of any company fundamentals, some investors rely exclusively on the track records of SPAC sponsors to invest in the blank check companies. Therefore, even the share prices of SPACs that have no immediate prospects and have not even identified a potential target company can move sharply higher. For example, Chamath Palihapitiya’s Social Capital Hedosophia Holdings IV (NYSE:IPOD) saw gains of around 40% despite absolutely no news on the merger front as public investors believe in their ability to source & acquire a strong, undervalued target company. This is risky as past performance is not indicative of future results.
3) Plummeting of share prices if target company lacks strong company fundamentals
Due to stark differences in the level of scrutiny and due diligence performed on target companies of SPACs as compared to traditional IPOs, companies taken public by SPACs are raising billions of dollars based on little more than a few prototypes and a business plan.
To make things worse, companies that have gone public via SPACs have begun ditching financial forecasts made only a few months earlier at the time of their mergers. According to Wall Street Journal, this stems partly from a regulatory loophole that lets SPACs publish very optimistic financial projections. Take the acquisition of Canoo Inc. for example, which demonstrates the perils of a premature listing. Despite going public via a merger with the SPAC, Hennessy Capital Acquisition Corp IV, in late 2020, the electric-vehicle start-up has already replaced some of its top management and abandoned key parts of its strategy, all while acknowledging its financial controls weren't robust enough. Unsurprisingly, Canoo is involved in a pair of class-action lawsuits filed by investors who claim they bought the Canoo shares based on misleading information.
Increasingly, it seems that companies that choose to go public via a SPAC instead of an IPO tend to be adversely selected. The most infamous example to prove this trend is Nikola. Weeks after going public last June via its merger with a SPAC, the electric truck start-up was accused of fraud by short-sellers, resulting in the resignation of its founder and a flurry of lawsuits by shareholders, causing Nikola’s stock price to plunge 55.6%. This pattern shows that the target companies of SPACs could be adversely selected since they go through less scrutiny and investors should be extra cautious when evaluating the long-term potential of a SPAC.
4) When SPACs soar in anticipation of a deal, they can fall after the deal gets done
You may be surprised but even when target company fundamentals are solid, SPACs don't always hold their post-merger premiums. Due to the speculative nature of this asset, investors are extremely sensitive to news regarding the SPAC and often overreact. In fact, share prices could potentially plummet drastically when speculative investors decide to take profit and the price corrects to a more reasonable valuation of the merged company.
Let’s take a closer look at one of the most high-profile SPAC mergers of 2021: Churchill Capital IV (NYSE:CCIV) and its acquisition of Lucid Motors. As a highly anticipated SPAC deal, CCIV’s acquisition of Lucid Motos was rumoured and well-known for a couple of months before, unlike most SPAC deals. It was so well known that within a couple of weeks, the stock ran up to $65 from $10, the par value. When shares of the SPAC jumped above $60 per share, it made it almost impossible for the SPAC's managers to negotiate a deal that would live up to those high expectations.
Naturally, as soon as the merger was officially announced, there was more than a 50% retracement of it shares from $65 to $27 as investors rushed to take profit from the lucrative pre-merger build up. If you want a relative bargain compared to what some people paid for it, you can get one right now at about $24. This “buy the rumour, sell the news” situation is common in the SPAC scene and has left several investors disappointed.
What does the future of SPACs hold for investors?
The frenzied growth of SPACs may be curtailed by a series of high-profile collapses and lingering regulatory concerns about the structure of the investment vehicles. Our observations showed that the SPACs that were most successful were the ones which managed two main risks well: 1) Free-riding by investors and excessive dilution of long-term investors, and 2) Adverse selection of companies with poor financial fundamentals.
Thus, financial hubs are looking to protect retail SPAC investors by limiting sponsors’ ability to force approval of a deal and requiring them to hold an interest in the SPAC for a longer period after a merger. In fact, the Singapore Exchange (SGX) has recently proposed a set of rules with respect to the profits, revenues and market capitalisation requirements that SPACs must comply with before they are listed on the SGX. With tighter regulation and more scrutiny, SPACs will continue to be a highly sought-after investment structure.