The rise of SPAC boom were a significant catalyst in pushing the stock market to record highs in 2020 and early 2021. Between 2009 to 2019, there is an average of just 20 SPACs in a year. However, in 2020 alone, there was a total of 248 SPACs created. Then in 2021, in the first quarter alone, there is a total of 308 SPACs listed, raising more than US$100 billion, more than the total in the entire year of 2020. The rise of SPAC boom has taken Wall Street by storm, becoming a favourite investment class among fund managers.
US Special Purpose Acquisition Company (“SPAC”) have gained a new label as a “virtually zero-risk” investment opportunity because of its inherently investor-friendly structure with little downside. The qualifying key is that the investors can opt to redeem all of their investments back.
Influential hedge funds such as Pershing Square Capital Management of Bill Ackman, Glenview Capital Management of Larry Robbins have piled into SPACs, fuelling a boom that has proved lucrative for both their early investors and promoters. Like private equity, SPACs raise money from investors for investments into private companies. However, unlike private equity, SPACs fundraises through a public listing and use that cash to take private companies public.
Hedge funds and money managing institutions can earn profitable rewards while facing little or “no risk” if the deal goes wrong because of the unique structure of SPACs. Getting in early in the SPAC IPO is the key to such gains. Usually, the SPAC unit is offered at US$10 apiece before the listing.
The cash from the original investment is placed into a trust that invests in US treasuries. The potential to make high profits come from a unique feature in the SPAC unit – the warrants and shares split shortly after the structure starts trading. The warrant is worth a fraction of a share and added as a sweetener for the early investors. These investors can hold the warrant and redeem their investment or sell out their shares at any point in time. When the SPAC merges with a target (a process known as “de-SPAC“), the warrant convert to shares at a strike price of $11.50, usually representing a 15% premium from the original unit price.
The rise of the SPAC boom because hedge funds view SPACs as an investment with equity upside and comparably low-risk. The dissection of the unit from the shares and warrants allows hedge funds to keep a material economic interest in the de-SPAC company for almost free. In a study conducted by Michael Ohlrogge of New York University and Michael Klausner of Stanford Law School – where 47 SPACs that merged between January 2019 to June 2020 – 97% of the hedge funds redeemed or sold their shares before a deal was consummated. Few institutional investors stay after a deal announcement, preferring to redeem or realise their stake at a profit. “Gold mine” for hedge funds, said Klausner, “it’s the separation that created the trade”. On the other hand, those who stay in for a stake in the de-SPAC company bear the risks of significant dilutions from the free warrants given to the early investors and a potentially bad deal, which increasingly includes retail investors.
Before this rise of SPAC boom, the best one could expect was to redeem their cash investments with interest and pray for a good deal so that the warrants become profitable. However, recently with the surge in interests for SPACs, by selling shares in the market at a premium, the hedge funds secure even better payouts.
One recent example is KCAC, the SPAC set up by Justin Mirro, Bob Remenar of Kensington Capital and supported by operators in the automotive industry. Rumours that KCAC was close to an announcement of closing a deal with QuantumScape Corporation sent shares of KCAC up to $132. It represented a thirteen-fold increase on their investors for the early shareholders who bought in at $10. Since the deal was confirmed, KCAC took on the ticker code of QS, and the share price of the merged entity has fallen by more than half, to $30. Regardless, early backers and insiders on the SPAC were sitting on huge profits. It was a different story for the retail investors that bet on the SPAC based on hype.
A victim of their success? This is the real risk of SPACs. A whirlwind of SPAC launches has increased competition for good private companies to take public to the capital market. Also, shares in SPACs trade at a discount when the vehicle is approaching the end of its twenty-four-month deadline to find a target company. Or if the market is swamped with new launches like now.
In April 2021, SEC issued a statement on the accounting and financial reporting considerations for SPACs and accounting the warrants to liabilities measured at fair value on a company’s balance sheet. SPAC prices headed south in early March amidst increasing bond yields and a rise of SPAC boom, leaving arbitrage opportunities for hedge funds barren. Investors have to be more selective about their backing sponsors, which reduces enthusiasm when share prices in SPACs drop. Some SPACS trade at a significant discount to trust value, so there is risk in owning it. There is too huge a premium factored in, given the uncertainty at the end of the target and management’s reputation, said Falcon Edge Capital, acknowledging the risks of a booming Spac market.
Money will still go in as long as investors believe that there are returns. How about switching back to the traditional IPO, anyone?