The past twelve months have seen a boom in special-purpose acquisition companies also known as SPACs or blank check companies. These are companies that raise cash intending to eventually acquire private companies and bring them public via reverse merger. This differs from a traditional IPO in that they more easily allow retail investors to gain exposure to private companies and are usually cheaper and faster than a "normal" IPO.
While SPACs have boomed over the past year, they are not new and have a history stemming back to the 1980s. The current boom is the largest with at least 306 SPAC IPOs so far in 2021 making them nearly as popular as traditional IPOs. The heightened interest has led to the creation of SPAC ETFs such as NASDAQ:SPCX which invests in a broad range of larger SPACs. It has also led to increased scrutiny from the SEC regarding the legal treatment of rosy SPAC projections which cannot be made in a traditional IPO.
SPCX has not been trading for too long, though it has already had a volatile history. It has outperformed both the S&P 500 and the IPO ETF (IPO) since went public in December. However, it has slid considerably since February. See below:
Overall, the recent drop was slightly larger in the IPO ETF, but the swing may be an initial sign of trouble ahead. SPACs and IPOs had a great year last year and garnered immense investor interest which has carried into 2021. However, the opportunities which exist last year may no longer exist - at least not at reasonable prices considering voracious investor appetite.
In my view, retail investor risk perception has never been as low as it is today. This is backed up by data using TD Ameritrade's "Investor Movement Index" which tracks retail sentiment among investors and is nearly at an all-time high. In such an environment, it would likely be wise to set aside dreams of making significant short-term gains and rationally assess risks. Considering there is growing risk concentration in SPACs and concerns over a "SPAC bubble", it seems like a good time to take a deeper look at SPCX.
Understanding The Risks Facing SPACs
There are many risks of which SPAC investors may not be aware. First, like IPOs, SPAC activity has peaked before broader crashes. The previous boom in SPAC activity peaked in 2007 and led to abysmal returns over the following year. It seems that, toward the end of market cycles, investors only see high historical performance and forget risks. With so many SPACs available today, one must wonder if there will be a lack of solid reverse merger opportunities or, more likely if the immense competition for private companies will push valuations to unreasonable levels.
The second major risk facing SPACs is tied to the first - ridiculously high promotion fees for SPAC managers. Typically, SPAC sponsors take a 20% cut after the deal is made which leads to many multiple returns on the SPAC sponsor's capital. This fee is usually in the form of shares and is usually under some lock-up period so the sponsors cannot sell right away. That said, this creates agency risk between investors and sponsors in that sponsors have a huge incentive to make a deal before the maximum two-year period even if it is not great for investors. Investors can vote on these deals, but as the SEC Chief has stated, "their (SPACs) performance for most investors doesn’t match the hype."
In fact, more than half of SPACs that went public in 2015 and 2016 were trading below their offering price by 2019. Last year may have seemed likely a good year for SPAC investors with a 13.1% return during the first half of 2020, but if DraftKings (DKNG) and Nikola (NKLA) were removed then the average would have dropped to -10.5%. Of course, the "high performing" NKLA is now believed to be mired in fraudulence by many. On that note, it is widely known that SPACs allow firms to go public with far less regulatory work than traditional IPOs. Considering they pay a higher cost, we must question whether or not the "SPAC route" attracts firms that would normally bring regulatory scrutiny.
Taking a Broader View
Clearly, SPACs are a risky bet and may not be the best investment choice for many. They have the potential to deliver outsized returns if sponsors find great companies which have solid growth potential. However, it seems clear to me that the boom in SPACs is indicative of a broader issue in financial markets - too much money chasing too few investments. The current economic environment has led to a boom in personal savings and a general decline in capital expenditures. In other words, there is a lot of money that wants to be put to use and very few companies actually have use for money. Thus, investors are flocking to increasingly less productive investments.
I would consider SPACs largely unproductive considering they are largely just bank accounts with cash. However, I would lump most (but not necessarily all) cryptocurrencies and non-fungible-tokens (NFTs) into the same category. The "SPAC boom" is largely over in regards to Google search popularity. As you can see below, the decline in search volumes for "SPAC" was replaced by "NFT":
Search interest for "SPAC" peaked in February and has declined since. Unsurprisingly, this peak corresponded to the peak in SPCX which was followed by the recent correction. The boom in SPAC search was apparently replaced by NFTs which are deemed the "new gold rush" - at least for this month.
It seems every few months there is a new viral investing "boom" which often appears to end in disappointment. To me, this is merely a symptom of an imbalance between cash savings and productive demand for cash. Perhaps more importantly, the immense interconnectedness between the mainstream financial media, social media, and markets. This interconnectedness seems to cause investors' newsfeeds to concentrate on a small number of investment choices - potentially adding pressure to the blowing of bubbles.
The Bottom Line
On the surface, SPACs may seem like an attractive opportunity that allows investors to dip their toes into a burgeoning market. Indeed, there are likely many SPACs that are trading below their NAV (based on cash) or have a stellar team that can find the best strategic deals. ETFs like SPCX makes this incredibly easy by casting a wide net over these companies. However, in my view, SPCX's "big tent" approach may cause it to hold the many SPACs which, based on historical precedent, are likely to underperform the broader equity and IPO market. SPCX is actively managed which may mitigate this risk, but I personally believe personal investors are usually best doing their own due diligence.
Overall, I would strongly avoid SPCX and most SPAC deals. I believe the SPAC boom is not founded on fundamentals and is instead built upon sensationalism which is leading to too much money chasing too few attractive opportunities. Even worse is the immense fees SPAC investors face which are compounded by SPCX's higher expense ratio of nearly 1%. Add on the poor historical returns of most SPACs and the high risk of regulatory scrutiny & regulatorily patchy private firms looking for SPACs and it seems to me that SPCX is likely to decline in value over time. I am bearish on SPCX and believe this correction may develop into a larger drawdown. However, if such a drawdown caused many firms in SPCX to trade far below their NAV then I may change this view.
