3 Reasons To Avoid SPCX And SPACs

Summary

• SPACs are excessively risky, expensive, and underperforming blank-check companies.
• Fees are high, risks are higher, and prospective returns low.
• I see few reasons to invest in a SPAC, or in SPAC ETFs like SPCX, at the present time.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Photo by Gearstd/iStock via Getty Images

The median SPAC charges a 50% fee and saddles investors with a 65% loss after one year. Although there are exceptions, and a savvy investment manager could always outperform the median SPAC, these are disastrous figures. As such, I see no reason to invest in SPACs in general, or in a fund focusing on these, like The SPAC and New Issue ETF (NASDAQ:SPCX).

Investors considering investments in SPACs should strongly consider investing in individual SPACs after doing appropriate due diligence on both the SPAC itself and its management team and should err on the side of caution.

SPACs - Brief Overview

SPACs, special purpose acquisition vehicles, also called blank-check companies, are publicly listed companies designed solely to acquire and take public a privately held company. SPACs themselves have no operations and only cash on their balance sheets.

In the short term, investing in a SPAC means investing in a pile of cash.

In the medium term, investing in a SPAC means investing in a pre-IPO private company, think SpaceX (SPACE) or WeWork (WE). SPACs are one of the only ways that a retail investor can access these markets and companies, and so have grown in popularity in recent years.

SPAC details matter. Different SPACs have different costs, prices, terms, and prospective returns, although some trends and commonalities emerge.

If you want to know more about SPACs, Fidelity has a good guide here. SPCX itself has another good one here, although it is a bit one-sided towards SPACs.

SPACs - Negatives

SPACs have many negatives, which combine to create an effectively un-investable asset class.

I've identified four key negatives. These are as follows.

SPACs are a black box. Investing in a SPAC means investing in a pile of cash that will soon merge with a private company, but you don't know which private company that is.

Perhaps it will be the next Tesla (TSLA), an innovative, if high-risk, company that will net you +14,000% returns, vastly outpacing the market.

Data by YCharts

Data by YCharts

Perhaps it will be the next Nikola (NKLA), and you get nice videos of trucks rolling downhill, and double-digit underperformance, and counting.

Data by YCharts

Data by YCharts

You just don't know, and you generally can't know. This serves to both boost risk, perhaps you end up investing in a subpar company, and all but precludes any sort of investment thesis. If I don't know what I'm buying, I can't know if it's a good investment.

SPACs are extremely expensive. As per Fidelity, SPAC sponsors generally charge 20% of SPAC shares for their services. In effect, SPAC sponsors are charging investors a 20% fee. This is a sky-high figure, and much higher than the average IPO fee of 3%-7%.

High fees directly reduce shareholder returns. When fees are high, as is the case for SPACs, the possibility of substantial alpha or outperformance is significantly reduced. In my opinion, no investment manager can consistently generate +20% in alpha, and so SPAC fees will necessarily lead to underperformance. Shareholder losses are quite likely as well.

SPAC fees are also an incredibly negative signal. Shareholder-friendly investment managers don't charge 20% fees. Greedy ones do. In my opinion, charging these excessive fees means the relevant investment managers are placing their own personal interests ahead of their shareholders, and if they do so once they will do so again. Think of SPACs as vehicles to enrich management. Shareholder returns are purely incidental, shareholders themselves an afterthought, so expect the worst.

SPACs are inherently dilutive. SPACs generally give shares, warrants, and rights to non-investor parties, mostly sponsors, investment managers, etc. These serve to dilute existing shareholders and (retail) investors and are effectively free money for better-connected investors.

The process and math behind these warrants and resultant dilution are outside the scope of this article, but I will link to other articles and analysts who explain these issues in more depth.

Matt Levine, Bloomberg columnist, explains how SPAC dilution works here and concludes that:

Real-money investors who buy SPACs as a way to invest in an IPO-to-be-named-later are subsidizing hedge funds who buy SPACs for free money.

It isn't quite a straight transfer of wealth from long-term retail investors to hedge funds, but close enough. Some shareholders get free money, others see their holdings diluted. Retail investors are generally the latter.

The Harvard Law School Forum on Corporate Governance does the math on dilution here. It also calculates that the median SPAC has total costs, including fees, shareholder dilution, and others, of over 50%:

(Source: Harvard Law School Forum on Corporate Governance)

High fees and excessive dilution directly reduce shareholder returns and are a significant negative for SPACs and their shareholders.

As an aside, these costs and dilutive actions are somewhat hidden from investors, and difficult to calculate. This is also a significant negative and a bad sign. It shouldn't take a Harvard corporate lawyer to estimate the costs of an investment, but it does when that investment is a SPAC.

Information is never hidden for the benefit of shareholders. Fees and costs are complicated to benefit management at the expense of (retail) investors. The SEC, tasked with protecting investors, is, belatedly, taking action:

SPAC Boom Faces New SEC Threat With Accounting Crackdown

Long story short, the SEC wants to change how these warrants are accounted for in SPAC financial statements. These changes should increase cost visibility, help investors understand what it is exactly that they are buying when investing in SPACs, and ultimately reduce SPAC prices. This is a good change for the long-term viability of SPACs as an asset class.

SPAC investors generally suffer catastrophic losses. Fees and shareholder dilution are borne by someone, and that someone is (retail) investors. As per Harvard Law School:

A reasonable inference is that targets negotiated prices or share exchanges based on the cash value of SPAC shares, and that SPAC shareholders bore the cost of SPACs’ dilution.

Invest in a SPAC and you will ultimately pay a 50% fee, on average, to investment bankers. These fees ultimately result in significant losses for SPAC investors, although there is a lot of volatility, and many exceptions:

(Source: Harvard Law School Forum on Corporate Governance)

As can be seen above, after one year the average median SPAC has returns of -65%, while the mean SPAC has returns of -35%. A couple of outliers with strongly positive results explain the said difference. You would expect an asset class with +50% in costs to underperform, so these figures are not surprising.

These are very large losses, indicative of a shareholder-unfriendly, frankly inadequate corporate structure, and all but preclude the possibility of investing in the average SPAC. I wouldn't invest in an asset class with double-digit negative returns, and so wouldn't invest in SPACs.

I know of no asset class in which average and median returns are this low. J.P Morgan has data for all major asset classes going to 2006, and only commodities have posted negative returns. Losses amount to 4% per year, quite low, but not even close to SPAC losses.

(Source: J.P. Morgan Guide to the Markets)

Looking through the presentation, I see similar results for fixed income asset classes, and for equity industries/investment strategies. SPAC losses are on a class of their own.

In my opinion, the excessive fees and disastrous returns of the average SPAC mean that the vast majority of SPACs will perform disastrously in the future, and are effectively un-investable.

SPCX - Positives

I've been focusing on SPACs as an asset class as most of my issues are with the overall structure, not with SPCX itself. Still, taking a look at the fund itself is important, and there are some positives to consider.

SPCX invests in SPACs, but not indiscriminately so. The fund is actively-managed and, as per management information, the only active SPAC ETF. A properly managed SPAC fund could plausibly achieve stronger returns than the average SPAC for several key reasons.

First, is the fact that a savvy manager should be able to select SPACs which ultimately merge with strong private companies. Harvard Law has shown how high quality (HQ) SPACs outperform the broader equities market, so a focus on these should ultimately be profitable:

(Source: Harvard Law School Forum on Corporate Governance)

Second, and somewhat related to the above, is that a savvy manager should be able to select comparatively cheap SPACs. Harvard Law has calculated that the cheapest quarter of SPACs has fees that are more than 20% lower than average. Lower fees directly increase shareholder returns, a key benefit for shareholders.

(Source: Harvard Law School Forum on Corporate Governance)

Third, a savvy manager should be able to take advantage of idiosyncratic factors in SPACs to boost returns.

As an example, both Matt Levine and Harvard Law have shown that SPAC warrants are effectively free money for investors that sell these but dilutive for long-term investors. A savvy manager should be able to exercise or sell their warrants in such a way as to maximize their profits, even if doing so proves harmful for other investors, and for the SPAC market as a whole. Paraphrasing Levine:

Real-money investors who buy SPACs as a way to invest in an IPO-to-be-named-later are subsidizing ETFs who buy SPACs for free money (from warrants).

From looking at fund documentation, SPCX seems willing to sell SPAC warrants, which should boost shareholder returns moving forward.

Now, the issue with these three key benefits if that they are somewhat theoretical, and strongly dependent on management execution. A savvy SPAC manager should be able to strongly outperform the (disastrous) average returns of the said asset class, but we really don't know if SPCX's managers will. The fund is quite new and seems to be mostly moving in-line with the market, although there was a large, temporary boom in its price earlier in the year.

Data by YCharts

Data by YCharts

SPCX could, potentially, in theory, significantly outperform the average SPAC, but I see very little evidence to believe this to be likely. As such, and taking into consideration the disastrous performance of the average SPAC, I would avoid an investment in SPCX. The negatives are large and real, and any possible benefits are purely theoretical.

Conclusion

SPACs are expensive, underperforming asset classes which should be avoided. Although SPAC ETFs, including SPCX, offer certain potential benefits to investors, these don't outweigh the many negatives of their underlying asset class. As such, I see no reason to invest in SPCX at the present time.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.