What is a SPAC?
For those who aren't familiar with the term, a Special Purpose Acquisition Company (SPAC), also known as "Blank Cheque" or Shell Company," is a company created to raise capital and then merge with or acquire a private company. It has no operations of its own and can only generate revenue by buying an actual business.
This strucuture has many benefits for private companies who wish to go public faster. It is lower in cost and has the potential to give private companies access to industry-specific management expertise (though this is not always the case - sometimes the SPAC managers know nothing about the industry they're buying into).
On the investor side, the advantage is the perceived low risk. After buying the SPAC shares at a set price (typically $10), SPAC investors can always sell before the merger happens if they don't like the prospects.
SPAC Mania
Over 63% of companies that went public did so via a SPAC merger in 2021. This was a total of 613 SPACs compared to 968 overall public offerings and represented an increase from 55% of public offerings in 2020 (248 SPACs) and a massive jump from 2010, where just two SPACs came to market. Media outlets dubbed the boom in SPACs in 2020 to 2021 as "SPAC Mania."
Disadvantages of SPACs
SPACs also have many disadvantages, which are mainly felt by the retail investor. The three main issues are dilution of shareholder value, misaligned incentives with sponsers and the cost of the SPAC listing.
SPACs are deemed to be cheaper for the company which wants to go public, and highly profitable for the sponsor (which owns 20% of the shares), but this is only because the retail investor seems to bears the costs indirectly.
The rise and fall of SPACs
SPACs had a metoric bull run in 2020, with many SPACs popping by as much as 30% to 1,000%. However, by the first quarter of 2021, as interest rates started to rise, insiders sold off their shares and most companies that went public via SPAC turned out to be disappointing for investors, the vast majority of SPACs plummeted in price.
For example, QuantumScape (QS), a solid state battery startup, skyrocketed by a meteoric 1,000% in 2020. However, the company's share price is now down a massive 86% from it’s highs in February 2021.
A great way of tracking the overall market is via an ETF made up of SPACs called the Defiance Next Gen SPAC Derived ETF (SPAK, Financial). This ETF has shown a similar story, with an increase of 53% from October 2020 to February 2021 and then massive decline down 49% year over year.
According to Renaissance Capital's Matt Kennedy, “70% of SPAC IPOs so far this year are trading below their $10 offer price.” However, he does go on to say, “That's not to say all SPACs are bad investments, on an individual basis... we've definitely seen very competent, experienced SPAC sponsors find the good companies."
In an interview on my Investing Podcast, I interviewed an investment manager that has $16 billion in assets, and he stated that “SPACs aren’t an asset class.” This is true, but there is no doubt a strong correlation of returns as many SPACs move in lockstep.
According to a Goldman Sachs (GS, Financial) strategist, referring to the SPACs in 2020, "The median has outperformed the Russell 3000 from its IPO to deal announcement... however, in the six months after deal closure, the median SPAC underperformed the Russell 3000 by 42%."
Many SPAC’s popped on the announcement of the merger news, and then investors sold heavily - this was a common arbitrage strategy in 2020.
Why did SPACs crash?
SPACs are down in price due to two main reasons, the first being high inflation, which caused rising bond yields and a great transition from growth to value stocks. This had the side effect of lowering investors' appetites for speculative assets, and the market's hunger for speculative assets is what drove the SPAC boom in the first place. Goldman Sachs predicts seven interest rate hikes in 2022. This suspected rise in interest rates affects the value of SPACs and young growth stocks more than mature companies. This is because the value of a business is the value of its expected future cash flows, discounted back to today. As growth stocks have more of their value coming from the future, a higher discount rate means much lower valuations.
The second reason SPACs have underperformed the market substantially is due to investor redemptions, the “money back guarantee” issued to initial investors that is literally sucking cash out of the company and causing the share price to drop below what should have been their “cash floor” of $10 per share.
Will SPACs recover?
If we tackle the first reason SPACs are down, inflation, then the question of "will the share prices of SPACs recover" can be rephrased as "how long will inflation last?"
Kiplinger predicts “An inflation rate of 2.8% by the end of 2022, a decline from 2021 (7.5%) but higher than the average annual rate of 2% over the past decade.” This is actually surprisingly optimistic.
Looking at this from another angle, the Federal Reserve can raise interest rates, which can lower inflation, but this typically takes longer to produce real effects in the market. According to data from the International Journal of Central Banking, “The average transmission lag is twenty-nine months.”
Thus, it could take over 2.5 years for inflation to subside, and thus growth stocks and SPACs to rebound. However, the high redemption rate “money back guarantee” for many SPACs is a real setback and has devalued many of the companies, permanently. Combining this with the high risk and volatile nature of the small cap startup companies, I expect a tough road ahead. My prediction is a rebound, once inflation subsides, but not to the levels we saw in 2020 due to the redemptions. Morover, many of these small companies likely won't survive that long.
