An Early Test for SPAC in 2021

investors flock to spac

The current generation of retail investors are quick to get in on emerging technologies and markets. With high valuations in traditional equity markets and stocks, consumers seek a lower-cost alternative with higher upside.

Many SPACs committed to new, up and coming industries provide a great portfolio option. These shell firms have a main purpose to merge with private startups needing capital and open to acquisition. Merging with a SPAC to go public provides a faster path with less friction and regulatory requirements for private firms.

The acquiring company gains a home for investor funds with a new investment and potential for high-growth. It’s a win-win for the SPAC and private company.

How about for investors?

SPACs are a compelling option for retail investors to get in early on companies going public. Investing in a public company that acquires high-performing startups seems straightforward. However, the space is getting crowded and the influx of SPAC with similar visions and target strategies can be difficult to maneuver. When few options for acquisition exist, a SPAC will need to return funds to investors due to lack of investment.

As with any other investment choice, homework needs to done. Not all SPACs are created equal or have the same focus. Starting with the management team, investors need to do due diligence on the soundness of the founder’s approach, experience, and company underwriting strategy. The SPAC itself has no previous revenue, performance history, and minimal financing for its own operations (seed funding). Investor funding for acquisitions is first gathered before identifying and entering into a merger agreement for a private firm. If no transactions are made during their pre-determined investment horizon, funds are returned to investors.

Target industry: It’s easy for companies to gravitate to the latest trend or emerging technology. FinTech offers a broad scope with payment/banking/investment focused private firms. Other sectors offer fewer opportunities of companies that are established. SPACs with limited focus are more likely to return investor funds due to lack of investment. Some SPAC founders maintain a general (industry-agnostic) approach based solely on predictable cash flow and strong business model.

Management: The retail investor should focus on learning about the management team, previous acquisitions, and history of market performance. Top founders have backgrounds in venture capital or banking, and success in previous roles and companies. Some established founders include Betsy Cohen, Chamath Palihapitiya, and Bill Ackman.

Sponsor Promote: Most investors may not know the management team, but they do know the celebrity participating in a fund. SPACs with high-profile names increase demand from investors. The “sponsor promote” feature increases the likelihood of skewed valuation and interest in a SPAC. Sponsors are rewarded with about a 20% share in the new firm (for as little as $25K). As the valuation of a new company increases in the millions, these small stakes become a substantial amount (based on the total equity).

A conflict of interest arises as these sponsors would benefit from further inflating company value. This may offer an unfounded level of comfort that isn’t related to acquisition strategy or target companies, which can lead to a poor investment choice. New SPAC entrants have sought to de-risk this by linking a founder’s compensation to stick performance over a multi-year time horizon. The key takeaway is to focus on the founder and their track record, and not an endorsing party.

Reporting: Private companies being targeted are not required to provide details on earnings, actual revenue earned, or completed orders. If a startup is in an emerging industry with backing from strong VCs, it may still be an eligible target for SPAC acquisition based on their acquisition strategy. There is no mandatory transparency about company stability of private firms.

For the SPAC industry itself, performance has fluctuated recently. The IPOX SPAC index (benchmark for SPAC market performance) was up above 48% for the last 12 months, but down 22% over the last month. Lackluster SPAC debuts and market saturation should be have investors take caution of a potential downward trend.

If investors can’t determine how the SPAC is structured or has performed, they should consider other investment options with increased disclosures and data.

REGULATOR RESPONSE TO SPAC GROWTH

With the high growth of SPAC and the lack of transparency for retail investors funding these entities, regulators are starting to step in. The areas of focus are celebrity endorsements, fees, and internal controls of the blank check company. The SEC’s (Securities and Exchange Commission) enforcement division began probing firms this month. Other regulatory agencies are closely monitoring this trend to protect consumers being negatively impacted due to minimal due diligence.

Top SPAC founder of Social Hedosophia Holdings Corp. III (Chamath Palihapitiya) is being investigated for issues of misleading investors in a merger with Clover Health. Under review are marketing practices and payouts to 3rd parties.

A general concern for all SPAC is insider trading — there’s a time period between the creation of these companies and when a merger takes place. During this gap, tips may be provided on potential or upcoming target companies that can sway new cash from investors before formal announcements or agreements are made.

OUTLOOK for spac in 2021

FOMO (fear of missing out) in the investment space has expanded from crypto, to hype stocks (e.g. GameStop), NFT, and SPAC. The market seems expensive to get in with well-known companies and industries now, and more retail investors are willing to take a risk on unproven and unknown options.

A downward trend in performance, public company debuts, and increased regulation may slow down the SPAC wave this year. What is clear is that available cash is at record levels (both in the private and retail investor arenas) and needs a home. Aggressive investors willing to take risky bets and losses will continue to review SPAC as a non-traditional option for their portfolio.