Refuge of ‘chancers’: Spacs draw criticism from big investors

Institutional investors are distrustful of special-purpose acquisition companies (Spacs) which they say encourage immature businesses to go public too soon, and lack the due diligence associated with traditional listings.

Some fear that the runaway growth of these funding vehicles is masking patchy returns on newly purchased companies, and that “deal fever” may tempt sponsors into rash acquisitions.

Steve Russell, co-manager of the £3.6 billion ($5 billion) LF Ruffer Total Return Fund, says Spacs “tend to only occur in great number at particular points in the market cycle, when everything has gone completely crazy. Their very nature attracts chancers, spivs and speculation, as an opportunity by people to essentially fleece investors. Very few of them turn out well.”

A lengthy period of low interest rates has helped fuel the popularity of Spacs. As investors struggle to achieve higher returns elsewhere, this limits the opportunity costs of having money tied up in the vehicles.

Spacs are shell companies listed on an exchange, that are seeking acquisitions to take public. The target firm is not revealed to investors, hence the moniker “blank-cheque” companies.

Their opacity won’t suit all investors. Energy-focused Hite Hedge manages $650 million in assets, and is a Spac investor. Its co-chief investment officer Matt Niblack admits that locking up money for two years in a vehicle searching for investment may not be to the liking of asset owners or long-only managers: “Spacs do not always fit into the risk models of larger institutions.”

Spacs have a lot of money to spend right now. According to website Spac Track, there are 552 active Spacs harbouring a total of $178 billion in invested funds as of March 29. Spacs raised $83 billion in the US in 2020, and that figure has already been surpassed in the first three months of 2021.

Spacs are usually launched with an investor roadshow, and then listed on an exchange. Units, typically costing $10 and consisting of a common share and a fractional warrant, are sold and traded on the open market. The sponsor of the Spac is expected to complete a merger with a target company within two years or return the funds to investors.

If a target company is identified, additional capital is often raised through a ‘Pipe’, or private investment in public equity. If shareholders approve the merger they can keep their shares, or redeem them and receive their initial investment back plus interest, or sell them in the market.

Spacs have existed since the 1990s, and previously saw a resurgence in popularity around a decade later. Index providers including FTSE Russell and MSCI do not allow the inclusion of cash shell Spacs in their standard benchmarks, although once they have merged with another entity they may become eligible for indexes.

But institutional investors are wary of the trend for firms to gain access to public markets without going through the disclosure requirements needed for a regular IPO, or initial public offering. April LaRusse, head of specialist investment at Insight Investment, which manages £752 billion ($1 trillion) in assets, says: “We do not invest in Spacs and one of the reasons for that is the lack of visibility over the businesses that a Spac owns.”

Others resisting investment in the vehicles include German institutions Allianz Global Investors and Berenberg. Allianz says its clients are “constrained investors and cannot invest in Spacs”.

Spac investors are effectively asked to trust its founder to identify suitable companies, says LaRusse, which is not in line with Insight’s approach to risk management. She adds that Spacs are used as a way for poor quality or small companies to go public before they are ready, and notes only a quarter of the Spacs created last year have found deals so far.

The lack of visibility extends to the purchase process. Experts say privately held companies that go public via a Spac are subject to lower levels of public disclosure than through the traditional IPO route. And because many Spac target companies are early stage, often pre-revenue businesses, this makes it a challenge for investors to analyse the firms.

Alan Bickerstaff, partner at law firm Shearman & Sterling, says there is a concern for institutional investors that the level of due diligence allowed in Pipe transactions relative to an IPO is “pretty limited”.

Ups and downs

Some defend the Spac approach, but accept it can lead to smaller firms going public ahead of their time.

OTC Markets Group is a trading platform that specialises in illiquid securities including Spacs. Jason Paltrowitz, executive vice-president of corporate services at the firm, says Spacs allow companies to “dip their toe in the water on a much smaller scale towards becoming a public company”.

But he adds that investors must be aware that Spacs can pose a greater risk than a traditional publicly listed company. “The Spac process doesn’t necessarily afford investors the same amount of protection as an IPO,” he says.

A major concern is that Spac companies perform well before they do a deal and a lot less well afterwards. The newly public companies often enjoy a short-term share price ‘pop’ soon after listing, to the benefit of early-stage investors. But analysis from Barclays found that the average returns for Spac-acquired companies in the six months following acquisition is -8.3%.

According to University of Florida professor of finance Jay Ritter, in contrast to the “compelling” pre-merger performance of Spacs, their post-merger performance has been disappointing, on average underperforming the broader market by 24% in the year following the Spac deal.

Matt Harding, global equities investment manager at Aegon Asset Management, which runs more than €350 billion ($420 billion) of assets, puts it another way: investors who rush to invest in Spacs “can often get stung.”

The amount of money sloshing around looking for opportunities is problematic, Paltrowitz admits. He worries that because Spacs have a one- or two-year timeframe in which to make an acquisition, there is currently a “deal fever”. That could see some Spacs make “ridiculous punts on private companies with crazy valuations.”

“As the opportunities dry up, some Spacs could be forced into making business decisions they otherwise wouldn’t have,” Paltrowitz adds.

Celebrities have promoted some Spacs. For example, OTC Markets has listed Spac acquisitions on its OTCQX market, including Subversive Capital Acquisition Corp, which has purchased a cannabis business backed by rapper Jay-Z.

In an investor alert published on March 10, however, the US Securities & Exchange Commission said: “It is never a good idea to invest in a Spac just because someone famous sponsors or invests in it or says it is a good investment.”

The investment vehicles also raise alarm bells with some investors because of in-built incentives that favour the sponsors. Spac sponsors dilute the value of existing investors’ shareholdings because they get automatic stakes – typically 20% of the post-buyout equity.

Aegon’s Harding says investors need to be mindful of the sponsor’s share allocation: “You need to understand what your dilution is. If it is 20% you need to be comfortable with that at current valuations, in terms of your risk/reward analysis.”

Strategies do exist for early-stage investors to mitigate that risk, during the Spac fund-raising when share sales are restricted. Northern Trust’s global head of options, Jon Cherry, says investors can look to hedge their exposure during the Pipe transaction, for example.

Firms can use an options strategy known as a risk reversal, or collar, which involves selling an out-of-the-money call and buying an out-of-the-money put on the same security with the same expiry. The strategy in effect creates both a ceiling and a floor for the underlying.

An alternative strategy is a put spread, which gives less downside protection but won’t leave investors exposed to a margin call, says Cherry.

Once the deal has been announced, early investors also have the choice to cash out by redeeming their investment at $10 per share, again limiting the downside.

Waiting for the pop

The proliferation of money invested in Spacs has led to fears that the market is starting to resemble a bubble. And like all bubbles, investors are wary of the moment it bursts.

Ruffer’s Russell says: “It’s gone on a little longer than I expected. I thought it would pretty much die at the end of last year, but the opposite happened.” He thinks the bubble has in part been inflated by stimulus payments made by the US federal government and, when those payments end, investment in Spacs will be curtailed as retail investor flows peter out.

Niblack at Hite is putting a timeframe of 12 to 18 months on a potential correction in capital allocated to Spacs.

“Just because of the amount of capital that’s gone into this market, relative to the private company opportunity set, you’re going to see a series of these not work out so well,” he says.

That will play to the strengths of investors who are selective, he concludes – those that can identify the most attractive deals to bring to market in that kind of environment.

For investors that are less agile, less educated and less aware about Spacs, however, it is likely that some may lose out.

Editing by Alex Krohn