2020 was a record-breaking year for SPAC stocks, with no less than 248 SPAC IPOs for the year.
This dwarfs the numbers from recent years, and looks like it’s a trend that’s set
to continue in 2021.
The excitement surrounding SPACs has also skyrocketed, as investors are jumping at the
chance to pick up shares of the private businesses they bring to market, which we’ve seen post
returns as high as triple digits following their merging.
I’m guilty of this excitement too, because if you’ve been following my channel, you
know that 3 of my latest videos covered SPAC stocks that I think have a lot of potential.
So as someone who has personally been investing in and discussing SPACs, I wanted to take
a closer look at the landscape to determine how much scrutiny and caution is needed in
this environment.
And that’s why in this video, we’re taking a closer look at the SPAC market and what
many people are calling a SPAC bubble.
To do this, we’re going to start by taking a look at how SPACs work, because their very
structure creates the primary criticisms and risks of investing into them.
We’ll also talk pros and cons, but if you’re already familiar with SPACs, feel free to
use the time stamps to jump ahead.
Then, we’re going to take a look at the current SPAC market to identify the causes
of the SPAC bubble.
After doing that, I think we’ll be able to determine what will cause the bubble to
pop and when it might happen.
Last, I’m going to share my insight on how I think investors can approach SPACs in 2021,
because ultimately, I think there is still money to be made if you look in the right
places.
So if you’re ready for this SPAC-tacular content, show me some love by clicking the
like button and be sure to stick around.
SPACs are special purpose acquisition companies, and they’re also known as blank check companies.
A SPAC itself does not have any business operations.
Instead, they’re a company that’s created with the sole purpose of acquiring a private
business and bringing it public.
So a group of investors will get together and form a SPAC, selling their shares via
an IPO to raise capital.
Once they raise capital, they’ll store it in a trust and begin seeking out target companies
to acquire.
And this is why they’re called blank check companies.
If you buy a SPAC at IPO, you don’t really know what you’ll be investing in.
You’re trusting that the SPAC sponsors will identify a business that you’ll be happy
holding stock in, but that’s not quite a guarantee.
Once formed, SPACs typically have two years to identify and execute the merger or acquisition
of a business.
If they accomplish this, the acquired business will become a publicly traded company, giving
investors an opportunity to get involved in that business.
If the SPAC does not find a target, the SPAC will dissolve and the money will be returned
to investors.
The SPAC is a unique instrument for bringing companies public, and it has both pros and
cons.
We’ll start with the pros.
First is that the SPAC process is much faster and easier than the IPO process.
With a traditional IPO, a company has to approach a bank to begin the underwriting process.
The investment bank then plays a huge role in valuing the company, even determining the
price that the new shares will be offered at.
They purchase shares from the business for this price, then turn around and launch them
publicly to other institutions and investors.
Traditionally, these banks do a lot of due diligence and the process can take several
months.
With a SPAC, a business can go public in just a few months.
Instead of a bank doing the underwriting, due diligence and valuation, it’s all up
to the SPAC sponsors and the business they’re acquiring.
Of course, this does have its cons, which we’ll discuss shortly.
Another benefit of the SPAC process is that it allows common investors to get into a business
without having to overpay after an IPO.
With IPOs, shares are first sold to institutional investors, making it impossible for the retail
investor to secure shares at the announced IPO price.
When demand for these IPO stocks is high, you see the price skyrocket when they begin
trading, forcing us to overpay.
We saw this happen a few months ago with Air BNB, which IPO’d at $68.
But by the time retail investors were able to trade it, they were paying over $140.
With a SPAC, you can buy the stock before an acquisition is announced, then enjoy ownership
of the newly-acquired business at the same time as anyone else.
Next, SPACs have limited risk for early investors.
If you invest in a SPAC before they announce and complete an acquisition, you have the
ability to vote on the acquisition of that business.
If you like the business in question, you can hold onto your shares and continue the
ride.
If you don’t you can back out and redeem your shares for what you originally paid for
them plus any interest that accrued over time.
You get all your money back, with the opportunity cost of missing out elsewhere being the only
downside.
The last benefit I want to highlight is the potential involvement of a great group of
sponsors in a SPAC.
Again, the SPAC sponsors will be responsible for selecting the business, and many SPACs
create a team focused on a certain industry in which they have a lot of expertise.
So theoretically, if you can identify a good SPAC team, you can trust that they’ll be
knowledgeable and profitable when they select a company to acquire.
The SPAC sponsors may also continue a relationship with the acquired business, offering guidance,
leadership and even management to help continue growing the company.
But let’s talk about the other side of things, because the cons that come with the SPAC process
explain some of their biggest criticisms.
The first and biggest con to consider is that the SPAC process heavily incentivizes sponsors
to find a deal, which can lead to a couple problems for investors.
Traditionally, SPAC sponsors are given 20% ownership in their acquired business via stock,
with little to no investment of their own up-front.
This is known as a “promote”.
So simply by forming a SPAC, raising capital and acquiring a business, they get a nice
take-home of 20% of their agreed-upon deal.
A research paper posted on the Harvard website points out that this dilutes the shares and
hurts the average investor.
Keep in mind that SPACs typically IPO at $10 per share, which is equal to the $10 in cash
that an investor pays per share to get involved.
But according to this study, after the payout to SPAC sponsors and the refund that’s given
to investors who are no longer interested, the average SPAC leaves an investor with a
share that is backed by only $6.67 worth of cash, or just two-thirds of the money they
initially invested.
Now this number does vary depending on the SPAC, but it’s important to recognize how
much these sponsors are profiting from a SPAC, and the risks it brings.
For starters, this “promote” encourages sponsors to make a deal no matter what.
They’ll earn that 20% regardless of the company they bring public.
So while they can definitely make more money by holding these shares and growing a young,
profitable company, there’s still the easy and shady option of making a deal just to
get that payout.
And this incentive structure combined with the SPAC process makes it easy for SPAC sponsors
to profit while bringing a bad business public.
The SPAC sponsors may not hold themselves to the same standards of an investment bank
underwriter when negotiating with an acquisition company.
This means that SPAC sponsors may overlook or ignore bad qualities of a business to get
a deal done and get paid.
Similarly, the traditional two-year time-limit for identifying an acquisition pressures the
sponsors to take any deal they can get if they’re approaching that deadline.
Again, they’ll get paid just for getting a deal done, so they may rather bring a losing
company public than return investors’ money.
So while SPACs do have their benefits, the biggest criticism of these vehicles is that
they reward sponsors for doing next to nothing, which comes at the expense of the investor.
Despite these unavoidable costs, though, investors have been eager to invest into SPACs, which
is reflected in the massive increase in SPAC IPOs we’ve seen over the last year.
They’re becoming more frequent and more expensive, with over 80 billion dollars raised
in 2020, and about 24 billion so far in 2021.
There’s no denying that’s a pretty drastic increase from previous years, and that’s
why so many people are calling this a SPAC bubble.
And there’s two big factors that continue to push this bubble even further.
The first is that SPACs are an efficient way to bring companies to the market.
Companies don’t have to jump through hoops for an IPO, making the process faster and
cheaper.
SPACs might also be the only option for businesses that are deemed too risky for the IPO process.
Additionally, IPOing during a volatile time in the market can be risky, because overall
market sentiment can affect a company’s valuation.
SPACs provide a smoother road to going public, with a more certain valuation for the business,
especially these days.
The second factor, of course, is the excitement surrounding the potential returns of SPACs.
We’ve seen recent SPACs deliver insane returns, especially those involved with electric vehicles.
Nikola was one of the first ones, which ran from 10 dollars up to over 70 dollars surrounding
its merger.
More recently, we’ve seen businesses like ChargePoint, EVGo and Lucid Motors making
headlines for SPAC mergers, all of which have seen huge returns based on pure rumors.
As more of these happen, it’s no wonder that investors continue to look to SPACs to
snag some quick and lofty returns.
These two factors are keeping the SPAC bubble growing, and many experts expect that trend
to continue.
The question is, what will cause the SPAC bubble to pop, and when will it happen?
The main problem we need to be aware of with SPACs is that more money flowing into SPACs
means that more money is being invested into bad companies - and this will be the eventual
cause of the SPAC bubble popping.
This is because continued excitement around SPACs means more SPAC IPOs.
As long as investors are excited about putting their money into them, there are easy profits
to be made for SPAC sponsors.
And as the number of SPACs increase, finding a good business to bring public becomes harder
and harder.
Each business that gets acquired is one less for other SPACs to consider in their search.
Unfortunately, as we know, SPAC sponsors are highly incentivized to make deals and bring
a company public.
No acquisition means no payday.
So I think SPACs will begin targeting increasingly risky and shady businesses to get these deals
done, simply because of a decreasing supply of truly great businesses and their desire
to secure a “promote”.
The scary thing is, some SPAC acquisitions won’t show enough transparency for investors
to know whether the underlying company will actually be a good long-term investment.
Even if they do show transparency, it can still be hard to tell because some of these
companies are in their infancy.
And I think we’ll begin to see the bubble pop when the true potential of these companies
come to light in the months following their acquisition.
Nikola, for example, seemed like a great opportunity until all sorts of fraud accusations came
out last September.
The company had to admit they’d been lying about their electric vehicle functionality
for years, which probably came as a surprise to most investors.
Understandably, the stock dropped quite a bit.
Another example is QuantumScape.
QuantumScape has no finished products, and doesn’t plan to bring in any revenue until
2024.
Investors poured into this stock after its merger, knowing that it could be years before
the company makes any significant traction.
This is a fairly high-risk SPAC investment that has yet to prove itself.
I’m not saying there’s anything shady going on here, but with nothing more than
projections to go off of, it wouldn’t be a shock if it failed to produce competitive
returns over the next few years.
And as we see more businesses fail to shine following their SPAC merger, investors will
gradually become disillusioned with the SPAC market.
In other words, the excitement of buying SPACs will die down when investors realize that
the businesses they’re bringing public aren’t really all that great.
The massive increase in SPAC IPOs is going to accelerate this issue, because like I said,
more SPACs means more mediocre businesses are being brought public.
So when will this happen then?
I’m going to base my estimate on the two-year timeframe that SPACs have to acquire a company.
With over 200 SPAC IPOs in 2020, I’m assuming we’re going to see a LOT of acquisitions
in the next two years.
I imagine most of the disillusionment from these deals will come in the months after,
so we might actually have a year or two before SPACs begin to disappoint and investors rush
out of the SPAC market.
And that means it’s very likely that there’s still some good days ahead for SPACs.
So let’s take a look at how we can invest in SPACs and protect ourselves from the potential
SPAC bubble pop.
We have to remember that the downfall of SPACs is most likely going to be an effect of poor
businesses being brought public, which leave investors with poor returns.
Although, some of these electric vehicle-focused SPACs could get hurt if we’re in an EV bubble,
but that’s a topic for another video.
Anyways, the SPACs that bring verifiably good businesses to market will likely persist through
a SPAC bubble and continue to deliver good returns for investors.
So the key to success in SPAC investing will be to dig as deep as you can into both SPACs
and their acquisition targets.
We’ve talked plenty about the incentives that SPAC sponsors have to get deals done,
so they’re obviously a good place to start.
If you can determine their experience or track record, it might indicate whether they’re
a good team to trust in identifying a good acquisition.
You can also look into the sponsor’s commitment to holding shares or what they’re getting
out of the deal themselves.
For example, Pershing Square Holdings sponsored a SPAC in mid-2020 that cut the 20% promote
to just 6.25% by not taking any shares themselves.
This is a huge indicator that the sponsor is actually interested in earning returns
for investors, and not just making a quick deal for themselves.
I suspect we’ll see more SPACs move in this direction in the future, so that might be
something to look out for.
After vetting the sponsors, I would focus the rest of my efforts on the acquisition
target.
Since that business will be responsible for producing your returns in the future, it’s
important to have a full understanding of their profitability and growth potential.
I would personally feel uncomfortable investing in a start-up or something like QuantumScape
that won’t be producing revenue for several years.
But when it comes to the SPACs I’ve looked at so far on my channel, I’ve been able
to identify current profitability, a proven track record of growth, and several catalysts
for future growth potential.
So even though I’m inevitably lining the pockets of SPAC sponsors, I can feel confident
in my choices thanks to my belief in the quality of the acquired companies.
In the end, I think there are still great returns to be had from SPACs, but it’s definitely
an area that deserves some extra scrutiny.
I’d love to hear your thoughts on SPACs, so leave me a comment if you have anything
to add about the SPAC bubble.
And if you found this video helpful in any way, please consider leaving a like and subscribing
to the channel.
Happy investing & I’ll see you next week!