Are SPACs Right for You?

Tom Lauricella:

Hi and welcome. I'm Tom Lauricella. I'm the editor for professional audiences at Morningstar, and I'm here today with Dave Sekera, who is the chief U.S. market strategist for Morningstar.

Dave, thanks for being here today.

David Sekera:

You're welcome, Tom. Always happy to talk to you.

Lauricella:

We're going to chat today a little bit about SPACs. SPACs are just one of many market frenzies that we seem to be seeing out there in 2021. But our specific focus here today is to really look at them as an investment: How do they differ from regular stocks, are they appropriate for individual investors, and then how to actually evaluate them if the decision is made--yes, these are an appropriate investment.

So, Dave, let's start with that first question, and this is something that I think makes it really interesting because there's an inclination to just treat SPACs like any other kind of stock out there, especially, a new IPO or something like that, but how are they different? What makes this a different creature?

Sekera:

You know, and it's interesting, too, because SPACs have a lifecycle. And so, it really depends on what part of that lifecycle that you are investing in. During the initial part of the SPAC's lifecycle, during its IPO phase and its premerger phase, you don't really know what you're investing in when you buy it or what the valuation is of the company that ultimately you would end up being a shareholder in.

A SPAC, when it's first developed, really, it's a backdoor way for private companies to be able to go public without going through that typical IPO process. And the way it's designed, you know, they do limit downside risk to start off with and provide some upside potential. But again, for investors, you really need to go through, do your analysis, do your due diligence and understand the terms and the conditions and shareholder rights of any individual specific SPAC that you might be looking to invest in.

Lauricella:

And we'll get more into how to evaluate them, but one of the things that does make them different is that, for most SPACs, you don't know what they're actually going to do with the proceeds, right? They don't have an existing business to merge into. So, even if you're trying to do some basic fundamental analysis, you're missing a big piece of the equation, right?

Sekera:

Correct. So, really, it's a blind pool, you know, to use a 1980s' term, where they're raising the cash to be able to use that in order to invest in the private equity of a company, and essentially that investment then becomes a reverse merger. Then they use that in order to take that private company public. So, it's really a different way of going through and becoming a public company without going through that typical IPO process.

Lauricella:

And so, you really can't do a valuation analysis of a SPAC until you know what they're actually going to be merging with?

Sekera:

Correct. And that's why it's so important upfront to really understand those terms and conditions and your shareholder rights. So, depending on what lifecycle you are in the SPAC, there are a number of different ways as an equityholder that you could get deluded by new additional equity that's brought in. So, for example, when the SPAC is first created, the sponsors receive 20% of the shares of the newly formed SPAC for a nominal amount. Those shares act as a fee to the sponsors for going out and looking for those merger targets, doing the due diligence, and negotiating the merger terms with the private company. In addition, oftentimes when the SPAC makes an investment greater than the amount of cash on hand, it will need to raise additional capital. This additional equity can be structured in such a way that it dilutes the existing shareholders.

Lauricella:

And of course, another unusual aspect among many is that there's a time frame here. This isn't an open-ended commitment, right?

Sekera:

Correct. So, when the SPAC is first IPO-ed, now most typical SPACs do have a two-year time frame for the sponsors to be able to go out and announce a merger target, the company that they have come to terms with. And at the end of those two years, if they haven't been able to do that, most times those SPACs will end up dissolving. So, what happens is the initial proceeds that are put up when the SPAC is IPO-ed are put into a trust, and they're going to be invested in short-term bonds. And if the SPAC ends up being dissolved, those proceeds end up going back to the shareholders. So, in that IPO process, you actually are buying what's called a "unit offering," so that's going to be one share and one warrant, and that warrant is then a right to be able to buy an additional share or a fraction of a share in the future at a set price.

Again, at the end of the two years, if you've bought those SPACs higher than what the IPO price was, that premium that you paid over the IPO price would end up actually being lost. And so, that's why you need to be careful if you're buying these in the secondary market--that if you are paying a premium over the IPO price, which is usually $10, that premium could be forfeit when that SPAC is dissolved. And also, that warrant, then, if you're buying that in the secondary market, because that unit does get split up and the shares can trade differently than the warrants, again, the premium that you would pay for that warrant--that also would end up going to 0 if that SPAC is dissolved.

Lauricella:

Wow. So, there really are a lot of moving parts to these, and that does raise the question of: Are SPACs appropriate for an individual investor's portfolio? Traditionally, this has really been the domain of institutional investors, hedge funds, but we've seen this filter in to the individual do-it-yourself investor almost at this point. So, when we look at the different risk characteristics as well as the work that needs to be done on evaluating the SPAC, how do you come at the question of whether these are even appropriate for an individual investor's portfolio?

Sekera:

Yeah, and I would say for the most part, for most investors, SPACs are probably not going to be appropriate depending on your risk tolerances. And again, it does require a lot of additional due diligence and analysis that you need to make, and you also have to have a much higher risk tolerance in investing in SPACs than you would for most public companies. So, again, with the public company, you're knowing what you're buying, you know how to be able to value it. In this case, in that blind pool, sometimes these turn out extremely well, and there are certainly a lot of examples out there, these private companies that have come public, the public market puts a high valuation on the companies, and these stocks have traded up significantly higher. Having said that, there's also certainly a lot of other examples that, because of the amount of dilution that ends up coming with these transactions, when they're finally put together, or depending on the market valuation in the public markets, a lot of times these SPACs have also traded down to $6 or $7 a share as well.

Lauricella:

Let's move on to that last leg of the question here. If an investor has decided, "This is appropriate for my portfolio. I'm going to do the work that it takes to evaluate a SPAC." What are some of the steps? What's the flow chart, as it were, for how to approach a SPAC? I know you build a lot of this around that timeline of life--that lifecycle of a SPAC, right?

Sekera:

Right. So, as we mentioned earlier, during that IPO phase, you're really looking for those companies that have the right terms and conditions. You're looking for those that have the right sponsor base. Again, you're looking for sponsors that have pretty significant experience in the private equity markets--people that know how to go out and be able to properly value the companies before they go public as well as have experience probably in operations and specifically within that sector that those sponsors are able to actually bring value to those companies when that reverse merger is conducted. Oftentimes the sponsors will end up getting a board seat on those companies when they go public.

The next phase is when that company is at what we call the "premerger stage," so before the SPAC has come to the actual agreement, but you're past the IPO, in that case, typically, the stock is going to be trading at some sort of premium to $10 because of the market having put some additional value on the potential for finding one of these really high value-added private equities that people really are putting very high multiples on in the marketplace right now.

Once that merger is announced, then as a shareholder, you do have rights to be able to require the SPAC to redeem your shares. So, that's now where the real work comes in and the valuation, looking at the merger-acquisition target, taking a look: Do you like the company's business? Do you like where they're going? And then being able to come up with an appropriate valuation multiple, which is usually very difficult to do because these companies are still very early on in their lifecycle. So, they're probably just at the stage where they're starting to monetize their product base, really starting to grow. And so, therefore, you're not looking at a typical earnings analysis. You're really looking more at the target market that this company can address and also looking at how quickly you think that company is going to be able to grow.

So, at that point, you have the option to put those shares back to the SPAC and get your cash back or continue to hold those shares. If you're going to continue to hold those shares, then you need to understand that, when that transaction closes, if additional capital needs to be raised, can I as a shareholder get diluted by new equity that's coming in the deal? So, oftentimes, they will do things called "PIPEs," Private Investment in Public Equity securities, or other different types of capital raises, which could potentially dilute you as a shareholder. And then, finally, once the acquisition closes, you are subject to the market valuation at that point.

Lauricella:

Wow. So, there's a lot of steps to this, and it's something that plays out over quite a long period of time here. It seems like one of the takeaways is that this is definitely not a buy-and-forget investment?

Sekera:

No. And again, that's why for most individual investors, it's probably not necessarily an appropriate investment in and of itself. I would say, if you really want to put in the work and you're willing to do the additional analysis and due diligence--high risk, high reward type of situations. And the other thing to think about is: If you are going to get involved in SPACs--maybe diversifying, buying smaller positions of a number of different SPACs and get the benefits of diversification. So, that way, if you do end up having an investment pool in SPACs, a couple of them which trade up will certainly be able to help offset any losses that you might take in those SPACs that might trade down.

Lauricella:

Fantastic. Dave, thanks very much for doing the legwork on helping us understand SPACs.

Sekera:

All right. You're welcome.

Lauricella:

Thanks very much.