DraftKings DKNG, Virgin Galactic SPCE, and Nikola NKLA are a few of the special purpose acquisition companies that have generated multibagger returns for their shareholders over the past year. Yet, for every SPAC that generates outsize returns, there are those (such as MultiPlan MPLN) that have led to losses for their investors.
Is now the time to invest in SPACs, or should you steer clear? Like almost everything else in this world, it all depends on several factors; in this case, timing, valuation of the merger target, and potential equity dilution. In a previous article, we offered a primer on SPACs, and here we break down the risks and rewards that investors face at each phase of a SPAC's lifecycle.
Risks and Rewards of Participating in the IPO
If you are able to invest in a SPAC during its IPO and can afford the opportunity cost of not being invested in the broader equity market for up to two years, then yes, it might be worth the optionality inherent in these vehicles.
But before committing to investing in a SPAC, one should consider the following:
- Investors need to conduct their own analysis of the documentation prior to the purchase in order to make sure they understand the structure and the rights of shareholders.
- Investors should conduct due diligence on the sponsor. We recommend looking for those sponsors that have a strong record of both valuing and buying companies as well as operational and managerial experience that will provide value to help the merger target grow its business. Lately, it appears that a multitude of new sponsors without these track records are trying to jump on the SPAC bandwagon to raise capital.
What are the risks and rewards to consider at this point?
Potential reward: The stock will trade up, and in some cases significantly higher, if the sponsor negotiates an attractive valuation or if the public market places a higher valuation on the company than the private market. In this case, as the equity price increases, the warrant acts as an additional kicker to the upside.
Potential risk: Ultimately, the sponsor may not be able to find a merger target, or the investor won't agree with the valuation of the private company. In that scenario, an investor can get the $10 per share back with a little bit of accrued interest and keep the warrant for free as an option if the valuation of the postmerger company takes off.
Risks and Rewards at the Announcement Phase Before the Merger
In most cases, individual investors are not allocated shares in an IPO and are relegated to purchasing shares or warrants in the secondary market if they want to invest in SPACs.
Following the IPO, but before a merger agreement is announced, a SPAC unit might be worth taking a position in--but investors need to be cautious and know exactly what they are purchasing in the secondary market. The unit typically splits up after the IPO, and the stock and the warrant can be sold separately and will have different return characteristics. Purchasing the stock without the associated warrant significantly decreases its upside potential.
The unit split means that:
- The stock and warrant must be valued separately. For any amount that the investor purchases the stock above $10, that premium would be lost if the investor decides to exercise redemption rights at the merger announcement.
- Trying to value the warrant is a guesstimate at best because investors don't yet know what the SPAC will invest in, how much it will pay, or how much additional equity dilution occurs. The warrants are typically issued to be exercisable between one to one-half share (that is, it takes two warrants to purchase one stock) per warrant with strike price of $11.50 per share, a five-year maturity, and capped at $18 per share.
How could this impact a SPAC’s investors?
Potential reward, stock: If the merger is conducted at an attractive valuation or the public market places a higher valuation on the company than the private market, the stock will trade up to the secondary market valuation.
Potential reward, warrant: Similar to buying a call option, the warrant valuation will increase significantly as the stock price moves higher.
Potential risk, stock: Any premium paid over the $10 IPO price will be lost if the shareholder ends up putting the shares back to the SPAC. For example, the shares of many SPACs before the merger trade between $12 and $14 per share in the secondary market. If shareholders were to exercise redemption rights when a merger target is announced and put the shares back to the SPAC, they would suffer losses between 15% and 30%. Or, if shareholders keep the stock through the merger, the stock could sell off if the merger price was too high or too dilutive.
Potential risk, warrant: The value of the stock may not rise toward the strike price of the warrant, which means the value of the warrant will dwindle over time as it nears expiration. Many institutional investors will hold a portfolio of warrants under the assumption that some will expire worthless, some will break even, and a few will be worth enough to provide an attractive return on the overall basket of warrants.
What Happens if a SPAC Dissolves?
SPACs have a two-year window to find a target to merge with. If they do not find one, the SPAC is liquidated at the end of that period. Based on the proliferation of SPACs in 2020 and thus far this year, this will not be an uncommon event. According to Pitchbook,
Potential risk: When the SPAC is first created, the proceeds raised in the IPO will be placed in a trust and invested in short-term bonds. When the SPAC is dissolved, the IPO shareholders will be repaid their portion of the trust, which is intended to be equivalent to the initial unit price. Upon dissolution, the warrants will be canceled. As such, any premium paid for shares above their proportional distribution and any amount paid for the warrants will be lost.
An Investor’s Decision After the Merger
SPACs are not buy-and-forget investments. It’s only once a merger agreement has been announced that the real work for investors comes into play.
At this point, the investor will need to determine an independent view of the acquisition target’s value and analyze how much dilution may be suffered when the acquisition closes. For example, when a SPAC is originally developed, the sponsors receive 20% of the total shares of the SPAC but only pay a de minimis price for those shares. When the merger closes, those shares vest, thus diluting the overall equity of the SPAC.
In addition, in order to close the acquisition, the SPAC will often need to raise additional capital to repay redeeming shareholders and/or raise new equity to pay for the merger. The new equity is often raised through a private investment in a public equity securities, or PIPES, transaction. In order to attract new investors, these transactions may have terms that could further dilute remaining shareholders.
Based on an investor’s stance at this point, there are options.
Potential reward: If the investor decides that the value of the merger target is an attractive investment and worth enough to cover the dilution that occurs in order to finance the merger, then the investor will continue to hold the stock and warrants.
Potential risk: If the investor thinks the value of the merger target is too high or will suffer too much equity dilution, then the investor will exercise the right to require the SPAC to repurchase the stock. However, the investor in the unit will be able to keep the warrant, which provides upside if the stock price rises in the future.
Who Should Invest in SPACs?
SPACs are designed to set up a public funding vehicle to merge with a private company and take it public without going through the traditional IPO process. To compensate investors for the opportunity cost of earning only a risk-free rate, the structure limits the initial downside risk and pays the initial IPO investor with a free option on the valuation of the eventual merger candidate.
Investing in SPACs should not be undertaken lightly. Based on the required due diligence, the valuation of the eventual merger candidate, and the determination of potential dilution, investing in SPACs should be limited to investors with the skill set and time to properly analyze the myriad additional risks that are not inherent to investing in normal stocks.