The Business Times
In collaboration with OCBC Bank

Investors need to stay alert to what SPACs can offer

A new wave of blank-cheque companies should prompt basic questions: why invest, and who stands to gain?

Published Mon, Mar 15, 2021 · 05:50 AM


EACH success has been described as no more determined than a flip of the coin - yet, listings of special-purpose acquisition companies (SPACs) in the United States have already raised some US$70 billion this year.

A quick sweep of headlines throws up some quirky names of existing SPACs. Four are inspired by Winston Churchill, another by Netflix hit The Queen's Gambit. Then there is deprecating wit from one Just Another Acquisition Corp.

The eye-popping numbers offer some lessons on investment savviness, and a broader lesson on the lure of investments inflated by fame.

Why are SPACs enticing? A resurrected listing structure from the late 80s, SPACs in the US involve a listing of a shell company - a listed entity with no business injected - with its shares typically priced at US$10 apiece. SPAC sponsors must find a suitable business to inject into this empty listing in about two years from the initial public offering (IPO).

To sweeten this reverse-merger offer, early investors are given warrants that confer the option to buy more shares at a certain price by a certain time after an operating business is injected into the listed shell. The assumption here is that the warrants, though usually priced at a premium to the IPO price, would still be priced lower than the actual trading price in five years or so.


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There is also some protection for such blank-cheque signees built into the latest SPAC structures, after early versions of SPACs were associated with pump-and-dump schemes. This comes in the form of the right of redemption. If investors disagree with the proposed business to be injected by the sponsors, they can ask for their money back, plus interest.

A SPAC listing challenges that of a traditional IPO, known to be laborious in its pricing process. Still, SPACs doesn't necessarily solve root problems tied to traditional listings. Instead, it brings new considerations when it comes to investor protection.

Before plunging into any investment, investors should always first ask: why. With SPACs, ask why would sponsors need a two-year time frame to find a viable business to list, and if that time frame is plausible.

Vasu Menon, OCBC's executive director of investment strategy, said those putting their money into SPACs should be aware that it comes with significant risks - including from having to deploy its funds to make an acquisition within a limited time frame.

"This time pressure may result in a less-than-ideal acquisition being made, translating to poor returns for investors. So it is important for investors not to overinvest in SPACs or speculate excessively in them."

Next, ask how your interests are aligned with the investment. On the face of it, SPAC shares that come with a redemption clause offer a low-risk optionality or hedge for investors keen to take an early dip. But as it is, investors must weigh this against the opportunity cost of not investing the funds elsewhere.

Secondary investors who buy at a premium in the open market also receive less protection than primary investors when a SPAC is dissolved. The US Securities and Exchange Commission (SEC) pointed out that investors are only entitled to the pro rata share of the escrow account that holds the shares, and not the price at which the investor bought the SPAC shares on the market. So if a SPAC had an IPO at US$10 per share, but the investor bought from the open market 100 shares at US$12 apiece, US$200 is not covered by this capital-protection built into the SPAC structure.

Many studies and publications note that most SPACs today are trading below US$10 apiece. It has opened up an arbitrage trade window for some hedge funds. It's also a painful lesson for some retail investors who have ridden the highs of SPACs and already nursed the lows.

Then, ask who's behind the investment opportunity. SPACs require investors to take a hard look at the terms behind SPAC sponsors too. There is criticism that as SPAC founders get a 20 per cent of their freshly merged firm for free, it disincentivises them from injecting quality businesses.

What's more critical is that while there is some downside risk protection for SPAC investors, most SPACs are structured to involve share dilution that SPAC shareholders likely have to bear at the post-merger level.

A November 2020 paper by professors from Stanford University and New York University School of Law noted that in effect, target companies negotiate prices of their shares in the reverse-merger entity based on the cash value of SPAC shares, which would be lower than US$10. The last SPAC shareholders who do not redeem will have the value of their shares fall at the post-merger level. "When commentators say SPACs are a cheap way to go public, they are right, but only because SPAC investors are bearing the cost," the paper said.

The OCBC Financial Wellness Index 2020 also found that 39 per cent of millennial investors speculate excessively to make quick gains.

With DraftKings - one of the few SPACs trading robustly above their IPO prices after merging into a shell - the terms for the fantasy sports league and betting company were reportedly such that founder shares could only be fully vested after the stock gained 60 per cent from its listing price.

Perhaps this ensures a bit more skin in the game. Though, the point is that investors would need to pore through the SPAC terms to know how sponsors are aligned to their interests. To add, several SPACs are turning in underwhelming performances, despite being backed by big names that include top private equity funds.

The SPAC structure allows the target company to offer forward-looking guidance to the SPAC and SPAC investors, unlike in a traditional IPO.

But that leaves a vulnerability to alleged fraud too. Nikola, a SPAC acquisition, was accused by a short-selling firm of inflating claims in just about three months after it was injected into a shell. The founder of the startup aiming to build zero-emissions long-haul trucks resigned soon after. The case poses big questions on whether due diligence by sponsors, many of whom rely on their fame to drum up interest, would be robust.

SPAC investors would have to figure out what recourse they have against fraud cases as well. Already, more than a dozen SPAC-related shareholder lawsuits have been filed since 2019 in the US, Bloomberg reported. More are expected.

That SPAC activity is surging amid pent-up liquidity seeking new returns in this low-rate environment, is no coincidence.

SPACs may come to Asia, and they should not be dismissed outright. But how far this trend can be sustained comes down to the details of how each SPAC is being designed. And that means more than before, investors must read the terms carefully and know what they are buying into. A SPAC stock cert should be distinguishable from a lottery ticket.


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