Not all SPACs are created equal; not all deals will work out

2020 was a boom year for Special Purpose Acquisition Company (SPAC) listings. An annual total of US$83 billion was raised, accounting for 46 per cent of US IPO proceeds and 55 per cent of total number of IPOs. The momentum has continued into 2021 with a record-breaking US$100 billion raised as at April.

The total amount raised in these last two years accounts for over two thirds of the total amount raised by SPACs in the last two decades. This marks an inflection point for SPACs as they changed from a niche listing option to a mainstream listing option.

Investors who participated in the US SPAC market in 2020 likely generated good profits. These investors often can buy pre-merger SPACs near their listing price of US$10. When the SPAC announces a pending deal, investors could enjoy an average return of 40 per cent + profit, in a matter of months.

Will this pattern continue? We believe investors should consider these three points before putting their money into SPACs.

3 DISTINCT RISK-RETURN PROFILES

It is important for investors to recognise that the lifecycle of a SPAC has three distinct phases: pre-announcement, announcement, and post-completion. The risk and return profile for a SPAC varies in each phase.

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A recent study by Nasdaq looked at the performance of SPACs that held IPOs after 2018 and successfully completed an acquisition between 2019 and 2020. It made the following conclusion for each of the three phases:

• Pre-announcement phase: Before the announcement of any acquisition, SPACs typically have bond-like returns with low volatility. Most SPACs go public at US$10 a share and trade around that price because 90 per cent or more of the gross proceeds from the SPAC IPO is held in a trust earning bond-like returns.
• Announcement phase: When an acquisition target is announced and before completion, there is likely to be a jump in price. On average, SPACs showed a 40 per cent jump in price. However, not all SPACs would have this jump in price as it depends on the acquisition target and its valuation. In fact, the median SPAC showed only a slight price increase.
• Post-completion phase: In contrast to the high return in the announcement phase, the return for the post-completion phase has been disappointing. One month after completion, about 50 per cent of the SPACs under study had negative returns, while there are a few big winners with over 50 per cent returns. This return profile for the group stabilises thereafter. Twelve months after completion, about 45 per cent of SPACs had negative returns and about 30 per cent of the SPACs had returns greater than 100 per cent.

One key factor for the post-completion performance is dilution effect from promote, warrants, and redemption. The sponsor of the SPAC will take a promote which is typically 20 per cent of SPAC equity.

In addition, the exercise of warrants dilutes existing shareholders. Dilution reduces the proportional stake of shareholders who continue to hold the stock without exercising any warrants.

Finally, redemption further increases the amount of dilution caused by the promote and the warrants. SPACs need to replenish the cash they lose to redemptions by selling new shares through private placement (PIPE), which are typically offered at a discount to the SPAC's publicly traded price. The greater the degree of dilution, the more likely the company is to underperform after assuming the SPAC's public listing.

Another key factor is whether the SPACs is led by an investor or an operator. A McKinsey study showed that the underperformance is concentrated in SPACs led by sponsors who come from the investing community.

On the other hand, SPACs led by operators, such as CEOs who have led companies in the industry of the target company, have relatively outperformed.

COMPARISON TO TRADITIONAL IPO

The jump in the SPAC price during the announcement phase has similarity to the price jump on the first day trading of traditional IPOs, thus some investors may be keen to take a chance. But investors must recognise the differences between SPAC and the traditional IPO. One key difference is that the traditional IPO pricing is based on the historical financial track record of the company. In contrast, a SPAC combination can provide forward-looking financial statements to justify their valuation.

According to the Wall Street Journal, "it took Google eight years to reach US$10 billion in revenue, the fastest ever for a US startup". In the US, five companies with current SPAC combinations in the electric vehicle and transportation sector have aggressive projections reaching US$10 billion in revenue in three to seven years. Perhaps there is a reason that such statements are not allowed for traditional IPOs.

COMPARISON TO PRIVATE EQUITY

Some may compare SPACs to private equity where the sponsors offer their track record as a proxy for the success rate in finding a good target company. Investors must recognise the difference in upside sharing. In private equity, the sponsor typically shares 20 per cent of realised profits. If the private equity fund is unable to sell the portfolio company at a profit, the fund manager does not receive any incentive fees or carried interest.

The SPAC sponsor will take a promote which is typically 20 per cent of SPAC equity when a deal is successfully completed. This means a sponsor who raises a S$300 million SPAC - the minimum capitalisation that Singapore Exchange (SGX) is proposing - will receive 20 per cent of its common stock initially worth S$60 million, if they complete a deal, whether the newly merged company's stock goes up or down when the transaction closes. Even if the stock falls 30 per cent after the deal closes, the sponsor's common stock will be worth S$42 million. This is over a 4x multiple of the S$10 million invested by the sponsor that SGX is proposing, a stark contrast to the 30 per cent loss by the investor.

We note that the sponsor investment that SGX is proposing is already significantly higher than in the US, where sponsors need only to invest US$25,000, which would have produced an over-1000x multiple of the invested capital by the sponsor under the scenario above. In many cases, US sponsors invest at least 2 per cent of the proceeds of the IPO, which is meant to offset the underwriter's fee so that the full proceeds of the IPO can be placed in the trust account.

CONCLUSION

This SPAC wave in the US has captured the attention of global financial markets. Different exchanges are exploring ways to offer SPAC listings. Exchanges in Singapore, Hong Kong and Japan are at various stages of getting their SPAC framework ready this year. Providing guard rails for investors is no doubt on the top of the list of priorities for these exchanges.

Investors, on their part, need to understand that not all SPACs are created equal, and not all deals will work out. Performing their own due diligence and being educated about SPACs is still essential.

• The writers are from CAIA Association, a not-for-profit for the alternative investment industry.Keith Black is managing director of content strategy, and Jack Wu Guowei is director, content Asia-Pacific.

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