Special Purpose Acquisition Companies (SPACs) are not a new investment concept but moved closer to the investment mainstream in recent years.
SPACs are essentially shell companies sponsored by an investor or management team. Funds are raised from third-party investors through an initial public offering (IPO). After funds are raised, SPAC managers seek to put those assets to work by acquiring one or more companies that are not yet listed on a public stock exchange.
By law, companies that are targeted for acquisition cannot be identified until the SPAC has completed its IPO and is fully funded. Therefore, SPACs have earned the moniker of “blank check” companies, as investors don’t know precisely what company or companies a SPAC will ultimately acquire with the funds it raised through the IPO.
“SPACs are not an asset class,” says Eric Freedman, chief investment officer at U.S. Bank. “SPACs are the byproduct of a corporate finance decision. Companies can raise capital in many ways, including through a traditional IPO, a direct listing, or through a SPAC. We don’t look at a company’s growth prospects or its investment merits based on its capital raising methodology.”
SPACs rapid growth – and decline – in popularity
The surge in SPAC activity in 2020 and 2021 may have been an outgrowth of an exceedingly healthy global equity market. Investors became more interested in exploring different ways to put money to work, and SPACs appeared to offer an intriguing opportunity to get in on what many perceived as a “ground floor” opportunity with companies that have yet to go public.
There were 248 SPAC offerings in 2020 and 613 in 2021. In the first quarter of 2022, fewer than 60 SPAC IPOs came to market and only 32 SPAC merger announcements.1
The drop-off in new SPAC issuances may be due in part to increased regulatory scrutiny of SPACs. The Securities and Exchange Commission (SEC) has focused on the following:
- Warrants. Warrants are securities that give investors the right to purchase another unit of the SPAC at a certain price before a certain time. Most SPACs issuing these warrants treated them as assets on their balance sheet. In 2021, the SEC issued a determination saying that in certain circumstances, these warrants must be treated as liabilities by the SPAC. Classifying warrants as liabilities could result in more regulatory reporting requirements for SPACs, which could affect offering activity.
- Disclosures. In March 2022, the SEC proposed additional rules and amendments aimed at increasing disclosure and improving investor protection in SPAC IPOs. This would require, among other things, disclosures about SPAC sponsors, their potential conflicts of interest and about how share value can be diluted through features that reward specific investors or entities associated with a SPAC. Also proposed are disclosures relating to the fairness of these transactions.2
“The biggest driver of increased SEC scrutiny is likely the desire to create more visibility for investors,” says Freedman. “It’s placing tighter controls on how these firms can project out revenue and earnings growth.”
Recent SPAC performance
Another factor in the changing environment for SPACs may be underwhelming results from recent offerings. “Retail investors may have pulled back from SPACs due to some relative performance concerns,” says Freedman. He notes that several high-profile SPAC offerings performed well for insiders and sponsors, but not as favorably for the investing public. “This has likely taken some of the luster off of SPACs for those who look at them as a category, at least for now,” he adds.
Performance for SPACs over the past year has been volatile compared to the performance of the broader market. The recent decline in new SPAC activity may reflect waning investor enthusiasm for this part of the market. However, this may also be a short-term development and activity could potentially recover over time.
A change in the investment environment may also be a contributing factor. “Some of what you see with SPACs is similar to the market for more traditional forms of stock IPOs,” says Rob Haworth, senior investment strategy director at U.S. Bank. “Investors attracted to these types of investments are looking for a chance to generate capital appreciation regardless of economic conditions.” He explains that in a slower-growth environment, which was predominant in previous years, SPACs and IPOs drew investor interest because of their potential to grow at a rate that outpaced a slower-growing economy.
“Investors need to pay attention to shifting sands in the SPAC market given regulatory changes. Hopefully investors will move away from viewing SPACs as an investment category and instead evaluate the underlying companies’ individual prospects.”
- Eric Freedman, chief investment officer at U.S. Bank
“That wasn’t so easily accomplished when the pace of economic growth picked up as it did in 2021,” says Haworth. He notes the sectors that benefited from cyclical economic growth were more advantageously positioned for the current environment. Growing investor concerns with the speculative nature of SPACs may be dampening enthusiasm, with increasing regulatory oversight potentially adding to investors’ caution.
Approach SPACs with your eyes open
Because SPAC investors lack advanced knowledge of potential targeted acquisitions before they commit money to it, it’s important to exercise caution as you consider this as an appropriate diversification tool. Assess each individual offering to determine its investment-worthiness. Selectivity in choosing individual opportunities is critical regardless of the types of investments you are considering. With SPACs, you’re primarily judging the track record and expertise of the management firm making the offering.
“Well-managed SPACs that are focused on industries in a strong position can represent attractive opportunities for investors,” says Freedman. “Yet investors need to pay attention to shifting sands in this marketplace given regulatory changes that may impact disclosure and accounting rules. That could alter the landscape for how people view SPACs. Hopefully investors will move away from viewing SPACs as an investment category and instead evaluate the underlying companies’ individual prospects.”
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