Being a white coat investor does not mean you are joining a religion, much less a cult, and I am certainly no prophet. Just because I don't invest in something, that does not mean you cannot do so. It's your life and your money; do what you want. That applies to whole life insurance, individual stocks, cryptocurrency, options, over-leveraged real estate, actively managed mutual funds (ARK anyone?), high-cost variable annuities, or gold. It also applies to today's subject, Special Purpose Acquisition Companies, or SPACs.
What Is a Special Purpose Acquisition Company?
A Special Purpose Acquisition Company (SPAC) is a “blank check” company that pools investor money and then goes and buys a private company and takes it public. Think of it as an alternative to the Initial Public Offering (IPO) process. In an IPO, one day a company goes public. With a SPAC, a separate company is formed, that separate company goes public, and then that new company merges with the old company. That separate company is a SPAC.
How Does a Special Purpose Acquisition Company Work?
Anyone can start a SPAC, so long as they can recruit enough investors to buy shares in it. Typically it is a management team with expertise in a certain niche of the market and hopefully with some experience doing this process before. Shares traditionally cost $10 a piece and really don't fluctuate until the deal is complete. The money raised is deposited into a blind trust account where it earns interest. If a “good deal” is found and negotiated within 2 years, then the SPAC moves forward. If negotiations fall through or no “good deals” can be found, the money is returned to the investors. If negotiations are successful, the now combined SPAC/target company begins trading on the public markets, at either a premium (hopefully) or a discount to the $10/share price.
The founders/management team are generally handsomely paid for their efforts. They generally get 20% of the SPAC for a nominal fee; this is generally referred to as the “promote”. If the value of the new company is $250 million, the sponsors may have put in $7 million for a $60 million share of the new company. In addition, investors pay another 3-5% in SPAC operating fees. Critics point out that the SPAC investors are subsidizing the process of the new company going public, and that their shares drop by 1/3 by the time of merger.
Are SPACs New? If Not, Why So Much Press on Them Now?
SPACs are not new; they've been around for decades. They had a rather unsavory reputation, particularly in the 1990s. They basically were involved in helping companies that “weren't quite ready for prime time” go public while offering excellent terms to the management team. You won't be surprised to learn that resulted in relatively poor returns for investors. However, it turns out that most investors do not have much memory and what is old has become new again.
The “Sarbanes-Oxley” Act of 2002 also made the IPO process more difficult than it was before, making it relatively more attractive to go through the SPAC process instead. Fans would argue today's SPAC is different and better from the SPACs of the 1990s, but the argument seems to boil down to “the companies are better and the management teams are better”. Maybe they're right. Over the last decade SPAC failure rates (failure to merge) have dropped from 60% to 20%. SPACs raised $82 billion in 2020. Explanations include “it was harder to do a regular IPO due to COVID because of all the paperwork” among proponents to “it's all part of the same speculative frenzy driving tech stocks and cryptocurrency” among critics.
Why Doesn't the White Coat Investor Invest in SPACs?
There are a number of reasons I don't invest in SPACs.
# 1 They Are Individual Stocks
First of all, this isn't a fair question because the truth is that I do invest in SPACs, just like I invest in IPOs and Tesla stock. I just happen to invest after they go public and I do so via broad market index funds. I own every successful company that ever SPACked. In fact, I invest in SPACs as soon as the SPAC itself is added to an index fund. But just like I don't buy individual stocks, I don't buy individual SPAC stocks. The main reason is that it introduces uncompensated risk to the portfolio. If a risk can be diversified away, there is no reason that an investor should be rewarded for taking it. Now that, of course, assumes an efficient market. We are all well aware that the market is not perfectly efficient, but it is generally efficient enough that it is best to assume it is perfectly efficient when making decisions like this one.
# 2 The ETFs Are Expensive Without Track Records
Now my portfolio is not a perfectly market-cap weighted portfolio. I tilt my portfolio toward small and value stocks. If SPACs are so awesome, maybe investors should tilt their portfolios toward SPAC stocks too. However, in order to do that and avoid uncompensated risk, you will either need to buy all the stocks yourself (which is far more work than I'm interested in putting into a portfolio), buy them as part of an actively managed mutual fund or ETF (which introduces manager risk and has a poor track record of adding value), or buy an index fund or ETF. At the time of this writing, there are three SPAC ETFs (although I'm sure there are more to come). The track record is practically non-existent for all of them. These three include:
SPAK: Defiance Next Gen SPAC Derived ETF
This is the “index fund” of the three. It's market-cap weighted with a portfolio of 40% SPACs and 60% post-SPAC companies. It's been around since last Fall and done pretty well.
However, its expense ratio is 0.45%, far higher than any ETF of publicly traded stocks that I'm currently invested in.
SPCX: SPAC and New Issue ETF
This is an actively managed fund that is 100% pre-deal SPACs. It's also brand-new but doing okay so far.
But if you thought 0.45% was too much, this one has an expense ratio of 0.95%.
SPXZ: Morgan Creek – EXOS SPAC Originated ETF
This one is 1/3 pre-deal and 2/3 post-deal, but is equally weighted rather than cap-weighted like SPAK. It's not doing quite as well as the other two.
Maybe that's because it charges the most of all of them at 1%.
At any rate, even if I thought SPACs were the cat's meow, there is still no vehicle I would use to invest in them. High expenses, low liquidity, active management, and short track record are not my favorite combination.
# 3 Echos of the South Sea Bubble
One of the funniest parts of the South Sea Bubble of 1720 was just how carried away it got. People would invest in anything and everything. Here's a summary:
“In 1720 the whole of England became involved with what has since become known as The South Sea Bubble. In 1720, in return for a loan of £7 million to finance the war against France, the House of Lords passed the South Sea Bill, which allowed the South Sea Company a monopoly in trade with South America.
The company underwrote the English National Debt, which stood at £30 million, on a promise of 5% interest from the Government. Shares immediately rose to 10 times their value, speculation ran wild and all sorts of companies, some lunatic, some fraudulent or just optimistic were launched.
For example; one company floated was to buy the Irish Bogs, another to manufacture a gun to fire square cannon balls and the most ludicrous of all “For carrying-on an undertaking of great advantage but no-one to know what it is!!” Unbelievably £2000 was invested in this one!
The country went wild, stocks increased in all these and other ‘dodgy’ schemes, and huge fortunes were made. Then the ‘bubble’ in London burst!
The stocks crashed and people all over the country lost all of their money. Porters and ladies maids who had bought their own carriages became destitute almost overnight. The Clergy, Bishops and the Gentry lost their life savings; the whole country suffered a catastrophic loss of money and property. Suicides became a daily occurrence. The gullible mob, whose innate greed had lain behind this mass hysteria for wealth, demanded vengeance. The Postmaster General took poison and his son, who was the Secretary of State, avoided disaster by fortuitously contracting smallpox and dying! The South Sea Company Directors were arrested and their estates forfeited. There were 462 members of the House of Commons and 112 Peers in the South Sea Company who were involved in the crash.”
But when I read about what a SPAC actually did, how could I not think of this famous description of a company? I mean, what is a SPAC if not a company “for carrying-on an undertaking of great advantage but no-one to know what it is”? I guess I prefer to invest in a company that, you know, is an actual company with real employees, products/services, income, and profits, rather than just a shell company to carry-on an undertaking.
# 4 IPO Track Records Are Not Awesome
Mostly, a SPAC is a way to take a company public. It is exciting when a company goes public. However, it is often a bit of a manic frenzy. The track record for IPO returns is not awesome. You don't have to look far for examples. Here is Lyft for instance:
The end of that chart doesn't look too bad at all, but look at that first year after the IPO! Nearly a 75% loss. That happens a lot. Here is a chart from CNBC on the subject:
Over the next 5 years, 60%+ of IPOs have a negative return. Over 5 years! I don't want to say “lottery ticket”, but it's not that different. Now you can argue that you're getting a better price as a SPAC since you're buying at a “pre-IPO price”. But at least one report says SPACs have even worse returns!
# 5 SPAC Investors Get Diluted by Managers
Most investors know the managers are making out like bandits, but they don't fully realize just how large of an advantage the managers have over them. Large investors that help sponsor SPAC IPOs buy different shares than you and I. Their shares have rights (warrants) that allow the large investor to redeem the share but keep the warrant to exercise, cutting their downside risk but keeping the potential for future large returns. The buy and hold investor gets hit by dilution through the exercise of those warrants.
# 6 Not the Time for New, Fancy Investments
If you can't recognize the speculative fervor currently present in our markets, you may be doomed as an investor. I'm not saying you should go to cash, much less short the market. I am saying it probably isn't the time to leverage up your investments or take on new risks. Mark Chen explains how SPACs are a bubble within a bubble:
“We are at a time when even scrutinized and established companies undergoing IPOs in certain sectors (read: technology) are experiencing bubble-like run-ups in first-day trading. SPACs are like a bubble within that bubble, as many of them have targeted tech in the broad sense as their area for acquisition. In this euphoria for electric vehicles, media companies, platforms, and so on, some of these SPACs will turn out to be good investments in the near term for their post-IPO investors (and excellent for creators and sponsors).
Unfortunately, the explosion in the number of SPACs hitting the market means that a lot of dollars are chasing deals of significant size in the same industries. This will inevitably mean that standards will slip and that weaker companies will be brought to market. Eventually, companies going public through SPACs will struggle to ever match the value of cash injected into them, let alone a return on top of that.
The celebrity connections, the general IPO madness, and the noted success of a small fraction of the wave of SPACs hitting the market have made them more enticing to investors than they ever have been before. While SPACs can be profitable for the sponsors and useful for the target company looking for a less expensive and restrictive way to go public, the odds are structurally stacked against post-IPO investors without warrants.
These stacked odds will likely get worse as the M&A frenzy on a deadline results in SPACs reaching further down the start-up cycle to pull companies into the public eye long before they are ready for it. Where the bottom of the barrel is and when it will be reached is hard to say, but investors should approach SPACs with the same caution they would if these entities were still dealing primarily in penny stocks.”
As investors, it is very hard not to chase performance. Even otherwise sensible investors with written investment plans can add new asset classes, even asset classes that are great long-term holdings, at the very worst time. Let me give you a personal example. My investment records indicate I first added REITs to my portfolio in late 2006, 11/27/2006 to be exact. Let me show you what happened over the next 2 years:
Now I didn't quite buy at the peak, but it was close enough for government work. The subsequent drop was 78% from peak to trough and resulted in me posting this on the Bogleheads Forum essentially right at the bottom. Let's just say the experience taught me a lot about my own personal volatility tolerance. SPACs did pretty well in 2020. The historical record would suggest you should not expect similar performance for 2022, but my crystal ball doesn't come with a calendar for when the market will turn.
# 7 Not a No Lose Investment
Some people tout SPACs as a no lose investment. The argument goes like this: If a deal isn't found, you get your money back with interest and it functions as the bonds/cash in your portfolio. If a deal is found, “it's probably awesome and you're going to make bank”. In reality, many new companies don't do well as noted above. In addition, about 25% of what you're putting in is going to the management. On average, you're going to lose 25% of your investment upfront and then have average returns on what's left. That's not a pretty picture and it certainly isn't a “no-lose investment”. Of course, we're also ignoring the opportunity cost of having your money tied up paying you almost nothing at current interest rates. Is that really your “bond money” that might soon go into the most speculative of stocks, an IPO? Or is it your stock money? If bond money, it's too much risk. If stock money, the return is too poor too much of the time.
# 8 SPAC Returns Are Not Awesome Either
While you may have heard of the SPACs that did great, you've also heard of the stocks that did great (Tesla, Amazon, Apple, etc). There's a certain amount of information bias there. You're not hearing about the ones that did poorly. So what should you do? How about looking at all the data? These guys did:
“Of the 313 SPACs IPOs since the start of 2015, 93 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -9.6% and a median return of -29.1%, compared to the average aftermarket return of 47.1% for traditional IPOs since 2015. Only 29 of the SPACS in this group (31.1%) had positive returns as of Wednesday’s close.”
The Wall Street Journal says SPACs underperform the market by 3% on average. Not exactly a ringing endorsement.
The Bottom Line
There are no called strikes in investing. If you don't like a pitch, don't swing. There will be another one in a few minutes for you to look at. You don't have to invest in everything to be successful, and you certainly don't have to invest in something that has recently become very popular. If you are really interested in adding SPACs to your portfolio, I suggest you wait a few years before doing so and see how this particular period of popularity plays out. If you still want them, great, go for it. If you cannot resist, do the same as I've told you with gold, Bitcoin, and individual stocks—limit it to 5% of your portfolio or less. The truth is most of my readers are going to do just fine with only 95% of their nest egg, so if “playing” with the other 5% helps you to stay the course with your main plan, then there will be little harm done.
What do you think? Do you invest in SPACs? Why or why not? How do you invest in them? Comment below!