Three Sure-fire Ways to Lose Money Investing in SPACs
On its face, the special purpose acquisition company, or SPAC, would seem to be one of the safest investment products ever invented by the money spinners of Wall Street. An investor ponies up $10 to purchase a “unit” that includes one share of common stock plus a fraction of a warrant, a “right,” or some other derivative freebie. Rather than handing that cash over to some wild-eyed visionary to invest in robo-helicopters or houses in the Hamptons, the investor’s capital is safely locked in a vault earning interest where it cannot be touched.
Once the SPAC has raised a few hundred million through an IPO (or a couple billion if you are Bill Ackman), then the SPAC team scours the globe searching for the world’s most fantastic robo-copter designer, interplanetary tourism company, or cure for cancer. Or whatever. Once they secure their prize, SPAC investors get to vote yea or nay if the deal should go forward. Separately, each investor can elect whether to receive stock in the new corporate confection or redeem to get back their share of cash held in an ironclad trust. Either way, investors get to hang onto the warrants and sell those at a profit should the stock later soar skywards. Sounds close to foolproof, right?
That’s what many hedge funds certainly thought, as they gorged on SPAC IPOs in 2020 and early 2021, using leverage to goose returns on what was essentially a treasury bill with an embedded option to convert to equity. But as the SPAC party started to get going, and more and more bold-faced names started to swan through with glittering SPACs on their arms, the SEC became nervous that things were getting out of hand. It is one thing when a balding, jowly private equity jockey pontificates about EBITDA synergies. But when Serena Williams gets amped about building rocket engines and Shaquille O’Neal contemplates nuptials with IPO-gone-wrong WeWork, there may be some headier intoxicants wafting through the air. For this reason, the SEC has unfurled more red flags than a Chinese Army parade about risks retail investors should consider with SPACs here, here, and here.
Despite the apparent safety of the SPAC structure, there are still several ways that investors can get their fingers burnt with this product. Some of the more popular ways to get wiped out result from a lack of understanding of the basic structure or a compulsion to run with the herd right before it heads off a cliff.
Wait for the SPAC to run up on rumors and then purchase the common stock.
Theoretically, negotiations between a SPAC and a potential merger partner should be conducted in absolute confidence. Unfortunately, consummating one of these corporate marriages is not as simple as hiring a coach and a country priest. There are multiple investment banks and advisors involved. The potential deal is marketed “confidentially” to dozens of fund managers and industry players to ladle more cash into the coffers through a PIPE. And all these people are in the business of sharing information and incentivized to see the share price move up. In the case of Churchill Capital Group IV, the stock went parabolic to $58 per share on rumors of a merger with luxury electric car maker Lucid Motors but then tumbled back again to the low 20s as soon as the deal was announced.
Why? Perhaps investors questioned if ascribing a valuation in the tens of billions to an auto company that has yet to produce a car was a smart thing to do? Or maybe they noticed that the institutions investing in the PIPE were picking up their shares for $15? Hard to say. But the lesson on how to invest in SPACs is clear. If you bought the IPO unit and sold anywhere between the height of $58 and the mid-$20s where it trades today, Lucid has been an extremely profitable trade. But a momentum investor who piled into the stock based on rumors in the weeks before it was announced probably got wiped out – even though the rumors, in this case, turned out to be true! Lessons learned: You are almost always better off investing in SPACs by purchasing the unit at the IPO. Avoid buying SPACs that trade at a significant premium to trust value before the company has even announced a deal that can be evaluated on its merits.
Invest “alongside” famous people.
Let’s be honest: stock picking is not all about dispassionately analyzing returns. There is an electric thrill about feeling part of the “smart money” and an exclusive club. What could be more exciting than telling your neighbors or, more realistically, fellow Reddit bros that you are “in business” with a star-studded name on the latest SPAC merger?
When Subversive Capital Acquisition Corp. announced it was merging with JAY-Z’s vertically integrated cannabis company, the stock blazed up to $12.85 as investors visualized blasting returns alongside Rhianna, Roc Nation, and DJ Khaled. But as that buzz wore off, the stock traded down to under $4 as The Parent Company (with the apt ticker, GRAMF) smoked a considerable portion of its cash in its first quarter of operations. Former Speaker of the House Paul Ryan’s SPAC, Executive Network Partnering Corp., soared to $50 a share in its IPO debut last November, but then quickly declined back to the $10 range and has yet to announce a deal. Even investing with a storied stock picker like Bill Ackman of Pershing Square is no guarantee of success. His Pershing Square Tontine Holdings ran up to the mid-30s as rumors swirled among Reddit “tontards” that he was wooing prize assets from Bloomberg to Stripe. But the stock traded back down to $20 once Ackman announced and then subsequently unwound a convoluted deal with Universal Music Group that no one seemed to like.
The supreme master of leveraging a celebrity following to send stocks soaring is Chamath Palihapitiya. He brought a series of high-flying SPAC mergers to the market while positioning himself as a populist advocating for outsider individual investors. Virgin Galactic Holdings rocketed to $60 before succumbing to gravity and spiraling under $20, while Chamath sold out his entire position. To be fair, most of Chamath’s SPACs are still trading above the IPO price. Even Clover Health, accused of deceptive disclosures and investigated by the SEC, staged a recent rally to $22 on the prospect of a short squeeze — before collapsing again to $8.
The most important thing to be aware of is that most of these celebrities are not investing in anything like the same terms as you. In the Virgin Galactic deal, Chamath had purchased his 13% stake of the combined company for $0.002 per share – which was how he converted an investment of $25,000 into hundreds of millions in wealth. SPAC sponsors and promoters have an asymmetric incentive where nearly any deal is better than no deal at all. While there is nothing wrong with buying SPACs associated with celebrities, be aware that they are probably on the “comp list” to this party and won’t be on the hook if the joint gets trashed.
Buy SPAC warrants without reading the fine print.
For more speculative investors, SPAC warrants can seem like a tantalizing way to take advantage of the inherent volatility of the high growth, high risk “moon shot” companies with which many SPACs merge. Typically, a SPAC warrant will provide the holder with the right to purchase shares in the combined company at $11.50 per share once the merger is completed. SPAC warrants have a life of five years, giving plenty of time for the fledgling company to show its mettle. And soon after the IPO, the warrants begin trading separately, often at relatively low prices. For investors with a high degree of enthusiasm for a SPAC story but limited funds, purchasing a warrant provides far more upside leverage than buying the common stock.
As with many things SPAC-related, there is a catch, however. First, investors can only exercise SPAC warrants after the merger is consummated. For this reason, they often trade below intrinsic value due to the risk that investor enthusiasm will fade in the months between deal announcement and closing. Second, SPAC warrants come with a “call” feature, which allows the company to force holders to exercise their warrants if the stock trades above a specific price for a set amount of time. In most cases, this threshold is $18, and companies have a powerful incentive to redeem the warrants to clean up their capital structure. The call feature limits the upside that SPAC warrants provide if the stock takes off.
In some cases, as in Clover Health’s recent redemption announcement, the stock needs only to be trading above $10 for 20 days within 30 days — meaning that the warrants may have no intrinsic value at all! Clover’s warrants had traded as high as $11 a few weeks before the announcement. Investors who purchased those warrants in June believing that a massive short squeeze was imminent have lost most of their stake. An even greater risk is that the company calls the warrants, and the holder fails to take action, in which case the warrants expire worthlessly. So, warrants provide a valuable kicker when investing in a SPAC IPO and can be a rewarding way to bet on high conviction SPAC merger deals. But those who ignore the fine print of these complex instruments are likely to be disappointed.
In the past few years, SPACs have evolved to provide ordinary investors with access to potentially industry-changing, high-growth investments — formerly the exclusive preserve of late-stage venture and crossover funds. The backers of SPACs now include a selection of the most successful names from the worlds of private equity, M&A, and venture investing. While SPAC sponsors have a “blank check” to source a deal of their choosing, investors retain the valuable right to have their capital returned if they don’t like what sponsors present. By understanding the SPAC format’s essential structure and potential pitfalls, investors can dramatically reduce the potential for a catastrophic loss of this sometimes lucrative and infallibly entertaining asset class.
Crocker Coulson is CEO of AUM Media, which advises SPAC sponsors and private companies considering going public through a SPAC merger.
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