Ask an advisor: Should I invest in a SPAC?

Ask an advisor: Are SPACs ever a good investment?

July 17, 2023 7:26 PM

Special purpose acquisition companies, or SPACs, surged in popularity in 2020 and 2021.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

This week's question is on special purpose acquisition companies, or SPACs.

These short-lived shell companies, also called "blank check companies," exist solely for the purpose of acquiring another business. Through an initial public offering, the SPAC sells shares of itself to raise enough money to buy the target company.

If it succeeds, the acquired company goes public. If it fails, after two years the SPAC dissolves and investors get their money back. In theory, this is a faster and easier way to take the target company public than a traditional IPO.

In the first years of the COVID pandemic, investment in SPACs skyrocketed. In 2019, there were only 59 SPAC IPOs, according to the website SPAC Insider. Then, in 2020, there were 248, and in 2021 there were a record-breaking 613, raising a total of $265 million. Celebrities got in on the action, from Shaquille O'Neal to Martha Stewart to Donald Trump.

Soon afterward, the SPAC boom began to bust. A number of high-profile acquisitions failed to pan out — O'Neal's SPAC, for example, eventually called off its merger with the hyperloop company it was trying to acquire — and SPACs started to lose their luster. In 2022, the number of SPAC IPOs sank to 86.

So are SPACs a bad investment? Or are a few bad apples ruining the whole category's reputation? A tech entrepreneur in New York is intrigued by the shell companies but wants to know the red flags to look out for before he invests. Here's what he wrote:

Dear advisors,

Some of the most exciting story stocks over the last few years were, for me, SPACs. Obviously, these shell companies have generally not done well since the end of the 2020-2021 boom, but is that because IPOs and story stocks in general haven't done well? Or are SPACs, by definition, cursed with selection bias (i.e., only companies with things to hide go public via SPAC)?

As an investor, I'm wondering what to look for when deciding whether to invest in a SPAC. Are there any good reasons why a fundamentally sound company would launch that way? What signs can I look for that a SPAC is a safe investment? Or should I avoid them all together?

Sincerely,

SPACing Out in SoHo

And here's what financial advisors wrote back:

Steer clear

Noah Damsky, a chartered financial analyst and principal at

Marina Wealth Advisors

in Los Angeles

There are some advantages for a company to launch through a SPAC. For example, a SPAC can be executed much more quickly than a traditional IPO.

However, the downsides of a SPAC are that there is a reduced degree of oversight by regulators and a lack of disclosure. As a result, the SPAC structure inherently invites companies that are not as open or forthright with information.

Buying a SPAC in advance of a deal means that investors are giving the promoters a blank check with oversight, which can be fraught with conflicts of interest. It's best for most investors to steer clear altogether.

In this case, oversight and regulation is very much your friend!

A pig in a poke

David Mendels, a certified financial planner and the director of planning at

Creative Financial Concepts

in New York City

It is with some reluctance that I refrain from saying "never." It is entirely possible that you might end up finding one that works out for you. But I, for one, wouldn't bet on it.

There may be legitimate reasons why a sound company would follow that route, but it is not clear what they might be. I have yet to hear one that held water.

After all, SPACs are really nothing more than a vehicle for bringing the eventual target company public without providing the disclosures that would be required to bring it public in the traditional manner. True, they tell you upfront that they will be doing that, but why would I want to trust an arrangement like that? It's hard enough to evaluate a public offering that comes with all the disclosures, but without them, you are just, as the saying goes, "buying a pig in a poke."

Only gamble if you can afford to lose

Ron Strobel, a certified financial planner and the founder of

Retire Sensibly

in Meridian, Idaho

SPACs are what we would generally consider the "play money" part of an investor's portfolio. It is money that is not needed for retirement or any other important goals, and the intent is just to have fun trading it, similar to playing a slot machine.

Some things to consider would be: Have you already fully funded your retirement goals with more traditional investments? Do you have the time and dedication to research and actively manage your holdings in SPACs, or would you prefer a more passive buy-and-hold index fund strategy? How would your life and your finances change if you lost money on your investment in a SPAC? For most people, the answers to those questions are going to dictate that the money be allocated to their retirement portfolio instead.

Good for the sponsor, not the investor

William Jeter, a certified financial planner at

Abacus Planning Group

in Columbia, South Carolina

The incentives of the SPAC sponsors are among the most important pieces when evaluating a SPAC and likely explain a lot of the optimism around SPACs in 2020-2021. There are three primary parties involved in the creation and bringing to market of a SPAC: the private company being acquired (the target), the investors who purchase shares in the SPAC (the investors), and the sponsors who create the shell company, raise the money and pick the target (the sponsor or SPAC sponsor).

SPAC sponsors receive a disproportionate amount of equity in the SPAC if they are able to close a deal. Generally, a SPAC sponsor contributes about 2% of the capital and receives about 20% of the SPAC (and usually some free or discounted options, too). SPACs have a limited amount of time to close a deal, and if the deal does not close, the sponsor loses their 2%.

If SPACs are not cursed by selection bias, the incentives of the sponsor — close any deal and earn 10 times the investment, or don't close and lose everything — may be enough to make that curse a reality. If, as the SPAC sponsor, I can only close a deal on a target that's worth half of what I raised, I am still likely to make that deal. If the stock gets cut in half on the first day of trading and my 2% turns into 10%, that is still a heck of a trade for the SPAC sponsor.

Those are pretty powerful incentives, and I think they explain why you saw so many sponsors marketing SPACs during the SPAC frenzy. But this fantastic trade for the SPAC sponsor is being done at the expense of the SPAC investor. As a general rule, I would avoid the temptation to chase the stories in SPACs or any investment where the incentives are both this lopsided and not in your favor.