Is the landscape changing for SPAC markets?

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Special Purpose Acquisition Companies (SPACs) have been around for many years but took a big step closer to the investment mainstream in the past year. SPAC market activity quickly skyrocketed and continued to grow rapidly through March 2021. Then a sudden turnaround occurred in April, as new SPAC offerings slowed considerably, with only a relative handful of new SPACs brought to market in that month.

Is this a sign that the SPAC boom is over? Does it raise concerns for investors who have an interest in putting money to work in SPACs or have already done so?

What is a SPAC?

SPACs are essentially shell companies sponsored by an experienced investor or management team. Funds are raised from third-party investors through an initial public offering (IPO). Once 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” offerings, 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 grow in popularity

The surge in SPAC activity may have been an outgrowth of what has been an exceedingly healthy global equity market in recent years. Investors became more interested in exploring different ways to put money to work, and SPACs offered an intriguing way to get in on what might be perceived as a “ground floor” opportunity with companies that have not yet gone public.

“Well-managed SPACs that are focused on industries in a strong position can represent attractive opportunities for investors.”

“In the month of March, there were more than 100 SPAC deals alone, a continuation of a trend of activity,” notes Freedman. In total, there were 328 SPACs offered in the first quarter of 2021.1 Yet in April, the number dropped precipitously to 10.

Enhanced attention to SPACs from regulators

What caused the drop-off in new SPAC issuances? It may be due in part to increased regulatory scrutiny of SPACs.

One regulatory concern centers around accounting related to 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. Recently, the Securities and Exchange Commission (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.

In addition, there have been reports that the SEC is pursuing more information from banking firms involved in SPAC offerings. The regulatory agency has also indicated it’s closely watching SPAC disclosures and other “structural” SPAC issues.2

“The biggest driver of increased SEC scrutiny is likely the desire to create greater disclosure and 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, at least temporarily, pulled back from SPACs due to some relative performance concerns,” according to 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,” suggests Freedman.

This is not a new development. Investment results for SPACs as a whole have been disappointing compared to returns generated in the broader market. The recent decline in new SPAC activity may reflect increased investor hesitation to pour more money into this part of the market. However, this may also just be a short-term development and activity could potentially surge again over time.

Yet 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 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 has been predominant in previous years, SPACs and IPOs drew investor interest because of their potential to grow at a rate that outpaces what may be happening with the underlying economy.

“That isn’t so easily accomplished when the pace of economic growth picks up, like it has in the past few months,” says Haworth. He notes that sectors benefiting from cyclical economic growth may be more advantageously positioned for the current environment. “That may create more headwinds for SPACs in the near term.”

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, and hopefully, investors will move away from viewing SPACs as an investment category and instead evaluate the underlying companies’ individual prospects.”

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SPAC managers may be unqualified or incompetent, a risk made more pronounced by lack of any operating history or past performance of the SPAC. There is a risk that an acquisition may not occur, and the investment may decline in value even if the acquisition is completed. Diversification and asset allocation do not guarantee returns or protect against losses.