Many investors are salivating over the latest way to presumably great rich quick — the special-purpose acquisition company or SPAC.
But the only folks making money on SPACs today are investment banks and sophisticated investors — not those saving for or living in retirement. And given that, as well as many other reasons, experts offer this unequivocal advice: Don’t invest in SPACs — an investment that one high profile money manager said in a recent webinar should be illegal.
So, just what the heck is SPAC? A SPAC is “corporation that raises money through (an initial) public offering to pursue a future acquisition” of a private operating company, according to Robert Huebscher, the founder and CEO of Advisor Perspectives and author of How SPACs Destroy Wealth . They are sometimes called “blank-check IPOS.”
The SPAC is led by a sponsor, and it has a board of directors and a management structure. And, typically, the sponsor, board and management have worked together before in the industry they intend to target for an acquisition, Huebscher said in an interview . “For the typical investor, this is not a good deal.”
Others agree. “The less people saving for or living in retirement know about SPACs the better,” said Robert Johnson, a professor at Creighton University’s Heider College of Business. “It is my strong belief that the biggest principle that investors should follow is only investing in things they understand. If you violate that principle you can get into trouble.”
The aforementioned money manager, by the way, was none other than Jeremy Grantham, the chief investment strategist of Grantham, Mayo, & van Otterloo. Read Jeremy Grantham: “SPACs should be illegal.”
Here’s how it works. The investor buys the initial public offering (IPO) shares at a standard price of $10. In addition, they get rights and/or warrants that they can usually exercise at $11.50, according to Huebscher. The sponsor also receives what Huebscher described as a “misaligned” incentive: 20% of the post-IPO equity at essentially no cost, in addition to other financial kickers.
The funds are held in trust and invested in short-term government securities and the SPAC must purchase a private operating company within two years or return the funds raised to investors. Once a transaction is announced, wrote Huebscher, the IPO investor can redeem their shares at $10 plus interest and they get to keep their rights and warrants. But if you don’t redeem your shares you’ll face the risk of dilution, said Huebscher.
No other entity in a SPAC transaction, he wrote, is exposed to that risk. The sponsor, redeeming shareholders, underwriters and legal counsel, private placement investors and shareholders in the target company will not suffer a certain loss through dilution.
But what’s good for the sponsor and the private company going public — i.e., DraftKings and Nikola — isn’t always so good for the IPO investor.
Here’s the laundry list of reasons to avoid SPACs:
You’re flying blind
Most times you know what you’re investing in. That’s not the case with SPACs. SPACs raise funds before they identify the company they intend to acquire, according Huebscher.
“Essentially, you are investing in an enterprise founded to simply raise capital in order to buy another company,” said Johnson. “You can’t possibly know what you are investing in.”
And that can create all sorts of problems if you’re trying to be prudent with your asset allocation. “SPACs are ill-defined, said Stephen Horan, a managing director with CFA Institute.
SPACs make it difficult to allocate assets prudently
Because investors know little about what underlying SPAC investments will be made, it makes it difficult to know how the rest of the portfolio should be structured to accommodate the investments that ultimately make up a SPAC, said Horan.
“In addition, the underlying investment is cash until the investments are made,” he said. “So, maintaining your asset allocation and rebalancing requires a bit more work as the SPAC makes its acquisitions.”
SPACs are not publicly traded companies, said Horan. And that means “there is less transparency and disclosure that investors of publicly traded companies enjoy,” he said.