By Michael Brush
If the recent big gains in shares of SPACs such as Churchill Capital have sparked your interest in this buzzy part of the market, we need to have a talk.
Anyone who bought Churchill Capital Corp. IV /zigman2/quotes/221104327/composite CCIV -4.09% near the offering price of $10 a few months ago is still up 150%, despite the sharp decline following news that it’s raising $2.5 billion in capital as it merges with electric-vehicle company Lucid Motors Inc, maker of the Air.
Other popular SPACs are up big from their offering prices just a few months ago, including VPC Impact Acquisition Holdings /zigman2/quotes/222591934/composite VIH +5.19% , TS Innovation Acquisitions /zigman2/quotes/223593609/composite TSIA -1.41% , Atlas Crest Investment /zigman2/quotes/223252119/composite ACIC -1.27% and Rodgers Silicon Valley Acquisition /zigman2/quotes/223655593/composite RSVA -6.99% .
Those fireworks are seducing small investors. Bank of America says retail investors account for 40% of SPAC trading on its platform, compared with 21% of S&P 500 /zigman2/quotes/210599714/realtime SPX -0.02% stocks and Russell 2000 /zigman2/quotes/210598147/delayed RUT -0.43% stocks. But behind the scenes are some big risks and trap doors that you need to be aware of if you are thinking about getting involved in these speculative trading vehicles.
Also by Michael Brush on SPACs: How to find the most promising SPACs and dodge the hidden dangers
First, a few basics.
SPACs are blank-check “special purpose acquisition companies” that expect to merge with a real company, typically within two years. Sponsors who bring them public collect a fee that can run up to 25% of the deal value, says Bank of America strategist Michael Carrie. For example, if a SPAC raises $100 million, the initial deal is for $125 million and the sponsor pockets $25 million. Wall Street banks that help execute SPAC initial public offerings (IPOs) typically collect 5.5%. SPACs normally come public at $10 a share.
SPAC cheerleaders cite three benefits. 1. They can be a cheaper way for companies to come public. 2. They give IPO market access to companies that don’t otherwise have it. 3. They are “private-equity” investments for small investors who don’t have access to early-stage private companies.
That all sounds good. But there are actually lots of issues and pitfalls for regular investors like you and me who buy in the aftermarket — which can make SPACs far less attractive than they seem.
SPAC issue #1: Hedge funds and Wall Street insiders get a much sweeter deal than you and me.
A “SPAC mafia” of hedge funds, arbitrage funds and other Wall Street insiders see SPACs as safe bets with almost guaranteed upside. It’s easy to understand why. Early investors at the IPO phase often get a free warrant with each IPO share they buy. But you don’t when you buy SPAC shares in the open market. Warrants give IPO investors the right to buy a share at a pre-arranged price. It’s often $11.50 for SPACs that come public at $10. This is a free call option on whatever success the SPAC may have.
These privileged investors aggressively work this angle. They sell or redeem their shares and get all their money back, but still have exposure to their SPACs via the free warrants. That’s a sweet advantage. Or else they can sell the warrants in the open market.
The bottom line: SPACs are an awesome deal for the hedge funds and other Wall Street insiders who buy SPAC IPOs. But not so much for the retail investors who buy in the aftermarket.
SPAC issue #2: Your SPAC position can get diluted big-time.
When you buy in the open market, not only do you miss out on those free warrants, but those warrants may come back to bite you. Here’s why. When SPAC shares do well because of a speculative frenzy or because the SPAC merges with a great company, the original hedge fund investors are going to exercise their warrants. This can create at least 100% dilution for the retail investors like you buying in the aftermarket.
I say “at least” because the actual dilution from the hedge fund warrants can be far worse, says Bank of America’s Carrie, in a research note published this week called “The rise of SPACs — A primer on SPAC structures & impact to capital markets.” The reason has to do with a special catch in SPAC rules. Investors can sell (redeem) their shares to the SPAC any time between when a merger is announced, and when it is finalized.