Opportunistic investors, such as hedge fund managers, are always looking for compelling investment opportunities. These opportunities are often niche, complex, have advantageous risk/reward profiles and fall outside of typical equity, fixed income and cash categories. One such vehicle growing in popularity is the Special Purpose Acquisition Company (SPAC).
What is a SPAC?
A SPAC is a publicly listed vehicle set up by a management team. Its specific purpose is to raise capital through an initial public offering (IPO) in order to acquire a yet-to-be-identified private company or asset. After listing, a SPAC typically has two years to find and close an acquisition.
A SPAC is issued as a unit. Each unit is typically priced at $10 per share. The unit is comprised of, and can be separated into, a common share and a warrant. Because common shares and warrants are separate, they can be traded independently. This creates trading opportunities for sophisticated investors, such as hedge fund managers.
The common share provides a yield. The proceeds raised at the launch are held in an escrow trust and invested in short-term U.S. Treasuries. Investors can redeem common shares for trust proceeds, meaning investors receive their principal investment plus any accrued interest.
The warrant provides optionality. It is typically struck at a premium to the SPAC IPO price, but can fall to zero if no deal is made – one of the potential risks for SPAC investors that decide to hold on to the warrant.
When the management team finds an acquisition target, the SPAC trades based on the quality of a deal and the likelihood of it closing. This creates upside potential. Shareholders in both the target company and the SPAC must vote on the proposed business combination. Without majority approval by SPAC investors, the SPAC management team can either liquidate or continue looking for another target. If they look for another target, the original two-year deadline remains. Once an acquisition receives majority approval, investors choose to sell out of their position or remain invested. If a SPAC fails to close an acquisition, it must liquidate and return capital back to investors — one of the structural benefits offered to SPAC investors.
Once the transaction is complete, the SPAC structure collapses and the acquired private company begins trading as a public company. Shares of the new public company are now subject to both company-specific and market-related risks.
History of SPACs
SPACs originated in the 1990s as a way for smaller companies unable to use the traditional IPO route to gain public-market access. Throughout the 90s and into the early 2000s, SPAC activity waned as the tech boom led to more traditional IPO activity. After the dot-com bubble burst, SPAC issuance picked up speed again.
When the global financial crisis (GFC) hit in the late 2000s, SPAC investors experienced mark-to-market losses. Units sold off amid the severe liquidity crunch. At that time, however, the IPO proceeds were invested in money market funds instead of escrowed government backed U.S. Treasuries, like they are today.
SPACs struggled to find deals during the GFC and liquidated as investors and deal-makers hit the reset button.
Since their origins, and largely in response to the GFC, SPACs have improved in both structural and procedural standards to benefit and better protect investors.
SPACs have improved in both structural and procedural standards to benefit and better protect investors.
Today, SPACs have benefits that seek to protect investors. These include the comfort of pre-determined investment periods, investing IPO proceeds in a trust made up of U.S. Treasuries, and the option to vote for or against a deal. Such terms didn’t always exist, but have allowed an increasing number of institutional investors to allocate funds to this asset class.
In the last three years, the SPAC market has more than doubled in size and now comprises more than 20% of overall IPO volumes. Average deal sizes and gross proceeds have also trended higher as larger, more sophisticated underwriters get involved.
Chart 1: SPAC issuance by year
Source: Bloomberg, Aberdeen Standard Investments, July 2019
What is the investment opportunity?
High-profile hedge fund managers are actively allocating funds and resources to this asset class. Since the risk of losing one’s principal investment is low, SPACs can be used as an enhanced cash management tool that provides a low yield-driven return, along with deal-driven equity optionality.
Hedge fund managers tend to play for the yield and occasionally the equity upside that the warrants can provide. Opportunistic investments aim to take advantage of a large discount to trust value, or by investing early in a private company based on strong fundamentals.
Key things to remember
Though becoming more popular, SPAC investing is still a fairly niche strategy that requires both structural and technical expertise. Some deals have unfavorable terms that may not be apparent unless the investor is a SPAC expert and conducts due diligence on the investment appropriately. And, as with traditional IPOs, gaining first allocation-rights and having the ability to trade tactically (e.g., via block purchases or sales) is beneficial. Investing when SPACs trade at a sizeable discount to their trust value enhances the baseline returns.
Like all investments, one must consider opportunity cost. Assessing where we are in the current economic cycle is important. As we have seen in the past, SPAC issuance appears to be cyclical in nature. Where we are in the cycle has implications for deal completions. When the cycle turns, current SPACs may find it harder to consummate deals in defensive periods. Skilled management teams can evaluate the current economic cycle to determine the suitability of SPAC investments.
Chart 2: SPACs withdrawn by year
Source: Bloomberg, Aberdeen Standard Investments, July 2019
Another factor to note is that if business combination fails, the management team will lose their entire initial investment. This creates a classic agency problem between the management team and the shareholders. The management team’s main objective may be to close a deal in the given time frame. But the shareholders would prefer to have a high-quality deal or no deal at all. Although this creates conflicting objectives between the two parties, the option to redeem shares for cash allows shareholders an exit if the deal presented is unattractive.
The bottom line is that SPACs have a unique structure that can offer investors an attractive risk-reward profile and potentially minimal downside risk.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.