JUST PLAIN TALK: When it comes to investing in SPACs, buyers beware

Buz Livingston
Buz Livingston

Like many, I have social media contacts who I have never met face to face. Heck, I have clients who I've never met in person either. The digital age is upon us. The pandemic forced social isolation, and instead of meeting in-person, social media fills the void. For the last year I’ve met people online instead of in person.

One posed a question on Facebook about the hot investment trend, specialty purpose acquisition companies, SPACs. Let's dig into them.

Without trying to sound overly snarky, SPACs are first and foremost a compensation mechanism. If you don't believe me, Bill Ackman, the billionaire hedge fund manager of Pershing Square Capital, calls SPACs a compensation scheme masquerading as an asset class. SPACs take your money. Within a specified timeframe, generally two years, the SPAC looks for a private company to buy. If nothing suitable pops up to buy, then the investor gets their money back. If the SPAC hits the jackpot, the investor wins, but if the acquisition goes south, they lose. Ackman points out the mania around SPACs is similar to internet companies in 2000. This alone should give investors pause.

What could possibly go wrong? First, there is a misalignment of interests. The SPAC's sponsor only fronts a nominal investment in exchange for 20% of the closed deal. It's a guaranteed return for the sponsor. Given the limited time horizon, the SPAC has an incentive to get the deal done, regardless of the price or the acquired company's prospects.

Contrasted with initial public offerings (IPOs), in a SPAC transaction, a company can use projected income versus prior financial records required for an IPO. In such an environment, there can be a temptation to use rosy forecasts. Sponsors do not have a fiduciary obligation to investors. Plus, they are not required to provide third-party valuations for the acquisition.

Promoters point out that an index of SPACs has outperformed the overall market. Others banging the SPAC drum argue companies can go public sooner versus an IPO. Some even use the egalitarian argument that SPACs allow less-sophisticated investors an opportunity traditionally available for the wealthy. I'm calling bull.

JP Morgan Chase crunched the numbers. From 2019-2020, sponsors averaged over 600 percent return. However, investors who bought after acquisitions would have been better off investing in a broad market index fund. It is essential to look at SPACs as a venture capital investment with high returns and high risks. According to SPAC research, there are over 300 SPACs with over $100 billion in cash as of early February.

Terence Kawaja, who worked on the most prominent deal of the dot.com era, the Time-Warner/AOL merger, warns of a demand-supply imbalance. "We know how it's going to end." In 21st century finance, when the dominoes start to fall, it's challenging to predict repercussions.

Regarding SPACs, the centuries-old idiom buying a pig in a poke comes to mind.

You can't always get what you want, but Buz Livingston, CFP, can help you figure out what you need. For specific advice, visit livingstonfinancial.net or drop by 2050 West County Highway 30A, M1 Suite 230.