How to Talk to Clients About SPACs

If you're a financial advisor or work in some other client-facing advisory capacity, there's a reasonable chance that over the past year or so you've fielded some questions about special purpose acquisition companies (SPACs).

Last year, nearly 250 blank-check companies commenced initial public offerings, raising more than $83 billion combined. As of Jan. 28, another 75 SPACs went public, indicating blank-check mania is rolling over into 2021.

Part of the reason SPACs received so much attention last year are companies that debuted by way of blank-check mergers. Think DraftKings (NASDAQ:DKNG), Virgin Galactic (NYSE:SPCE) and a slew of electric vehicle makers. That's another theme that's carrying into 2021. Just one month into the new year and some big names are already striking again in the SPAC universe. For example, Chamath Palihapitiya, a SPAC king if there is one, orchestrated two blank-check deals in a single day last month.

Coupled with a steady stream of media hype, name recognition is another impetus for client inquiries regarding blank-check fever. Advisors can easily prepare for these conversations.

Tempering Expectations 

Above, I intentionally mentioned DraftKings and Virgin Galactic. Those are prime examples of ballyhooed stocks that came to market via blank-check mergers. The shares subsequently soared following those transactions, but these stocks and plenty of others in the SPAC universe aren't suitable for all investors.

In the case of DraftKings, the sportsbook operator isn't yet profitable and Wall Street doesn't expect that to change for another two or three years. For its part, Virgin Galactic barely has revenue and its service – space tourism – is targeted at a narrow demographic, one that can afford a $250,000-ish vacation. Still, these names are being bid higher, but investors can't expect these SPAC scenarios to consistently. In fact, they shouldn't and by tempering expectations, advisors can add value to the blank-check conversation.

Although last year made it seem as though SPACs are a new strategy, these companies have been around for about three decades so there's plenty of historical data with which to gauge post-merger performance. Prior to 2020, those performances, in aggregate, weren't great.

“Although some SPACs with high-quality sponsors do better than others, SPAC investors that hold shares at the time of a SPAC’s merger see post-merger share prices drop on average by a third or more,” according to a study conducted by researchers at New York University (NYU) and Stanford University.

Part of the problem – one that many clients don't recognize – is dilution. The NYU/Stanford team uses a hypothetical example in which a SPAC sell 80 shares to the public and gives 20 shares to the sponsor for a small fee. If half those 80 shares are redeemed, a third of the remaining shares aren't backed by cash.

“Redemption actually tends to be much higher than 50%. Mean and median redemptions for SPACs that merged between January 2019 and June 2020 were 58% and 73%, respectively. Over a third of those SPACs had redemptions of over 90%,” according to the study.

Other Issues to Consider 

In addition to the dilution issue, there are other areas where advisors can show their mettle to clients in a blank-check world gone wild.

“First, You do not know in advance the acquisition target; you’re taking a bet on the founder of the SPAC. Retail investors rarely have insight into the minds of founders, and they can make bets based only on public perception. This is a risk,” notes Morningstar analyst Ruth Saldanha. “Second, even if the founder has a target in mind, the SPAC might not be able to close the deal. If this is the case, and you get your money back a few years after the initial investment, that is an opportunity cost. An opportunity cost is what you lose in gains you could have potentially made had you not invested in the SPAC.”

Bottom line: For most clients clamoring for SPAC exposure, advisors may want to steer them toward the three SPAC ETFs – two active, one passive – that came to market in recent months. The basket approach reduces single stock and dilution risk.

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