Why Investors Should Be Cautious
SMITH BRAIN TRUST – This year, special purpose acquisition companies, or SPACs, seem to be all the rage, as companies seek to go public while bypassing the initial public offering process. But, be wary, Maryland Smith’s David Kass advises.
While SPACs do offer investors an opportunity to invest in a startup’s early days, things that seem too good to be true frequently are.
“SPACs offer an opportunity for investors to get in early on a young company and earn a much higher return. However, with that higher potential return comes much higher risk,” says Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business. “One thing we teach in finance is the tradeoff between risk and return. And that very much applies with SPACs.”
The risk that SPACs pose is that they serve essentially as a blank check company, Kass says. In most cases, investors are handing over money for intermediaries to spend on their behalf with little to no information about the company. But the people who really come out on top are the promoters and intermediaries putting the mergers together, Kass says.
“The promoters who raise funds from investors stand to gain enormous fees from facilitating these negotiations and serving as middlemen between parties as well as receiving large stakes in the companies merged with the SPACs at very little cost,” says Kass. “They have all the incentive for completing these deals because it’s the investors who assume almost all of the risk.”
If a SPAC fails to take a company public, investors can expect to recoup their initial investment usually within two years.
“The formal Securities and Exchange Commission (SEC) approval process for Initial Public Offering (IPO) involves more people, generally investment bankers exercising due diligence, and takes place over a longer period of time, as opposed to a SPAC,” says Kass. “But what you get is someone proverbially kicking the tires and ensuring the process follows accordingly, much like getting verification during a used car sale.”
So far this year, a stunning $54 billion has been raised by SPACs listed in the United States, more than three times the previous record.
Among the largest: DraftKings, an online betting firm, merged with a SPAC in April with a valuation of $3.3 billion and was later taken public. It is now valued at over $15 billion. But for every DraftKings, there are many more unsuccessful SPAC deals. Since 2015, of the 313 SPAC deals launched, only 93 have completed mergers and gone public, according to Renaissance Capital. Of those, only 29 have yielded positive returns.
“For smaller, less experienced investors, it’s really important to understand the risks involved with investing in SPACs. Based on previous results, you could argue that it’s a negative expected return,” says Kass.
“If you’re lucky, one or two of these SPACs could work out and yield incredible gains, but the probability is very low and you could find yourself losing a lot of money because of this fad.”
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