SPACs were the hottest thing in 2019 and 2020, however, in the first months of 2021, they have failed to outperform the S&P 500.
So, what is the reason behind the recent underperformance of SPACs and are we seeing signs of a potential bubble burst in this speculative market?
In this article, I am going to discuss rising rates and their impact on SPACs and their valuations.
Over the last two years, over $93 billion has been raised in Special Purpose Acquisition Companies. More than 50% of all of the funds raised by IPOs in 2020 were from SPACs.
Over the last few weeks however, as interest rates have risen, we are seeing SPAC prices down by double digits. Therefore, why are SPACs falling and what should you do about it if you are stuck in one?
SPACs: Synthetic Bonds on Steroids
In order to understand the downfall of SPACs, you need to understand their mechanism and how they work. Very briefly, SPACs are by nature a reverse IPO. Sponsors or investment banks first raise the money and promise their investors that they will find a good target company. If they are unsuccessful in finding a good target company, they then return the money (plus interest) to the investors.
Sometimes however, depending on the deal structures, investment banks are incentivized to find low-quality companies, because regardless of the quality of the deal, they will still get paid a hefty fee.
In summary, SPACs are a pool of cash waiting to find a company, and if they do not find a company within two years, the cash they raised will be returned to the investors who initially provided it. This structure is very similar to a fixed income bond. As an example, you lend the government $926.80 and you get back $1,000 in five years (hence a 1.56% yield). When interest rates are rising, you can earn more interest in buying the newly issued bonds, thus you will sell your current bonds, causing prices to fall. The same logic applies to SPACs. As rates rise, newer SPACs become more attractive, therefore investors dump their existing SPACs, especially as the pool of high-quality companies narrows.
So What Does it Mean for Investors?
If you are invested in any of these highly speculative instruments, do make sure that you have done the proper due diligence.
The key to investing in these SPACs is the term sheets. Who are the sponsors, and how is the deal structured? Are the interests of underwriters and investors aligned? Who are the primary owner(s) of the SPAC? As an example, one of the largest holders of PSTH, the SPAC that has raised the most funds ever, is the Ontario Teachers’ Pension Plan. One significant reason PSTH has done so well is because it is structured so that Bill Ackman and Pershing Square Capital Management are taking no fees and no compensation if the deal is unsuccessful.
SPACs are highly speculative instruments, and you must do your due diligence, especially in the current environment of rising rates.