Are special purpose acquisition companies (Spacs) really worth the hype? Should they be part of a retail investor's investment portfolio?

For those unfamiliar with them, Spacs are public companies that raise money through an initial public offering (IPO) to make a specific acquisition. In other words, they are essentially public shell companies that have only one purpose: as a transaction vehicle for private entities to go public.  

And while they have been around for a while, the popularity of Spacs appears to be on the rise. Recently, former US President Donald Trump's blank-cheque firm Digital World Acquisition Corp saw its stock spike after his new social media app topped downloads on Apple's App Store.

So why all the interest in Spacs? One reason may be that they provide retail investors with an opportunity to invest in private companies through the Spac.

And while Spacs, which are also known as "blank-cheque companies", have been receiving greater scrutiny by the US Securities and Exchange Commission, global interest in Spacs seems to be intensifying: From November 2020 to August 2021, the Netherlands' total Spacs investment surged from EUR 55 million to nearly EUR 300 million — amounting to an almost five-fold increase, notes Mandy Tham, SMU Assistant Professor of Finance (Education); Academic Director, Master of Science in Wealth Management.

Moreover, the proportion of investments in overseas Spacs has also been on the uptick, with Singapore listing its first Spac at the start of 2022. She adds that many millennials have been pursuing the Spac trend in the US, driven by social media and the Yolo (you-only-live-once) mindset. The demographic has been making Spac investments through loans and financing, or purchasing cheaper yet riskier Spacs, such as the call options of the Pershing Square Tontine Spac belonging to billionaire Bill Ackman. Unfortunately, some investors had incurred severe losses, some of which amounted to over US$2 million.

Nonetheless, the overall percentage of Spac investment is still tiny, representing only 0.04 per cent of total stock investments. Therefore, to evaluate its true potential, we need to start by comparing SPAC investment against three asset classes – stocks, real estate investment trust (Reit) and private equity (PE), says Prof Tham.

Investment goal – Return on capital or dividend yield

As an investor, what is your priority – capital gains, dividend yield, or both, asks Prof Tham.

She explains that a Reit is exempted from income taxes if it distributes at least 90 per cent of its taxable income to the shareholders. As such, a Reit usually distributes the dividends based on units in a regular manner (known as DPU – distribution per unit). It also experiences relatively low price volatility and will not quickly benefit investors with a significant price appreciation. Consequently, Reits are more attractive to investors seeking a steady flow of income instead of capital gains.

In comparison, private companies are always short of cash in their early phase of development, observes Prof Tham. As a result, they cannot support any dividend policy. Therefore, the main goal of private equity investors is an attractive capital gains and not the dividend yield. Those who wish to have the best of both worlds – capital gains and dividend yield, may consider large, stable listed companies to meet their expectations in overall return.

In fact, a Spac is a shell company that will not pay any dividends before the merger stage. Instead, using the funds raised from investors via an IPO, it aims to find an acquisition target before a stipulated deadline. As such, the funds raised by the Spac in an IPO are placed in a trust account of an independent trustee and are used to acquire the target company. When the Spac fails to complete the acquisition before the deadline, it will return the funds to the investors after deducting expenses incurred

No one can predict the dividend outcome from the business combination which is the merged entity after a de-Spac transaction.  The de-Spac transaction refers to the process  whereby the Spac  and the targeted private company merged into a business combination.   As such, Prof Tham elaborates that the primary investment goal of Spac investors is the capital gains and not the dividends.

Investment term and liquidity

Further, Prof Tham says that the duration of your investment is another consideration when deciding on the type of asset class in which to invest.

Undoubtedly, private equity investors have to commit to the most extended investment term with the lowest liquidity as private companies usually require a long development period from their early stage to a public listing.

Reit investors may also fall into the category of long-term investing. However, since Reits are listed on stock exchanges and hence have more liquidity, investors can enter or exit the market at any time, dictating an investment term based on their requirements. As for stocks, this asset class has attracted all types of investors, ranging from day traders to long-term investors. As such, the investment term may vary according to the types of investors.

However, in the case of Spacs, the investment goal of capital appreciation can only be achieved after a de-Spac transaction is completed. Typically, a Spac has to zone in on a target private company within two years of launching an IPO. Under ideal conditions, the development of this target company should be close to the IPO stage, or at least in the later stages of development, for a merger into a business entity. As a result, investors are advised to maintain a holding period of more than 24 months.

Diversification, volatility and sponsors – key factors to consider with Spacs

In terms of diversification, buying a single Spac or a single large-cap stock will only constitute a single stock position, states Prof Tham. In comparison, a Reit is a collection of many real estate assets in an investment portfolio. When investors purchase the Reit, they are buying into an investment portfolio. On the other hand, private equity investors can either directly invest in a private company or indirectly invest into multiple private companies through a private equity fund, which will then invest in a portfolio of private companies.

The price volatility of a traditional private equity investment is the lowest not because there is no volatility but because its valuation is carried out privately. In other words, the price volatility cannot be tracked as the price is not transparent. In contrast, the prices of asset classes such as Spacs, stocks and Reits can be observed as they are listed on exchanges during trading hours. As a result, price transparency is a prominent feature. But these prices are constantly fluctuating due to the changing market conditions and investor sentiment. When comparing Spacs, large-cap stock and Reits, the price volatility of Reits is perhaps the lowest because it constitutes a relatively stable investment portfolio of many real estate assets, providing a more diversified income stream that lowers the overall investment portfolio volatility, explains Prof Tham.

A Spac listing is often regarded as an easier route for private companies to become listed, relative to the traditional IPO route.  This is because in a Spac listing, the private companies are screened by the Spac sponsors and subjected to the due diligence standards of these sponsors. However, the process completely differs from listing a company via a traditional IPO — whereby it needs to meet stringent listing qualifications stipulated by an exchange, including a multi-approach review of its finances, operations, governance, management team, ownership structure, business strategy and so on.

For example, Nasdaq stipulates that a company must achieve a non-negative earnings and cash flows for three consecutive years. These requirements usually pose a comparatively higher barrier to entry for private companies. Consequently, private companies that cannot be listed in the market via the traditional IPO route or possess inadequate preparation would deem the Spac a simpler alternative to an IPO. Investors must understand that the success of the business combination, and hence their investments in the Spac, depends critically on the due diligenace standards applied by the Spac sponsors in screening private companies to be merged into the Spac.

Although it is equally vital for Reits to have high-quality sponsors, a Reit is not a blank cheque company. The prospectus of a Reit IPO includes a complete analysis of the companies in the investment portfolio, providing an avenue for investors to make an informed decision.

For private equity, the quality of sponsors is also key to success as it relates to the ability of the sponsors to choose and invest in the next Tesla or other startup with high potential to become a unicorn. It is also worth noting that private equity has the highest uncertainty, most prolonged development and investment term, and lowest liquidity.

Investment is both an art and a science. The main purpose of such a comparison is to help investors assess the viability of Spacs in their investment portfolio. While private equity investment is restricted to accredited investors, the various asset classes of Reits, stocks and Spacs listed in an exchange are open to all retail investors. As Spacs are a new asset class in Singapore, Prof Tham encourages retail investors to invest adequate time into understanding it before taking the plunge.