How to Avoid Getting Burned by Wall Street’s Hottest Money Machine

Billionaires, celebrities and hedge fund titans are all touting SPACs, or “blank-check” firms. Here’s what you need to know about the rewards and risks.

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By Claire Ballentine
August 19, 2021 | 04:18 PM

(Bloomberg) — By Claire Ballantine

At their peak, they looked like the A-list’s hottest new accessories. Alex Rodriguez got one. So did Colin Kaepernick and Shaquille O’Neal. Jay-Z was a fan, as was Serena Williams.

Special-purpose acquisition companies — better known as SPACs, or blank-check companies — made a splash during the Covid-era retail-trading surge. They are companies built with a single goal in mind: They raise money on the public markets by selling investors on a vision, and then buy a public company that fulfills that vision. SPACs let just about anyone with a wild idea, be it flying taxis or even space travel, and a bit of money raise hundreds of millions of dollars.

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For retail traders, SPACs are an opportunity to get in early on startups, often in buzzy sectors like electric vehicles and online gaming. For the rich, they’re an easy way to make even more money and further their fame. And for the private companies acquired by SPACs, the process is an easier route — less paperwork and scrutiny, essentially — to going public than a traditional IPO.

About 250 SPACs  held initial public offerings last year, attracting more than $80 billion. This year, more than 700 of these once-obscure investment vehicles have sold about $174 billion worth of shares.

With all the enthusiasm comes increased scrutiny. The U.S. Securities and Exchange Commission is looking into concerns that SPACs aren’t properly disclosing risks. Investors have lost money on once-hot companies that went public through SPACs, such as ATI Physical Therapy Inc. and Nikola Inc. In an indication of how SPAC shares have suffered this year, the SPAK ETF — which invests in U.S.-listed SPACs and companies derived from SPACs — has fallen more than 35% in price since its peak in February.

So how do investors dip into the world of SPACs and avoid getting burned? Here’s how to get started, and what red flags to look out for:

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How a SPAC Is Born

A SPAC begins its life when a group of people team up, sometimes brought together by expertise in a certain industry or interest in an acquisition target. At this stage, a celebrity might get involved, bringing in additional capital and name recognition. The initial set-up costs are typically between $550,000 and $900,000, according to SPAC Consultants, an industry group.

Then, the SPAC will go through an IPO to sell shares and warrants in units that usually cost $10 each. After this, the management team behind the SPAC can use the money to buy what they consider a promising private firm.

“What you’re investing in really is that future deal,” said Sylvia Jablonski, chief investment officer for Defiance ETFs, the firm behind the SPAK ETF.

The SPAC typically has two years to complete a deal. If it doesn’t, the cash is returned to investors. It’s a faster turnaround than many other kinds of investments.

Once the merger is complete, the SPAC and the acquired company become a single public entity. This is how companies such as DraftKings Inc., Virgin Galactic Holdings Inc. and Lordstown Motors Corp. made their debuts.

But investing in future potential deals can have serious downsides.

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Be Wary of Wild Projections

One of the biggest risks of investing in a SPAC is that the company being acquired could overstate its projections or make false claims about its products. SPACs aren’t subject to the same regulatory scrutiny as traditional IPOs.

“We’ve seen numerous litigation and shareholder class-action lawsuits coming out,” said Andrew Chanin, co-founder and chief executive officer of ProcureAM, an ETF issuer. “Some [SPACs] are making misstatements about what they are doing.”

In the first half of the year, there were 14 federal suits filed against blank-check companies, as well as seven in 2020 and six in 2019, according to an analysis by Cornerstone Research and Stanford Law School’s Securities Class Action Clearinghouse. More than half of those involve claims that firms are overstating the viability of their products.

Shares of SPACs that fail to live up to projections can plummet. Last month, ATI Physical Therapy Inc. released its first earnings report after merging with a SPAC. The company revealed that it had to revise its revenue projections down sharply and had large staff turnover. That sent its shares down more than 50% in two days.

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Question Rushed Deals

Management firms of SPACs face a ticking clock to complete a merger — usually 24 months — leading to criticism that a blank-check company could hurry into a deal that doesn’t actually benefit investors longer term.

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Hedge funds are often more willing to invest in SPACs if they make a deal quickly, allowing investors to get their money back even faster. In a crowded marketplace, SPAC issuers are doing anything they can to stand out.

“The fact the company has to do a deal within two years increases the risk profile a bit because if there is no one to merge with, what do you do?” Defiance’s Jablonski said. “A lot of those companies end up doing bad deals.”

If a deal is announced only a few months or weeks before the deadline, that could be a warning sign that there are overlooked risks or that the SPAC overpaid for the firm it is acquiring, said Josh Warner, market strategist at City Index.

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“There’s a chance that’s just how the timing ran, but it’s also worth considering why,” he said. “There could be this element of just trying to get the deal done. The timing can be particularly important.”

And the time frame is starting to get even shorter. For a while, many SPACs were setting a two-year time frame to complete a deal. But about half the U.S. SPACs that filed in June and July set a timespan of 18 months or less to find a company to acquire, according to SPAC Research.

Mind Inexperienced Management Teams

There are three stages when an investor can buy a SPAC’s shares: When the company is trading as a blank-check firm, after it’s announced a merger and after it completes the merger.

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Investing before the SPAC finds a company to acquire means you’re essentially betting on those in charge — the management team. Research the team’s track record, said Keith Lerner, chief market strategist at Truist Advisory Services. “If they have done SPACs before, look at those SPACs,” he said. “Were they able to deliver?”

While some figures like venture capitalist Chamath Palihapitiya and fintech founder Betsy Cohen have successfully executed multiple deals, others might not have the same history or experience in the financial industry.

It’s a good idea to look into the past careers of the management team members, Lerner said. For instance, if they worked at a hedge fund, what was the performance like? If they worked at a startup, how did that company fare? Were they able to bring new products to market and were they profitable?

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For SPACs that have picked sectors to target, it’s a bad sign if the management team doesn’t have history in those areas.

“Some of these SPACs can be very specific in terms of where they operate,” Lerner said. “If you go into something tech-focused, you want to make sure they have experience in that side and have the contacts in the industry.”

Fame Won’t Necessarily Bring You Fortune

Names like Jay-Z and Steph Curry (yes, he’s involved, too) may bring extra attention to a SPAC, but that doesn’t mean the project is going to be successful.

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Earlier this year, the Securities and Exchange Commission warned investors about buying SPACs based on endorsements from celebrities or their ties to them.

For Matthew Tuttle, chief executive officer at Tuttle Capital Management, a well-known actor or athlete can be a red flag.

“Celebrities in and of themselves don’t disqualify it for me, but if you’re throwing a celebrity in there, and I can’t tell why you’re doing it besides eye candy, I probably won’t be interested,” he said.

Even if a famous name initially attracts your attention, make sure to take a closer look at the SPAC’s goals and the team behind it, Tuttle said.

Shares of blank-check companies can be volatile, and celebrity-endorsed ones especially so. For instance, Jaws Spitfire Acquisition — the Barry Sternlicht SPAC that brought tennis star Serena Williams to its board — is down more than 15% from its February high.

With celebrity-backed SPACs, there’s the risk that excited investors could rush in at first, then sell shares as more details come out about the SPAC, causing its price to drop.

“Look for the non-sexy names,” said Josef Schuster, founder of IPOX Schuster, an index provider. “At least initially you need to stay away from these high-growth, super-high-multiple companies, because more often than not they’re subject to very erratic price swings.”