What Should IPO Investors Make of All This SPAC Fanfare?

Investors are likely seeing special purpose acquisition companies (SPACs) discussed frequently in financial news and media, but it’s probably less clear how to build them into a portfolio or if it’s even wise to be involved with them at all. These investment vehicles have been around for several decades, but there has been a recent explosion in the number of SPACs starting up. They are certainly not appropriate for all investors, but they often bear similarities to IPOs in terms of sector exposure, upside potential, and uniqueness of opportunity. Investors who are thirsty for more options may enjoy some success by considering this alternative.

IPO activity has surged this fall

A flurry of high-profile listings was supported by investor appetite for new names and pent-up demand following a COVID-related delay in listing volume earlier in the year. Low interest rates and support from the Fed have pushed investors into U.S. equities, and certain hard-hit industries such as travel, hospitality, and dining have lagged in demand as capital flows toward less affected sectors. Put off by share prices that are decoupling from fundamentals, IPOs represent new opportunities where investors haven’t necessarily been priced out of the upside potential. Meanwhile, private companies are eagerly opting to tap into public markets to capitalize on favorable equity valuations before potential alterations to capital gains tax policy.

Investors are clearly seeking new opportunities, especially in the healthcare and aggressively valued technology sectors, but the overall number of publicly-listed stocks is still low relative to historical levels. A few dozen IPOs are certainly exciting, but they fall short of scratching the itch for fresh stories. A smaller investable universe and mostly efficient markets are motivating investors to look elsewhere. Fortunately, IPO investors now have an alternative that delivers many of the same benefits.

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The blank check company

SPACs, also known as blank check companies, raise funds through public markets in the same fashion as an IPO. However, these funds do not simply go to the balance sheet of an operating company. A SPAC is basically a shell company with a very small operating structure that holds invested funds in a trust account until they are deployed to acquire a private company at some point in the future. Individual investors generally have the opportunity to vote to approve acquisitions and can often redeem shares if they disagree with the decision. In the event that funds are undistributed, they are returned to investors at a set date, usually within two years. SPAC investors, therefore, gain exposure to an otherwise unlisted company with some built-in safety measures.

Consider an individual who wants to invest in an enterprise software company but isn’t enticed by the upside potential of any stocks in the market. That person might find a SPAC led by experts in the enterprise software industry and elect to trust their judgment on the next best opportunity. That person will purchase shares in the SPAC, and some time later, that SPAC may acquire a high-growth company that would have been years away from their IPO. DraftKings and Virgin Galactic are two noteworthy recent examples of successful SPAC transactions.

Why the shoe fits for IPO investors

The reduction of information asymmetries in public markets makes it more difficult to identify clear mispricing of stocks than at any point in history. Meanwhile, the allure of tremendous returns has fueled interest in high-growth opportunities such as venture capital and private equity. IPOs are often considered among the earliest-stage opportunities to get this exposure for average individual investors, but they can be risky propositions.

Analyzing newly-listed companies can be very challenging for investors at any level of expertise. These companies can hardly be considered start-ups, but they are disproportionately disruptive newcomers to their industries with relatively limited operating history. Their executive leadership and board are often less established. Growth trajectories may not be stable. All of these factors combine to create an uncertain narrative, making analysis and valuation a complicated process.

Alternatively, SPACs provide a relatively simple route for the regular stock market investor to gain exposure to other high-growth asset classes through the curation of industry experts. Ideally, investors can lean on the expertise of the SPAC management team to acquire equity that yields returns in excess of the traditional stock market. This is obviously different from IPO investing, but it provides many of the same benefits.

SPACs play an important role in the market, but they no doubt carry risks. The fund structure completely disallows any fundamental research, since investors do not actually know which business they will eventually hold. They must simply trust that the management team is competent. Moreover, the acquired company faces the regular slate of business risks in terms of execution, market size, and competition, which are especially relevant to growth stage or disruptive entities.

Finally, there are major regulatory and administrative hurdles that companies must overcome to be listed publicly, and these must often be completed on an accelerated timeline to be eligible for SPAC acquisition. That puts the company management’s reputation at stake, and it can distract from operational performance.

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Ryan Downie has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Virgin Galactic Holdings Inc. The Motley Fool has a disclosure policy.