‘They’ve all gone up’

The red-hot SPAC market will get even hotter in 2021, raising concerns about rampant speculation apart from the reason retail investors might leave fresh off the GameStop bust with the bag stuck.

Not only are specialty acquisition companies raising record levels of capital – more than $ 30 billion so far for the largest quarter ever – before the merger, SPACs are also seeing an inordinate pop on the first day of trading.

New deals recorded an average jump of 6.5% at their debut this year, a nearly six-fold increase from their historical levels (from 2003 to 2020, the mean first day yield of SPAC IPOs is just 1.1%), according to the University from Jay Ritter, Florida finance professor.

“They have all gone up in price. They are not driven by one or two outliers,” said Ritter.

Unlike traditional IPOs where debut pops are generally seen as a sign of a healthy investor appetite and an optimistic market environment, SPAC’s initial rallies are less rational in nature. These blank check companies are empty business shells that raise money from investors and then merge with a private company within two years, while making it public.

So when investors hungry for yields raise the prices of blank checks, they’re essentially taking a leap of faith by betting on something with no valuation or a real business. Many believe that the rise in SPAC prices could be a sign of speculative behavior in a new bull market with massive liquidity and uncontrolled animal spirits.

“There is a lot of money coming into the market,” said JJ Kinahan, TD Ameritrade’s chief market strategist. “That lends itself to people who are going off course of the S&P 500 or Nasdaq 100. You will continue to see this behavior just because people are looking around to see what is more than buying the same stock that everyone else is buying.”

There are signs that the SPAC boom is becoming entangled in the retail-driven market frenzy. Bank of America’s client flows showed retail investors accounted for 46% of the trading volume in SPACs on its platform in January, compared to about 30% two months ago. In comparison, retail only takes up about 20% of S&P 500 trading on the Bank of America platform.

“The speculative nature of SPACs appears to be especially attractive to retailers,” Bank of America analysts said in a note. “We absolutely don’t need to remind anyone what could happen if something speculative hits the retail radar (ahem, GameStop).”

Getting the first installment of a SPAC deal has allure to many retail investors looking at high-growth start-ups. However, given that the majority of individual investors buy common stock of SPAC in the open market, they would most likely miss the first day. In addition, many brokers do not offer trading SPAC warrants, which are a deal sweetener that offers early investors more compensation for their money.

In fact, buy-and-hold investors who don’t get in until after a deal is closed almost always lose money.

For the 114 companies that went public through SPAC mergers in the past 10 years, investors lose an average of 15.6% if they buy the common stock of a merged company on the first day of trading and hold it for a year, Ritter said. And they lose 15.4% on average if they hold the stock for three years.

However, it is a different story for institutional investors. Hedge funds and other players participating in SPAC IPOs can often get a bid price of $ 10 plus the benefit of warrants. They also tend to sell stock as soon as the merger is complete which can have a negative effect on prices.

“Institutional buyers found out that this is a great deal,” said Ritter. “SPAC’s IPOs are essentially undervalued, standard-free convertible bonds. The worst they can do is $ 10 plus interest, and no one has lost money.”

Another worrying factor is the sheer number of deals chasing targets right now. A record of over 300 outstanding SPACs is on the hunt, giving private companies more bargaining power and allowing investors to play off against each other to get a better valuation.

“Valuations have, of course, become increasingly competitive,” said Soumya Sharma, corporate lawyer at Troutman Pepper. “The whole reason this will survive is that high-end targets agree to merge with SPACs because they think they are better valued.”

As target companies’ valuations get higher, this diminishes the upside potential for the SPAC investors. Meanwhile, sponsors could compete for lower quality companies, many of which have yet to produce a physical product.

“The past few months have been great for the SPAC investors with very high returns, but I don’t think it will continue like this,” said Ritter.

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