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Caution urged for high risk, potentially high reward SPACs

Special purpose acquisition companies: the risk is amplified when markets are near the top of a cycle, as we appear to be now

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More ultra-high-net-worth investors seeking potentially higher returns in a historically low interest-rate environment are considering including a special purpose acquisition company (SPAC) in their portfolio – if they can stomach the potential downsides associated with such instruments.

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SPAC investments present a considerable amount of speculative risk, says John De Goey, a portfolio manager with Wellington-Altus Private Wealth Inc. in Toronto.

In contrast to a conventional corporation, which is a going concern, “a SPAC is just a pool of capital that has been cobbled together for the purposes of buying a conventional corporation that might do an IPO down the road. But there’s nothing there yet. It’s just a shell,” he explains.

One potential upside from the extra risk involved with SPAC investing is that “if the stars align and things work out beautifully, you can have an outsize return,” says De Goey.

But, he adds, there are several potential cons, including less transparency, and a lack of control regarding what the SPAC ends up purchasing. There are also uncertainties around the market acceptance of any IPO that might eventually result.

“I would not recommend anyone putting more than 10 per cent of their net liquid investable assets into a SPAC because it’s pretty much – by definition – speculation on steroids,” De Goey advises.

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Moreover, many market experts believe corporate valuations are extremely stretched. Therefore SPACs are not only risky in general, but even more so at a time when the market is near the top of a cycle as we appear to be now, warns De Goey.

Rod Larson,  co-head of research and director of private markets at the BMO Family Office in Boston, notes that SPACs can be financially lucrative for private equity managers, often providing them with the opportunity for an accelerated portfolio exit at a premium, compared to the rigour of a traditional IPO process, which requires a lot of time, money and effort.

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“If you look at all the SPAC money that’s been raised in just the last two years – that has a fuse on it,” says Larson. “The SPAC sponsors, knowing they aren’t going to get paid if they don’t deploy the capital, are going to be aggressive trying to ultimately populate the SPACs with a company. Oftentimes, SPACs end up paying premiums because they are on the clock and competing for deals,” he explains.

SPAC investors typically have up to two years to identify a target investment company. At the end of 24 months, if a company hasn’t been identified for acquisition, then the assets must be returned to the investors.

“The SPAC fund sponsors have a built-in advantage just by the nature of how they are compensated in most of the structures. If you’re a sponsor, your chances of getting a nice return improve because you’re ultimately getting a decent discount when you convert to shares, in addition to collecting fees,” Larson elaborates.

However there is, for the most part, a misalignment of interests between the fund sponsors and common shareholders. Whereas SPACs have historically provided a healthy return for the sponsors, broadly speaking they haven’t always performed well for investors, says Larson.

In most instances, 80 per cent of the equity in a SPAC will be purchased by investors, with 20 per cent retained by the SPAC’s sponsors, says James Sweetman, a senior global alternative investment strategist for Wells Fargo Investment Institute in Charlotte, N.C.

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SPACs are currently more of an American than Canadian market phenomenon. “It’s just a bigger pond to go fishing in. There are more people who are multimillionaires that are prepared to put the money forward,” says De Goey.

John De Goey, Wellington-Altus Private Wealth

Using a baseball metaphor, he notes that U.S. investors are more likely to “step up to the plate swinging to hit a home run. Even though the home-run hitters are also the people who strike out the most, they know and accept the risk, and that’s part of their culture.”

In some instances, SPACs have attracted investors not because of the sponsors’ immediate investment acumen but because of the hype associated with them, and all the more so with those sponsored by celebrities, notes Larson.

Even if an investor shows interest, there may be entry restrictions.

“SPACs don’t necessarily even want your money unless you’re at the very least an accredited investor, and more likely than not, a high-net-worth investor, because they’re trying to raise big money,” says De Goey.

Unlike other investments, which are often specifically targeted toward certain sectors of the economy, many experts do not see that as a key determining factor in decision-making regarding SPACs.

Investing in SPACs requires “a hyper commitment to proper due diligence and knowing who your business partners are. Make sure the people you’re investing with know what they’re doing, because it’s fraught with a great deal of possible pitfalls,” De Goey stresses.

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“We don’t have dedicated managers that focus on trading public SPACs because there is a lot of equity market sensitivity and market volatility associated with it,” says Sweetman. “And we haven’t been able to pinpoint any sort of alpha or skill-based investing across these various different SPACs that have come to market,” he adds.

As with other investments, “a lot is going to depend on the SPAC sponsor and their diligence and investment discipline as to whether or not this is going to work for both sides,” says Larson.

“We’ve treated SPACs with an abundance of caution, and would really only see it helping realize private equity returns. There is an argument to be made that there are arbitrage plays around SPACs that could be interesting to an ultra-high-net-worth investor,” he adds.

For UHNW investors who are interested, Larson only recommends that a very small percentage of their investment portfolio be covered by SPACs.

“We advise taking a cautious approach to SPACs at large. We don’t see it as an advantageous or attractive investment vehicle,” he says.

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