Time To Invest In SPACs?

Dear Rich Lifer,

It is gearing up to be an eventful week for the SPAC market. SPACs — or special-purpose acquisition companies — are companies with no commercial operations that are formed solely to raise capital through an initial public offering (IPO) in order to acquire an existing company. 

At the time of their IPOs, SPACs have no existing business operations or even stated targets for acquisition.

Investors in SPACs can range from prominent private equity funds to the general public. Also referred to as “blank check companies,” SPACs are not a new phenomenon, but they have grown in popularity recently and have attracted investments from big-name underwriters like Goldman Sachs, Credit Suisse, and Deutsche Bank.

Further, SPACs have been breaking financial records recently. In 2019, their IPO fundraising hit a record $13.6 billion — more than four times the $3.2 billion they raised in 2016. Fast-forward to the first quarter of 2021, and we have already seen $166 billion raised by SPACs.  

However, SPACs are now facing a new challenge — short sellers. Investors who bet against stocks are targeting SPACs. 

Targeted SPACs 

According to data from S3 Partners, bearish bets against shares of SPACs have drastically increased to about $2.7 billion from $724 million at the start of the year. 

Many of the stocks that have become singled out by short sellers belong to large SPACs that are backed by high-profile financiers. 

One of the most popular targets is a blank-check company created by venture capitalist Chamath Palihapitiya that plans to merge with lending startup Social Finance Inc. Currently, 19% of its outstanding shares sold short, according to data from S&P Global Market Intelligence.

Some are also going after companies once they combine with SPACs. For example, Muddy Waters Capital LLC announced that it was betting against XL Fleet Corp., a fleet electrification company that went public in December after merging with a SPAC.

Muddy Waters released a report alleging XL inflated its sales pipeline and made misleading claims about its technology. The day of the report’s release, XL’s stock price dropped by about 13% to $13.86. 

XL maintains that the allegations have “numerous inaccuracies,” but the damage was already done and this past Friday, the stock price closed at $12.79. 

Muddy Waters’s Carson Block, a vetern short seller, says he views most SPAC companies as “abysmal” and mostly free from certain challenges, such as high short interest, which can make betting against them difficult.

The Allure of SPACs

As we mentioned, SPACs are shell firms that raise capital by issuing stock with the singular purpose of buying or merging with a private company to take it public.

There are many reasons people desire to invest in SPACs. For hedge funds, they see investing as an opportunity to make a large return with little risk. Individual investors, on the other hand, are attracted by the chance to get positions in newly public companies, something very difficult to do through a traditional IPO.

But just as SPACs may seem ideal for investors, they also are desirable to short sellers. 

Short sellers borrow stocks they think are overvalued and quickly sell them, hoping to repurchase the shares for a lower price when they need to be returned, while pocketing the difference. 

Analysts and fund managers believe that post-merger companies are especially attractive to short because they have larger market capitalizations, making their shares easier to borrow. Early investors in SPACs are also typically eager to sell shares to lock in profits, making them even more desirable to short.

The Downside of SPACs

However, this doesn’t always work out the way short sellers hope. Take, for example, when individual investors organized on Reddit to push up stocks like GameStop Corp., forcing short sellers to buy shares and cap their losses.

Short sellers could be caught in a similar predicament if strong investor demand for SPACs continues. Analysts also say shorting SPACs can be risky because their shares have a natural floor at $10 and because they are prone to drastic price fluctuation.

Recently, we have also seen a broad selloff in technology and high-growth companies. The Nasdaq Composite Index declined about 7.3% from mid-February to March 10. During the same time period, an index of SPAC stocks operated by Indxx fell about 17%. 

Aware of the risks involved with SPACs and the growing “celebrity” surrounding them, the U.S. Securities and Exchange Commission issued a statement on Wednesday warning that it “is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it.”

Regardless of the risks and the warnings, the portion of shares sold short in SPACs and their acquisitions is climbing. 

Some are betting against stocks they believe rose too fast, such as bioplastics company Danimer Scientific Inc. whose stock price tripled to $64 in the six weeks after it was bought by a SPAC. Now, according to data from S&P, the short interest in Danimer stock has climbed to 8.5% from around 1% in January, and its share price has traded down to about $42. 

Others are making bearish bets to hedge against potential losses in the SPAC stocks they own. 

At the end of the day, SPACs can serve as an easy way for retail investors to get access to previously private or high growth companies. However, they are prone to overvaluation and hype by big names, and now we are seeing them come under attack by short sellers. 

Make sure you weigh the prospective risks involved with SPACs before you make a quick judgment on their potential value. 

To a Richer Life,

The Rich Life Roadmap Team 

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