2021: A SPAC ETF Odyssey

“2001: A Space Odyssey explores technological innovation, its possibilities and its perils. Two particular dangers of technology are explored in great detail. First, Hal presents the problems that can arise when man creates machines, whose inner workings he does not fully understand.” sparknotes.com

SPACs, or special purpose acquisition companies, began their odyssey in 1993. While the financial technology enabling SPACs is not new, since 2020 there has been a supernova of interest and issuance in the U.S. market. One way to invest in SPACs is through three recently issued ETFs. Hal 9000 and Dave (me, not the movie protagonist) explore the SPAC universe to understand why the investment returns on SPAC ETFs have not exploded to the upside in line with SPAC issuance.

SPAC to Basics

Hal 9000:

“… [SPACs are] puzzling. I don’t think I’ve ever seen anything quite like this before.”[1]

Dave:

Hal, as usual you’re right, SPACs are confusing so let’s review the basics. There are many parts to the SPAC structure, and they vary in size, structure, and quality. Norbert Knutel and Alex MacMillan provide a good general description[2]:

“A SPAC is a publicly traded “blank-cheque” or “blind pool” company created to gather capital by way of an initial public offering (IPO) and thereafter to utilize such funds to acquire business(es) or assets (referred to as its “qualifying acquisition” or “qualifying transaction” or more colloquially, “deSPACing”). Pursuant to a prospectus, a SPAC issues “units” on its IPO with each unit typically comprised of a share and a full or partial share purchase warrant which securities are listed on one of Canada’s senior exchanges. The gross proceeds raised through the IPO are placed into an escrow account to be used towards the SPAC’s qualifying acquisition or to satisfy redemptions of shares in specified circumstances. A SPAC must complete its qualifying acquisition within a permitted timeline or the escrowed funds are to be returned to the SPAC’s shareholders.”

Investing SPACsation

Hal 9000:

“Just what do you think [investors are] … doing, Dave? Dave, I really think I’m entitled to an answer to that question.”

Dave:

I know you are wondering why SPACs are of interest to individual investors. They buy SPACs as they believe the sponsors have the experience and skill to buy good companies and grow them to earn a strong return on the acquisition price. SPAC IPO buyers also have warrants that will allow them to buy more shares at a discount in the future if the acquisition is performing well. Investors have limited downside as their share of escrowed funds is returned with interest If they do not like the acquisition, or If an acquisition is not made within the permitted timeline.

Of course, there are risks too, as you are relying on the reputation and motivation of the sponsors. The sponsors may overpay for an acquisition as they are incented to complete one within the permitted timeline. Since the sponsors purchase equity in the SPAC at much more favourable terms than the IPO price, they can still make a big return even if the post-acquisition share price is below the IPO price of the SPAC. Given that some SPACs have acquired companies that have no track record of revenue or profitability, there is a risk that the benefits and financial projections of an acquisition may be overstated. There can also be dilution in the investor’s ownership share of the acquired company, as additional financing is usually needed to fund the acquisition.

SPACs Snowballing

Hal 9000:

“I think you know what the [issuance] problem is just as well as I do.”

Dave:

Well Hal, the amount of new issuance has been out of this world. While there are a small number of SPACs issued in Canada, the U.S. is where the action is.

Chart 1 shows the numbers since 2009 from SPACInsider.com. You can see that U.S. issuance has increased to such a scale that the first few years are barely visible on the chart. The $83B of issuance through 248 new SPACs in 2020 was almost twice the total issuance between 2009 and 2019. But issuance in 2021 to the end of May has been even more explosive at $105B and 330 deals. The issuance in 2021 is 67% of all U.S. IPO issuance year to date. So, you see, a potential problem is that there is too much capital chasing large deals in the next couple of years, so they could end up buying less attractive companies or overpaying.

Chart 1

According to SPACInsider.com, of the SPACs launched between 2009 and 2018 2% have announced an acquisition, 83% have completed one, and 15% have liquidated. Looking at the SPACs issued since 2019, 66% are searching for an acquisition, 24% have announced one, and 10% have completed one.

UnSPACtacular Returns

Hal 9000:

“Look Dave, I can see you’re really upset about this. I honestly think you ought to sit down calmly, take a stress pill, and think things over.”

Dave:

Things were going so well Hal, at least up until early this year. Since you have a computational mind, I put together some data for you, although the history is short. There are no Canadian ETFs focused only on SPACs, so I used U.S. data. There are two SPAC indices and three ETFs that invest in SPACs or their post acquisition companies. You will notice that the names are ones that only a rocket scientist would love!

On the index side, the Indxx SPAC & NextGen IPO Index inception date was April 2020 and the IPOX SPAC Index was July 2020. Indxx has a 40% weight in SPACs and a 60% weight in the IPO’s derived from SPAC’s (the acquisitions). IPOX is intended to capture the performance of SPACs from their IPOs to the consumption of their acquisitions, although it may hold onto the shares of the post-acquisition companies.

On the ETF side, the Defiance NextGen SPAC Derived ETF (SPAK) was launched in September 2020 and is passively managed as it tracks the Indxx SPAC index. The SPAC and New Issue ETF (SPCX) was launched in December 2020 and is actively managed by holding a broad portfolio of SPACs and the IPOs of the companies that they acquired. The Morgan Creek – Exos SPAC Originated ETF (SPXZ) was only launched in January 2021 and is also actively managed. The MER on the indexed ETF is 0.45% and around 1% for the active ETFs.

Chart 2 below shows the return on $1 invested in the indices and ETFs. For comparison, I also show U.S. large capitalization (cap) stocks as measured by the iShares Russell 1000 ETF (IWB). Since Indxx was launched in April 2020, $1 has grown to $1.45 versus $1.50 if it was invested in U.S. large cap stocks. As you can see, SPAC returns were strong until February of this year. Since then, all the SPAC indices and ETFs have lost money while U.S. large cap stocks have made money.

Chart 2

Sources: IPOX.com, Indxx.com, TrackInsight.com

SPACs Latest 3 Month Return Odyssey

Hal: “Stop Dave. Stop Dave. I am afraid. I am afraid Dave.”

Dave:

Sorry Hal, but we need to look at the latest 3 month performance since the SPAC peak in February. Chart 3 shows that SPAC ETFs have had negative returns while large cap stocks have increased 10%. Perhaps this isn’t surprising given how many SPACs have been issued, the dilution that has occurred when acquisition have been made, and the poor performance of many of the recent acquisitions. What is interesting is the difference in performance between the two actively managed SPAC ETFS. The SPCX is down 6% but SPXZ is down 17%, in line with SPAK, the indexed ETF.

Chart 3

Sources: IPOX.com, Indxx.com, TrackInsight.com

SPAC to the Future

Hal 9000:

“I know everything hasn’t been quite right with [SPAC ETFs] … but I can assure you now, very confidently, that it’s going to be all right again.”

Dave:

Hal, I think that SPACs can be OK, but you must do your homework before buying. I think there is a lesson in the poor performance of the SPAC ETFs and their broad holdings of SPACs. Rather than buying a SPAC ETF, you will likely be better off focusing on a few high-quality individual SPAC securities.

The SPAC sponsors’ experience and track records are the most important considerations when you are doing your analysis of a SPAC. Second, don’t rely on what other people are saying about the SPAC. As the SEC warned recently, “It is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment.” Third, look at the sponsors’ incentive structure. Make sure you are comfortable with the alignment of the interests of the sponsors and the investors. In the future you may see structures where sponsors have a much smaller amount of ultra-cheap sponsor shares in the post acquisition company than the typical amount of 20%. Another improvement you may see is structures that have a longer lock-up period before sponsors can sell their shares or exercise their warrants.

Hal 9000:

“I feel much better now. I really do.“

Dave:

You’re welcome Hal, I am signing off now.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.

[1] 2001: A Space Odyssey Hal 9000 movie quotes from Rotten Tomatoes and Wikiquote

[2] Visit this U.S. Securities and Exchange Commission link for a more detailed explanation.