MARK RIEPE: When I was a kid, I loved game shows, and one of my favorites was Let’s Make a Deal! hosted by Monty Hall. The format of the show was simple. Monty would walk through the audience and pick an audience member to make a deal with him. Usually, the audience member or contestant would be offered an item of value—it might be a calculator, or perhaps a new piece of furniture, or perhaps some cash.
The contestant would then be given the choice of keeping it or exchanging it for a different item.
But what made the show interesting was that the contestant didn’t know what the other item was.
Often there would be three choices hidden behind doors. The contestant could keep the item or trade it in for what was behind one of the doors. Typically, one door was hiding something really nice, like a new car. Another door had a prize that was OK but nothing special. But one of the doors always had a “zonk”—the nickname for something that was worthless or of minimal value.
On this episode we’re going to look at an investment vehicle that bears some resemblance to this process. Special purpose acquisition companies (or SPACs) take funds from investors in order to buy or merge with another company. They’re sometimes called “blank check” companies because it’s as if investors are giving the companies a blank check to buy whatever sort of business they want. Until a merger is announced, investors in a SPAC don’t know exactly what they’re buying or trading. They’ve already traded away their investment dollars and are waiting to see what exactly they’re investing in.
I’m Mark Riepe, and welcome to Season 9 of Financial Decoder. It’s a show about financial decision-making and the cognitive and emotional biases that can sometimes cloud our judgment.
SPACs aren’t new—they’ve been around for decades, but they’ve gained immense popularity among investors since the beginning of 2020. SPACs perform a function for investors. Investors tell us all the time about how they want to get in on the ground floor of a new company through an IPO, or initial public offering of stock. SPACs are a method of doing that.
But they’re also complex vehicles and can differ widely in size, structure, and quality, among other characteristics.
What’s especially interesting to me is that there are also emotional and cognitive biases that are relevant when it comes to SPACs. One of them is saliency. Saliency causes us to pay too much attention to or ascribe too much value to investments that have attention-grabbing features.
In extreme instances, the story behind the stock is so compelling that the investor becomes blind to the cold reality that stocks are about ownership in a company, and companies need a solid model for how they’re going to eventually make money for their shareholders if they are going to be sustainable.
Many SPACs are built around a compelling story about the future. But much like playing Let’s Make Deal! and the choice of whether to trade in what you have for what’s behind one of three doors, you don’t have as much visibility into what the company’s business will ultimately be.
Another bias that comes into play is FOMO, or “fear of missing out.” The way I think about FOMO is that it’s a special case of the decision-making mistakes that happen when regret is involved. Sometimes regret causes us to avoid a decision and stick with the status quo because the pain regret causes when we proactively make a decision that doesn’t work out.
FOMO turns that on its head, and people plagued by FOMO fear the regret of having an opportunity and letting it pass by.
Turning back to the Let’s Make Deal! example, they look at the $100 Monty Hall gave them, and then they look at the three doors. They’re pretty sure there’s a new car behind one of those doors, and they won’t be able to live with themselves if they don’t at least give it a shot by giving Monty back the $100 and selecting one of the other doors.
This emotion is relevant when it comes to SPACs. Some of these businesses may turn out to be big and this is an opportunity to get in on the ground floor. I get it and I’m sympathetic. In fact, I don’t even like using the word bias when it comes to describing these types of emotions. We feel the way we feel, and who’s to say the way we feel is wrong?
Nevertheless, very, very few of us have an unlimited amount of money to throw around when it comes to investing, and we need to be prudent. And that starts with understanding where we choose to allocate our hard-earned dollars.
To explain more about SPACs and how they work is Liz Ann Sonders. Liz Ann is Schwab’s chief investment strategist. She’s regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron’s, and the Financial Times.
She also appears as a regular guest on CNBC, Bloomberg, CNN, Yahoo! Finance, and Fox Business News. Liz Ann has been named “Best Market Strategist” by Kiplinger’s Personal Finance and one of SmartMoney magazine’s “Power 30.” Barron’s has named her to its “100 Most Influential Women in Finance” list and Investment Advisor has included her on the “IA 25,” its list of the 25 most important people in and around the financial advisory profession.
MARK RIEPE: Thanks for being here, Liz Ann.
LIZ ANN SONDERS: Thanks for having me, Mark. I always enjoy these conversations.
MARK: All right, we’re going to start with the basics here, what is a SPAC? And a little follow-up question, why do they exist?
LIZ ANN: So, Mark, as you mentioned, they are vehicles that are used for bringing a company public. So from the time of its IPO to what is called a merger with a target company, the SPAC acts as a place where investors can park their cash. Then, if and when a deal is reached, the SPAC actually takes on the so-called identity and also the stock ticker of the target company. And I think the simplest explanation for why they exist is to provide an easier way for companies to go through the IPO process. That process is traditionally pretty arduous, especially for newer companies that may not have a long history of revenue and/or production. So while that may sound a bit odd, the lack of transparency is actually one of the more appealing aspects of SPACs. The companies that they are targeting for a merger don’t face any major restrictions based on prior performance, and they’re also not prohibited from making forecasts about future products or services.
MARK: So, Liz Ann, SPACs have been around for a while—this isn’t just something that was, you know, invented last year—and yet, I don’t know whether it was late last year or early this year, their popularity seemed to really increase pretty substantially. What was behind that? What’s going on?
LIZ ANN: So I think there’s probably several reasons. You certainly could start with the unbelievable liquidity environment in which we have been living in, in the aftermath of the initial plunge in markets last year due to the pandemic. And then the subsequent swift recovery in virtually every pocket of the market, especially equities, there was a pretty acute wave of optimism and overt speculation that emerged among investors. And that came on the heels of the massive fiscal monetary support, which as we now know with the benefit of hindsight, coincided with a rally in various other speculative segments of the market. So not just SPACs, but non-profitable tech companies, heavily shorted stocks, the meme stocks, and then, again, including SPACs.
There was also a big celebrity influence that transcended the investment business that can do what we often see on social media, and you not only saw famed money managers starting their own SPACs, but professional sports stars, and even some retired CEOs of Fortune 500 companies. And there’s no doubt that that had an influence on investors and helped to pique their interest, especially in a time of lockdown when so many individuals were just getting introduced to investing.
MARK: You mentioned some of these … sort of these meme stocks contributing to that popularity. There was also just kind of a big, I don’t know, trading frenzy going on, particularly in the first quarter. Do you think that contributed, as well?
LIZ ANN: Oh, for sure, I do think they go hand-in-hand. And, you know, I’ve mentioned that with newer investors in the market—I’ve been calling them the newly minted day traders—I think the frenzy and hype and speculation was pretty pervasive across many areas. And I don’t think it’s a coincidence that the collective frenzy trade peaked in the February/March timeframe of this year, and depending on what segment or what speculative cohort you look at, whether it was SPACs or the meme stocks, as you mentioned, maximum drawdowns, so the maximum, you know, kind of peak-to-trough decline from this year’s peak among those various areas are in the 30%, and to believe it or not, 80% range.
Also, not coincidentally, deal value for SPACs also peaked in February, essentially at the same time we saw a peak in the ISPAC Index, which is a basket that tracks the broader performance of the SPAC world. So not only have we seen it unwinding in the price of many SPACs, we’ve also seen a heck of a lot of air come out of overall activity. And I think the latter is probably due to the just sheer number of SPACs that have come online. Since June of 2020, which is when the number of new deals started to spike, there’s been a cumulative $250 billion in total SPAC deal value created, and that’s just here in the United States. So it’s safe to say that the market has been flooded, and without an equal size increase in the number of target companies, the math, of course, emphasizes that it’s a tougher environment for any newer SPAC to enter. And I think for sure that has contributed to some of the cooling in new SPAC IPOs, which has occurred alongside the broader decline in these other aforementioned speculative segments of the market.
MARK: Yeah, I want to get back to some of that, performance numbers you were just talking about in a minute. But before we get to that, to understand a little bit about why SPACs exist and, you know, what their … why companies like them, but how does an investor go about trading them? Are their shares traded just like any old stock, or is there something different?
LIZ ANN: Well, once they IPO, they trade just like any other company on an exchange, but from a fundamental perspective, they’re a bit different. You know, they’re often called, generically, blank-check companies and essentially are just vehicles of cash. There aren’t any fundamentals attributed specifically to the SPACs themselves. They have no earnings, no dividend stream, so that’s always important to remember in that pre-merger timeframe.
MARK: Liz Ann, you mentioned earlier that the traditional IPO process is pretty arduous for companies. What about investors? Is there something about that process from the standpoint of the investor that makes that less attractive and SPACs more attractive?
LIZ ANN: So I guess if you’re viewing it through the lens of SPACs, maybe one of the more important aspects is the ability to talk about the future and make a prediction. That’s a big differentiator. Looking at the broader landscape, many of the more popular SPACs are hunting for companies in the electric vehicle, the solar, the tech space, so pretty hot areas. And there’s obviously other sectors, but the overarching theme has been a focus on innovation, on disruption, and that is mostly tied to opining on what may happen in the future. So I think that’s a major reason why many of these companies can’t and couldn’t go down the traditional IPO route.
There are also fewer barriers when it comes to doing roadshows. So you have the traditional IPO process, involves many meetings with groups of institutional investors, that’s in the interest of amassing capital, and the SPAC group, at least theoretically, makes the match a bit easier, since the capital is gathered, effectively, in one vehicle. Now, there’s still a process of vetting and making sure companies are the right fit, but it is arguably less arduous and time-consuming for most companies.
MARK: There’s another way of going public, and that’s the DPO, or direct public offering. How does that differ from, let’s say, an IPO?
LIZ ANN: Sure. So initial public offering, IPOs, use a broker, while the direct public offerings, or DPOs, offer a more direct approach. Both, however, are ways in which companies can sell shares for really any reason. And although DPOs are not as common as IPOs, each way of issuing shares comes with potential advantages and disadvantages for both the average investor and the company itself. I think a clear advantage is finding a sound company with bright prospects, appreciation potential, of course. So to the extent investors can scout out a true disruptor that can make money, that can prove its longevity, then there is most likely a benefit from a return perspective.
Now, for this most recent wave, it’s probably still a bit early to determine whether there’s a definitive advantage for SPACs, but there is some historical perspective that suggests their performance over the long term is actually pretty weak. So we looked at data tracking SPACs that launched from the early 2000s up until 2019, so the year before the pandemic. And median performance was positive in the first two years of trading, but right after the second year, returns dropped greatly, and by the fifth year, the median return since the IPO was actually about negative 25%.
Now, the overall performance for traditional IPOs is a bit harder to track. That group is, obviously, much larger, spans back many decades. Now, to shed some light on performance in this past decade, there is an index that tracks these newer IPOs. It’s the Renaissance IPO Index, and we do keep an eye on that. Since its inception, which just dates back to 2009, the total return is quite strong, well over 600%. But there have been some pretty significant drawdowns, again, peak-to-trough declines, the largest one being negative 36% in 2016, down 38% in March of 2020, and then down 29% in May of this year.
So with traditional IPOs and SPACs, there’s an attractive long-run potential, but investors also need to understand that there can be severe pullbacks along the way. And one issue, for sure, is volatility. As I mentioned earlier, SPACs themselves don’t trade on fundamentals given that they’re just holding cash, but over the past year, many have seen their share prices double or triple after the IPO. That sometimes can be attributed to excitement around who the sponsor is, especially if it’s a celebrity, as I mentioned, or whether a deal is coming soon, but that is still pure speculation. And the rub with that is most of the hype tends to fade quickly, and, unfortunately, many SPACs have come back down to earth, or in some cases, well below their IPO price, with not much of a boost even after they find a target company with which to merge.
Another risk is if a SPAC doesn’t fulfill its goal of finding a merger target and then is forced to liquidate. So, in general, SPACs have two years to complete a merger, and if they don’t, they liquidate, and investors just get their pro-rata share of the aggregate value of the SPAC. Right now, this isn’t as much of an acute risk, but could be something worth watching as we get into next year, and that is when many of the SPACs that launched in the fall of last year, 2020, will be approaching, of course, their two-year mark. So it will be their, let’s call it, show-me moment.
And then the third risk worth mentioning is the regulatory environment, and that’s certainly getting a lot of attention these days. Not only has speculative activity, in general, over the past year raised a lot of eyebrows, but, of course, there’s also the change in leadership at the SEC, with Gary Gensler at the helm, and his team have made it quite clear that they’re looking into revamping some of the disclosures and rules. That’s tough to forecast at this point, but it’s something we definitely need to pay attention to.
MARK: So, Liz Ann, let’s, you know, pull out your crystal ball, if you may here for a second, always a little bit difficult, especially now. We’ve seen this, you know, big rise, you know, late last year, early this year, and then as you’ve mentioned, some of the ardor has started to cool off the SPAC market. What do you expect going forward? Do you see kind of a reversal of that, or do you think that, ultimately, the traditional IPO process, which has been tried and true and around for decades, is that going to continue to kind of be the dominant way that companies go public?
LIZ ANN: Well, Mark, as you know, anytime I get a question that has the word “crystal ball” in it, I start by saying mine is just as cloudy as everybody else’s, but I think there are a couple of angles in terms of trying to answer that question. The first being that in the near term, we have seen just a complete collapse in popularity. By just looking at deal volume and value, I think, definitively, the boom has ended, at least for now. To put some numbers on that, the average weekly deal value for SPACs in the U.S. in the first quarter of this year, of 2021, was 10 billion. So far, in the third quarter, that has fallen sharply to just $1 billion. In addition, SPACs made up more than half of all IPO value in February, and that has come down to just about 10%.
I think longer term, there’s probably room for SPACs to stay in the game, maybe gain some further traction, but it’s important that we sort of see how this current wave plays out. We have to assess how many SPACs, ultimately, are successful in finding target companies, whether they can see performance, and if they respond well to what we don’t know yet but we know is coming, which is this heightened regulatory environment and the changes that are afoot.
MARK: Well, I think it’s … yeah, it’s interesting, just the number of companies that will kind of hit that one- to two-year mark coming up. How has that performance been between companies that have announced deals versus those companies that haven’t announced deals?
LIZ ANN: Well, to some extent, we’ve seen this happen already. So back in April of this year, the SEC started to hint at the possibility that SPACs needed to account for warrants, which are securities issued to early investors, and that they needed to account for them as liabilities rather than equity. And that, right away, caused a pretty big headache for many of the existing SPACs because they had to revise their past financial statements. It also, I think, was part of the reason for a pause of new SPACs coming online, so there was definitely a dampening of spirits that stemmed from that.
The other more recent change has been less material but still worth paying attention to. The SEC has noted that there may be stricter rules for the sponsors of SPACs. Those individuals may have to disclose more information about their roles, about their financial interests. That could cover their expertise, what their contributions in terms of capital have been, conflicts of interest. And although, again, we’re going to have to wait a bit longer to see how this develops, as the SEC is including this change in its broader April 22 update, that certainly will come into focus next year.
More broadly, you can slice and dice it in different ways. The ISPAC Index had a return of just over 100% from its inception in April of 2020 to, as I mentioned, its peak in February of 2021, but since that point, that index is down around 30%. And the indices and baskets that track broad performance do mask some larger moves, particularly for more popular or larger SPACs. And some of the largest companies by IPO value did, in fact, surge by, in some cases, upwards of 500% in just a couple of months after going public, but many of those same companies have had maximum drawdowns in the 80 to 90% range.
If you look at performance since the fall of 2020, SPACs that have had deals announced have outperformed those without deals by almost 30%, but there are some nuances. The basket of those with deals announced were up 80% from the fall of 2020 to the peak in February of this year. The decline since then has been about 20%. Conversely, the basket of SPACs without deals climbed by a lesser 34% over the same timeframe, but since the peak in February has also had a less severe drop of only about 12%.
Now, the most important aspect to know is what you’re investing in. From a fundamental perspective, SPACs have limited information, so investors need to do a lot of their own due diligence on the sponsor, on their history, along with details associated with what the goal of the SPAC is. And I think investors also need to be able to stomach the volatility that we’ve talked about. Huge swings can occur on a daily basis, a weekly basis. So even though, at least for now, the boom is behind us, it doesn’t discount the fact that many SPACs will still see massive bouts of volatility, and much like in any asset class, that can muddy the picture as to whether it’s a move on pure speculation or something else. So I think investors, as with any investment, need to assess what works best for their risk tolerance, their time horizon, etc. And that’s the case with any investment, again, but I think especially those with more volatility like SPACs.
MARK: Yeah, maybe that’s a good place to wrap up. We’ve talked about returns, we’ve talked about risks, we talked about the regulatory environment. It’s really important for people to understand how this fits into their portfolio or it doesn’t. Any other advice for someone who maybe is considering a SPAC but hasn’t yet done so, any other advice you have?
LIZ ANN: So, you know, retail investors—I’ve been in this business for 35 years, and I’ve heard this the whole time—have wanted the same kind of access to new companies that historically only hedge funds or private equity firms or big institutions have enjoyed. And I think that’s a key reason why people have wanted to take the risk of buying shares in a SPAC. It’s yet another step in terms of democratization. But, again, just like any investment, especially one with more volatility, that has to be taken into consideration in the context of overall portfolio risk.
MARK: Yeah, you’re trying to get in on the ground floor of something. There’s almost kind of a FOMO, fear of missing out, angle to this, but, you know, there’s some consequences to that, as well, when it comes down to it, right?
LIZ ANN: Absolutely.
MARK: All right. Thanks for your time, again, Liz Ann. This has been great.
LIZ ANN: My pleasure, Mark. Thanks for having me.
MARK: Individual investors have long wanted the same kinds of access to new companies that hedge funds and private equity firms enjoy and SPACs help fill that need. But the fact remains that there are risks when it comes to buying shares of a SPAC before a deal is announced.
In my opinion successful investors are those who are attuned to both the upside and the downside of any investment. By all means, listen to the story by the promoter of the SPAC. As Chuck Schwab says, investing is ultimately an act of optimism. All great companies started out as a dream, and getting in early on that dream can be lucrative.
But there’s another side as well. Not all dreams pan out. Some dreams aren’t especially well thought out and never have a chance. Investing based on dreams is like walking across the street with your eyes closed. Your odds of crossing that street successfully go way up if your eyes are wide open and you take the time to look both ways before you cross.
To learn more about SPACs and investing, you can visit schwab.com and click on the Insights tab. In order to invest in SPACs at Schwab, you have to enroll in trading services. You can learn more about trading at Schwab.com/Trading.
Thanks for listening to our first episode of Season 9. We’ve got a lot of great episodes coming up between now and the end of the year. If you’ve enjoyed the show, please leave us a review on Apple Podcasts and access the show for free in your favorite podcasting app. You can also follow me on Twitter @MarkRiepe. That’s M-A-R-K-R-I-E-P-E.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.