SPACs Fall From Favor

SMITH BRAIN TRUST – SPACs (special purpose acquisition companies) give investors an opportunity to get in early on a young company and – potentially – earn a high return. SPACs soared in popularity on Wall Street during the COVID-19 pandemic. Nearly 250 companies in 2020 went public through mergers with SPACs. The momentum continued, and even ramped up, in the early part of 2021 with 300 SPAC-merger filings in the first quarter alone.

However, that enthusiasm dipped sharply last month.

A factor, says Maryland Smith’s David Kass, is fear of inflation. This fear “has resulted in a rotation in 2021 from the ‘growth stocks’ that rose sharply in 2020 to ‘value stocks.’

“Higher inflation will result in higher discount rates of earnings several years into the future and therefore lower valuations for growth companies relative to value companies that have more predictable short-term profits,”says Kass, clinical professor of finance in the University of Maryland’s Robert H. Smith School of Business. “SPACs primarily focus on relatively young, rapidly growing tech companies.”

The enthusiasm in 2020 for SPACs and growth stocks, Kass says, also led to an oversupply of SPACs relative to the number of attractive private companies available to be merged with a SPAC. “As a result of near-zero interest rates, SPACs face a lot of competition from private equity firms as well as other large investment firms.”

Sponsors of SPACs “face a risk/reward profile that is very appealing, with the possibility of earning very high returns with almost no risk,” Kass adds. “By contrast, small (retail) investors face a very different risk/reward profile, with a low probability of earning a profit and very high risk of incurring losses.”

“Completed mergers between January 2019 and June 2020, lost 12% of their value within six months following the merger, while Nasdaq rose about 30%,” says Kass, citing a recent analysis from The Wall Street Journal. “The 20% stake that sponsors get for free resulted in returns on investment of more than 500% as of the end of 2020.”

However, the bloom appears to be off the vine now for many, where SPACs are concerned.

“Most companies are choosing the IPO or direct listing path to go public rather than SPACs,” Kass says. “SPACs have performed very poorly in 2021 as the demand by small investors has dried up.”