‘The level of confidence is high’

Wall Street has a new investment darling. And while financiers can reap big profits, there are reasons for small investors to be cautious.

Investments – SPACs or special purpose acquisition companies – are like quasi-IPOs:

A publicly traded front company uses the investor’s money to buy or merge with a private company, usually within two years. In doing so, the private company becomes publicly traded. If there is no deal within the specified period, investors get their money back.

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Proponents of SPAC see them as a form of venture capital that can allow investors to get a share of high-growth start-ups at an early stage. There is also some protection against losses, depending on when investors buy.

But SPACs are also known as “blank check” funds – because investors give money to a manager without knowing which company they can buy. Managers can identify specific industry or business targets in the initial records, but are not required to pursue them, basically by giving them carte blanche.

In some cases, investors may purchase star power from a manager.

SPAC’s list of sponsors includes, for example: Bill Ackman, the renowned hedge fund manager; former Mayor Paul Ryan; Gary Cohn, Trump’s former economic adviser; and sports icons like Shaquille O’Neal, Alex Rodriguez and Colin Kaepernick.

“You are investing in people,” said Michael McClary, chief investment officer at ValMark Financial Group. “The level of confidence is high.

“At the moment, we are putting [SPACs] in a bucket with gold and bitcoin, “he added.” It is highly speculative. And there is no financial analysis that you can actually do. “

Investment pools are not new. But they have grown in popularity.

Initial SPAC offerings quadrupled last year to 248, according to Jay Ritter, a professor of finance at the University of Florida. IPOs are on track to quadruple again in 2021, he said.

They raised nearly $ 26 billion last month, a record.

“The market is exploding,” said Ritter.

Retail investors seem to be driving much of the frenzy – as they have done with other recent fads, such as GameStop’s stock.

But the video game retailer offers a cautionary tale for investors trying to capitalize on a high-value item: stocks rose 1,700% in less than a month; he promptly lost most (85%) of his value in the next two weeks.

In the case of SPACs, retail investors appear to be looking for previous returns, according to Ritter.

The SPACs listed this year had an average return of 6.1% on the first day – about six times the average between 2003-20, said Ritter.

“If things hadn’t gone so well in the past six months, I don’t think we’d see this boom, “he said.

There are reasons for caution, according to financial experts.

Increasingly, retail investors are not buying shares for the initial listing price of SPACs, said Ritter. (They tend to be quoted at $ 10 per share.) Retail investors who do not enter the market early will not participate as much – or in any way – in the initial stock price increase.

A key selling point for SPACs is the money-back guarantee, which limits the risk of falling. Investors may choose to redeem their shares when a merger or acquisition is announced, rather than becoming shareholders of the combined entity.

However, investors will not necessarily recover everything. They are entitled to $ 10 per share plus some interest. If they bought higher priced shares on the open market – say, for $ 12 – they would lose (about $ 2 per share, in this example). The combined entity’s shares may also fall below $ 10 when they start trading.

“As with anything, there can be some risks,” said Marguerita Cheng, certified financial planner and CEO of Blue Ocean Global Wealth in Gaithersburg, Maryland. “They are not suitable for everyone in all situations.”

Returns were also not stellar when measured against standard benchmarks, according to experts.

The typical SPAC purchase and maintenance investor achieved a 45% gross return between January 2019 and 2021, wrote Michael Cembalest in a recent analyst note from JPMorgan. (The analysis measures returns for the average investor.)

However, investors would have obtained a higher return on the S&P 500 stock index, which yielded 52% in the same period.

“Good absolute returns so far, but in bullish stock markets, rising tides lift all boats,” said Cembalest, president of market and investment strategy at JP Morgan Asset Management, suggesting that SPACs are hitchhiking on a strong stock market.

The typical SPAC fund manager also made much more money than investors – a 682% return over two years, according to Cembalest.

This is partly due to the structure of the funds: managers usually obtain a 20% stake in the acquired company for a small initial cost. They receive nothing if an agreement does not materialize, however.

Therefore, they have an incentive to do business. The good ones can be more difficult to find in a market flooded with investor capital.

“The SPAC boom may end up bringing many companies in earlier and much more risky stages to the market,” according to Cembalest.