SPACs: Why They Are Generally a Poor Retirement Investment

SPACs: Why They Are Generally a Poor Retirement Investment

More than ever before, people are considering unique investments as they prepare for retirement. For example, many people have begun investing in unit investment trusts once they maximize contributions to their 401(k)s and IRAs. Another vehicle that has generated a lot of buzz recently is the special purpose acquisition company (SPAC).

A SPAC has no commercial operations and is created solely to raise capital through an initial public offering (IPO) to purchase an existing company. SPACs are also referred to as “blank check companies” because of how they operate. While SPACs have existed for decades, they have become more popular in the past couple of years and raised a record amount of money in 2019.

How SPACs Work as an Investment

Investors or sponsors with expertise in a particular industry create SPACs to pursue deals in that sector. Often, the people behind a SPAC have a specific acquisition in mind, but they typically do not disclose this during the IPO process. For that reason, investors typically do not know what they are actually investing in when they purchase shares in a SPAC.

Importantly, SPACs typically seek out underwriters and institutional investors prior to making shares available to the public. All the money a SPAC raises during an IPO is placed into an interest-bearing trust. Funds can only be disbursed to complete an acquisition or refund investors if the SPAC is liquidated. Typically, the acquisition must be completed within two years or a liquidation is forced.

SPACs can complete acquisitions because the owners of smaller companies can benefit from the transaction. Often, the owners of such companies are private equity firms. Selling to a SPAC has been known to add 20 percent to the sale price when compared to a typical private equity transaction. In addition, selling to a SPAC provides the business owner with what is essentially an IPO, but carried out and with an experienced partner. Companies that are acquired can ignore swings in the market or other trends, since they essentially already have their individual investors.

Using SPACs to Invest in Retirement

Some people preparing for retirement have taken notice of SPACs—primarily due to the possibility of earning a very high return in a short period of time. Generally, however, institutional investors are the only ones to see significant gains. People who invest in SPACs for retirement often end up surprised how little money they make. In many circumstances, individual investors may lose money on these deals, especially if they do not understand the fine details of how SPACs operate—and many people do not. SPACs do not disclose many details, after all.

Once the SPAC announces its acquisition, investors can redeem their shares at the price they paid, plus any interest. At this point, it often makes the most sense for investors to redeem their shares to make a small profit off the interest gained during the waiting period. Failing to redeem puts them at risk of dilution.

Unfortunately, the dilution risk is faced solely by investors in SPAC transactions. Underwriters, sponsors, legal counsel, and private placement investors will not experience a certain loss through dilution as the individual investor does. In other words, there is no reason to control this risk, which only increases the likelihood of individual investors suffering a loss. What is good for the sponsor and the private company essentially going public is not always good for the investor in the SPAC IPO. However, this is only one reason among many that retirement investors should avoid investing in SPACs without a solid investment plan.

The Issues Involved with SPAC Investments

One of the main reasons that retirement investors should avoid SPACs is the fact that the investment is blind. Typically, investors know exactly what they are investing in, but that is not the case with SPACs, which makes it very difficult to be strategic in terms of asset allocation. Investors cannot know how to structure the rest of their portfolio until they ultimately know what company the SPAC acquires. The picture becomes even more complicated when you consider the fact that SPACs are not publicly traded companies, which means that they have limited transparency and make few disclosures.

Investors should also recognize that SPACs are inherently riskier than an IPO, which is already an investment with a significant amount of risk. While studies have shown that the average IPO outperforms the stock market, the average investor does not get an average return in most IPOs. The median return for IPOs is lower than the larger market, which is what makes this sort of investment a bad idea for retirement savers, especially as they get older and need to reduce risk. SPACs add a whole new layer of risk.

Much of the drive to invest in SPACs comes from the recency bias. Because a handful of deals proved very lucrative, people become interested in similar deals, instead of looking at what has historically been the best for achieving growth.

The other point to consider is that most individual investors have very limited access to the best SPAC deals. When brokerages get these investments, they typically offer them to clients with the largest portfolios. In other words, getting access to these deals is difficult, and those that are offered to the average investor have already been passed up by others.