SPAC Investing: Risks and What to Look For

Special purpose acquisition companies, or SPACs, are one of the hottest trends in the investing world. And at first, it might seem like they don't have much downside risk. After all, if a SPAC, or "blank check" company doesn't find an acquisition target, investors simply get their money back.

However, there's more to the story. In this Fool Live clip from Dec. 22, 2020, Fool.com contributors Dan Caplinger and Matt Frankel, CFP discuss some of the risks that come with SPAC investing that you need to know about.

Matthew Frankel: A lot of people think of a SPAC as kind of a no lose investment. The reason being, if you buy a SPAC and they can't find any type of business to acquire, investors get their money back after a certain amount of time. Usually it's about two years, in some cases 18 months or so. There is some period of time after which investors will get their money back, so it might seem like a no lose situation. Whereas you buy a SPAC, you pay $10 a share. They either find a great IPO or they don't. If they don't, you get your money back. But there are some risks. For one thing, IPOs go badly all the time. Lately, investors are forgetting this with Airbnb (ABNB 2.77%) and DoorDash (DASH 1.64%) and things like that, that seem to triple every time you look at your computer screen. But IPOs go the other way all the time. There's no guarantee that the management team is going to make a good decision. Don't think of a SPAC as a risk-free strategy. What do you think investors should be aware of before they buy their first SPAC?

Dan Caplinger: I think for a good SPAC, you want to take a look at the management team behind it. You want to take a look at the people who are going to be negotiating the contracts with privately held companies, the people who are going to be talking to those privately held companies as founders. Find people who are actually going to get good target businesses to pay attention to them. Like you and I could set up a SPAC, and we could ask a bunch of Motley Fool folks to give us $10 a share. But I don't know about you, I wouldn't have the first thought of, "Well, how do I go find a privately held company that's going to be investable, that's going to make a lot of money for my investors." That's why you've got so much attention paid to big names, SPACs by Thomas Polly happy tier, from Bill Ackman's, the Pershing Square new SPAC (Pershing Square Tontine Holdings (PSTH)). Those big names have demonstrated their ability to find good target businesses. They come with a premium. Although it's a limited universe, that premium has generally been justified in terms of what's happened to the shares of the companies that they've found after those mergers take place. If you're looking at SPAC for the first time, probably best not to take just a randomly picked one. Instead, take a look at ones that have a good management team in place. The situation changes a little bit once you have an acquisition candidate. Frankly, that's when a lot of people first look at SPACs, is they don't look at the SPAC before they've targeted somebody. They only take a look once they pick a company. In those cases, that's much harder deal. It becomes much more like a pre-IPO, IPO in the sense that you get hype about the underlying business, what industry it's in. We've seen a whole bunch of SPACs targeting companies in the electric vehicle battery technology areas. Once you know what business that SPAC is going to be buying, then you can do the Foolish look. You look at the fundamentals of the business, where you see the growth opportunities, where you see the risks. You look at the terms of the deal and see where your risks and reward as a shareholder is going to be, and then you can go from there. But there's two phases to it in terms of whether you're going to buy into the SPAC before they take the target or after they've already identified a merger company.

Frankel: I look at a SPAC as a bet on management. If you notice some of the SPACs you just mentioned like Pershing Square SPAC, and all the ones that start with the symbol IPO, they were five and now there's just three left in the market. But if you look at some of those, they create a pretty big premiums even though they don't have deals yet. The reason is because this management has a fantastic track record and people are willing to pay up to get a piece of whatever that manager is going to do. Speaking of the electric vehicle, I'm getting absolutely skewered on Reddit and Twitter (TWTR) right now because I put out an article this morning advising people against EV stocks. [LAUGHTER] Our normal auto writer, John Rosevear has just texted me, "Welcome to my world." [LAUGHTER] I don't know if I'll doing that again. So for this segment, I have no comment on EV stocks whatsoever, but it's a bet on management. Don't chase speculation, which is something that you would do after a deal is announced. But be sure that you're really confident in the management. Whenever I look at an S-1 filing, which is the regulatory filing a SPAC would file before it goes public, I always scroll right down to the management page because to me the most important page in the entire 150-page document is who is going to be running the show? Who is going to be selecting an acquisition candidate?