The Texas Teacher Retirement System recently announced that it would make its first investment in a special purpose acquisition company (SPAC) totaling $200 million. Pension funds across the nations have spent the last decade seeking out higher investment yields from alternative investments like private equity in response to stagnating returns from more traditional investments. Recently a few funds have started to experiment with even more non-traditional vehicles such as cryptocurrencies and NFTs to improve investment results. Texas’ SPAC investment signals pension funds’ continued interest in these alternative assets.
While the returns from non-traditional vehicles have the potential to be high, the risks are higher as well. Pension funds like the Texas Teacher Retirement System (TRS) should be cautious as they venture into these areas and take risks with funds that retirees depend upon and taxpayers are on the hook for.
What are SPACs?
SPACs are a vehicle for a company to go public with the goal of being acquired or merged with another company, making it different from a traditional initial public offering (IPO). The original company finds a sponsor who is tasked with taking the company public via the SPAC. The sponsor for the deal raises money via investors through traditional stocks as well as warrants, which are stocks that have guaranteed prices at a future date. This money is set aside in a trust. The sponsor then has 24 months to find a target company to acquire or merge with. If no target company is acquired, then the deal will fall through, and the investors will recover their investment. In the case of TRS, the pension fund is considered an investor and has put up $200 million for a sponsor to search for a target company.
What risks do SPACS pose for investors?
SPACs are often called “blank check companies” because the investors, in this case, the Texas TRS system, are putting all their faith in the sponsors to make the best possible decision with the money raised. The investor may be given a guarantee of a payout if there is no deal but there is no guarantee they will get their money back if there is a bad deal that falls apart further down the road. From the sponsor’s perspective, any deal is better than no deal simply because the sponsors do not own the company, they are only tasked with finding a buyer. In other words, the sponsor’s first goal is to get paid, and they can do so even if the deal will end up losing money for the company and investor. This leads to the second issue, which is the fees for the sponsors. Sponsors argue that their method is cheaper than paying an investment bank to go public. This is true on the surface, but if you consider that the sponsors often take a 20% ownership in the merged company, it’s more of a mixed bag. All in all, the quality of the sponsor is a make or break for a SPAC.
From the perspective of pension funds, this means that they could either be in the crosshairs of acquiring a bad company with no way out and/or they could be charged significant fees for the investment. Large investment fees are not new to the pension world. Transparency and the size of investment fees for alternative investment managers have long been a contentious topic.
Why the recent interest in SPACs?
SPACs are not new, they have been around since the 1990s. Historically, most investors steered clear of them because they were seen as opaque and unreliable, as investors are relying on a sponsor that may or may not have the same incentives to find a good deal. But recently the quality of sponsors and market impacts of the COVID-19 crisis has led to an uptick in SPACs.
First, notable hedge fund managers such as Bill Ackman and Chamath Palihapitiya became some of the biggest sponsors for SPACs via Pershing Capital (Ackman) and Social Capital (Palihapitiya). This fostered a cycle where more notable investors jumped into the fray and made the idea more mainstream.
Second, there has been a massive boom in SPACs during the pandemic-related market volatility. SPACs went from raising around $13.6 billion in 2019 to over $83 billion in 2020 to doubling it again to $160 billion in 2021. During the onset of the pandemic, valuations were extremely volatile, and many IPOs fell through. SPACs offer more certainty early on as well as greater upside to early investors. One of the main advantages of SPACs is that early investors can capture more of the early growth within a company before taking it public. For example, if a company had a traditional IPO at $40/share and after 2 years, the price jumped to $60/share, the early investors would capture a fraction of that gain. Since SPACs have not gone fully public yet in that 24 month period, the investors end up capturing most of the true value of the company.
All of this sounds great on the surface but unfortunately, SPACs have failed to meet their high return expectations in most cases. As of Mar. 2021, 60% of the SPACs lagged behind the S&P 500 and 40% of those SPACs sold below their initial price of around $10/share.
SPACs are a perfect example of a high-risk, high-reward investment. Risk and transparency issues associated with this type of investment have even motivated the creation of SPAC insurance. Companies like HubInternational sell this insurance to investors for each stage of the SPAC process, ensuring they come out whole. Public pension funds like Texas TRS could theoretically buy this type of insurance on their SPAC investments, thus reducing the risk of the investment. The problem is the cost of SPAC insurance is rising fast, and the return adjusted for these costs is dwindling.
The risks associated with SPACs should make public pension funds very weary. Rather than continuing to take on riskier strategies to achieve lofty investment return goals, policymakers and those managing the retirement investments of public workers should lower assumed rates of investment returns and make other funding reforms that secure the long-term stability of retirement systems.
Originally published by Reason Foundation. Republished with permission.