SPAC'd out: Everything you need to know about the next hyped-up investment fad

From house pricesto tech stocksto digital art, the COVID-19 pandemic has had a counterintuitive impact on the prices of a variety ofassets, driving manyto record highs at a time when theeconomy is still reeling.

Now, some experts are warning about a niche type of investment vehicle that's veering into bubble territory and in danger of bursting.

The investment in question is known as a SPAC, a special purpose acquisition company. While SPACs have been around for more than a decade, 2020 has proven to be a record year for themas investors explore more and more arcane fields in search of stratospheric returns.

Conventionally, a company would start out by slowly building out its operations to the point where it became profitable or showed enough growth to attract investor attention. The company may then choose to go public in an initial public offering (IPO),selling its shares to raise money to grow and expand further.

SPACsturn that process on its head, because they are essentially just a pool of money that already tradeson the stock market, looking to buy up promising companies. SPACs arealso known as blank chequecompanies they don't do anything besides buy up companies that are either functioning businesses, or sometimes little more than an idea for one.

Celebs get in on the action

And business is booming. Almost 500 SPACs have gone public since the start of 2020, and they're flush with more than $150 billion US in investor cash,data compiled by Bloomberg suggests.

The trend has gone mainstream, with celebrities from outside the world of finance jumping in. Former NFL quarterback Colin Kaepernick heads up one with the stated goal of investing in companies "that currently have or have the potential to generate a positive social impact." Hip-hop mogul Jay-Z's SPAC is focused on cannabis. Retired baseball player Alex Rodriguez is the frontman for one worth $500 million US. The former slugger says his braggadocious goal is to build "the Yankees of SPACs."

Some members ofthe investment community are now saying the SPAC hype has gotten way ahead of itself.

"I think it's no different from any other asset bubbles right now," said Genevieve Roch-Decter, CEO of Toronto-based investment firm Grit Capital, in an interview. "It's all the phenomenon of cheap money being printed, and people at home with nothing to do playing the stock market."

The more ephemeral and weird the SPAC's focus, the more appealing. Anything to do with technology or "ridiculous ideas" like flying cars are de rigueur, she said, but "if you can value the company like boring old real estate, those don't do well."

Big upside for founders

Regardless of whetheraSPAC ends up finding a good business to buy, its appeal is obvious for the people building it and then trying to curry favour from stock market investors. Many SPACsoffer up to 20 per cent of the shares to sponsors and founderswhen they are set upas a way to generate attention and hypefrom mainstream investors.

A recentJP Morgan analysissuggestsSPAC founders saw returns of almost 1,000 per cent on average, regardless of how the SPAC itself performs once it makes an acquisition. As Roch-Decter puts it, "they don't havethat much downside and tons of upside."

The same can't be said of retail investors buying in. Of roughly 100 SPACstracked up to the middle of 2020, the analysis foundless than a third of them saw their share price go up.

Those founder shares usually have far more lenient lockup periods, too. When companies go public via anIPO, there are normally stipulations that require insiders to hold their shares for several years, which conveys confidence in the business but also prevents them from flooding the market by cashing out, and pushing down the price for everyone else.

Most SPACs don't have the same stringent requirements.

And that's just wrong, according toAnthony Scilipoti, president and CEO of Toronto-basedVeritas Investment Research.

"Ibuy the stock thinking the insiders are locked up for months and now Ifind out they can sell?"

While good businesses will always attract investment, Scilipotisays he thinks a lot of the SPACscoming to market today "will end in tears."

He says SPACs have been around for a while, but have become overhyped during the pandemic,partly because there is a lot of stimulus money floating around the markets, looking for a place to go. "People have short memories," he said.

The SPAC boom is primarily a U.S. phenomenon, but there are a handful of ex-SPACs on the Toronto Stock Exchange's main index. One of them, Apollo Healthcare, raised $1 billion to much fanfare in 2015, and ended up deploying that money into threehealth-related acquisitions. The early returns were not good: from an initial stock price of $10 a share in 2017, Apollo was trading as low as 31 cents a share at one point last year.

The shares have since jumpedto about $5 because of the frenzy over hand sanitizer, one of the products that Apollo makes, but Scilipoti says he thinks the shares "will probably fall 80 per centagain once the pandemic is over."

A bubble ready to burst?

Roch-Decter says she worries about what happens to the stock frenzy once markets turn, which they seem to be doing. A Bloomberg index of SPACs has fallen by 10 per cent since the start of March, far more than the broader market.

She says the same generation that made a fortune by holding firm with GameStop may be in for a rude awakening if the SPAC appetite weakens. While some high-profile, successful businesses got their start via SPACs, "alot of these businesses don't have revenue and the valuations are ridiculous," she said.

"Some will be successful likeDraftKings," she said, citing the fantasy sports and gambling company that merged with a SPAC last yearand has seen its value soar by more than 600 per cent since the pandemic began. "But there's going to be a bunch of them that are just going to die.

"As long as everyone knows what game they're playing, I'm fine with it, but I don't think a lot of retailunderstands this."

Scilipoti says the SPAC frenzy is being driven by the same forces pumping up many asset bubblesand he's seen first-hand just how intensethe market frenzy has become.

"My62-year-old physiotherapist is asking me what's happening in bitcoinand what's happening in GameStop,or if I've heard of some of these other ... startup penny stocks," he said.

"These are not things that happen at the bottom, [so] I know we are near the end."