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There is a common misconception among retail investors that SPACs are close to a riskless way to bet on emerging industries. Special Purpose Acquisition Companies (SPACs) or “blank check” companies as they were known to prior generations before they became so commonplace, are simply shell companies formed to pursue mergers with private companies looking to raise capital. Compared to the traditional IPO (Initial Public Offering) route, the SPAC process moves along more quickly and forces the “targeted” private company to jump through fewer regulatory hurdles.

© TheStreet The Biggest Risks of Investing in SPACs

But therein lies the risk — at least in part. The first risk, and one that perhaps many investors overlook, is in the management of any given SPAC. These vehicles have become so popular that they are now challenging the IPO as the route to going public, but investors need to do their homework.

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Basically, the “no-risk” concept is born of structure. The typical SPAC is founded and goes public itself with seed money, but no revenue to speak of. It searches over a defined time to target, acquire or merge with a private company; if no target is found (usually within two years), the principal is returned to the investors.

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The problem for Mom and Pop investor is that they don’t know the founders or the managers. They don’t know who has been successful in the past. They do know celebrities, and they do know which industries are hot. That is a potential problem, since for retail investors, a SPAC that involves a well-known personality that shows an intention to merge into industries such as electric vehicles, cannabis, space travel or online gaming is likely to appear more desirable than something or someone that they may not have heard of.

What’s Wrong With That?

Here’s an example. Private companies do not have to report earnings. In fact, they don’t have to report much of anything. You can have a private company projecting billions of dollars in future sales of electric vehicles with nothing yet built, and no orders. You can also have a company like Utz Quality Foods , a purveyor of snack food that was acquired by a SPAC (Collier Creek Holdings) last year and wound up listed on the New York Stock Exchange. Utz has been around for a century and could show investors 2019 sales of almost $770 million at the time.

What sounds more interesting to a retail investor, however? The electric vehicle company that has never sold a car, or the regional snack food company that has been selling potato chips and pretzels for 100 years? Yet we know which one of these is likelier to be a more stable performer going forward.

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Just as problematic are SPACs that use a celebrity name to gather attention either from the public or from private companies, thus drawing attention away from proven dealmakers. In these cases, due diligence is required, especially if the SPAC in question makes a big deal of their connection to or involvement with, for example, a famous athlete or well-known performer.

The Sponsor Promote

One feature of the way that some SPACs go about rewarding their sponsors for putting a deal together is known as the “Sponsor Promote.” This allows the dealmaker to purchase what’s usually a 20% equity stake in the resulting company for just $25K.

How lucrative can this feature be for the sponsor? Think about it. Basically, for a minimal investment, this incentive could be worth millions and millions of dollars that’s all dilutive to the aggregate equity stake of existing investors. Not just that, but the Sponsor Promote can encourage these dealmakers to inflate the value of the targeted private company in order to boost their own payout, thus leading the SPAC into an undesirable acquisition. Moreover, even if the merged company quickly flops, that 20% stake still looks pretty attractive, given the small investment required.

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More recently, in order to avoid such mishaps, some SPACs are tying the compensation of their founders to stock performance over a number of years. This is obviously more desirable than the old way of doing business, but buyer beware still applies. Know how your SPAC is structured. And if you can’t find out, maybe do something else with your money.

Two Key Factors

The way I see it, SPACs can be a way for ordinary retail investors to get in on a private company pre-going public, by investing in a public company that will target that upstart company for you. Are there too many SPACs now? Of course. Are too many SPACs targeting the same industries? Again, undoubtedly. This probably means that a decent percentage of these “blank check” firms will end up returning their money to investors, or involved in overcrowded industries that simply seemed hot at the time.

Therefore, I think all retail investors need to carefully consider two factors prior to choosing a SPAC for investment:

1) Management. Have an idea who founded the SPAC and if they have a track record. Substance over style would be my preference. Just a couple of examples of SPACs with founders or managers that have track records that are fairly easy to look up would be Pershing Square Tontine Holdings PSTH (Pershing Square and its founder Bill Ackman have a track record; you can make up your own mind) and Social Capital Hedosophia Holdings V IPOE, founded by venture capitalist Chamath Palihapitiya. You may already have opinions of these individuals and did not know that they were behind some of these companies, or you could simply trust some folks who have hit some massive home runs in the past.

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2) Targeted Industries. Personally, I would rather look at SPACs that are not too narrow in their description of what types of private companies they would be willing to target. I would be more interested in a SPAC that simply chased profit wherever it might be than a specific industry that might be too hot for its own good today. For example, there are probably more SPACs now looking to merge their way into the electric vehicle industry than there are electric vehicle manufacturers, or at least ones with both orders as well as finished products. On the other hand, I kind of like the way Bill Ackman has gone about it with the above mentioned PSTH. Ackman has been purposely vague on what sectors he’s targeting, but he has already raised over $4 billion. And all Ackman has said is that a private firm would probably have to be eligible for the S&P 500 with a predictable cash flow to be considered a merger candidate. I don’t think he cares about what that company does, as long as that company has a quality business. Personally, I do not currently own any SPACs in my own portfolio, though I have in the past. Pershing Square is one that I would be/am willing to consider with my own dough, however.

Stephen “Sarge” Guilfoyle writes on stocks and the markets each trading day for Real Money, TheStreet’s premium site, including his popular Market Recon column every morning. Guilfoyle is also co-portfolio manager of TheStreet’s Stocks Under $10.

Disclosure: At the time of publication of this article, Guilfoyle held no positions in any of the investments mentioned in this article.

This article was originally published by TheStreet.

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