5 things to watch out for before you invest in SPACs

Similarities to the dot.com and subprime bubbles are unmistakable.

The world's financial exchanges are now in gold-rush mode for IPO listings spurred on by the resurgence of the blank-check company. Now called a SPAC (for special purpose acquisition company), this is rapidly turning into an exercise in financial contagion as one global exchange after another contemplates getting in on the action and retail investors look to buy in.

In 2020 SPACs accounted for more than half of all IPO proceeds raised in the U.S., and just in the month of January 2021 alone, more than 60 SPACS raised nearly $20 billion in proceeds. Meanwhile, the Singapore Exchange Ltd. Is said to be considering new rules that would allow blank-check companies to list sometime later this year. Likewise, the SPAC boom has caught the eye of U.K. exchanges also looking for ways to increase their participation in the listing phenomenon.

The glaring investor protection issues that are endemic with these listings has CFA Institute on alert. The similarities to the dot.com and subprime bubbles are unmistakable. We think the SEC should immediately establish a working group to examine the marketing, shareholder rights, and investor protections issues involved. Investors considering SPACs need to remember that much can go wrong. Here are five important things retail investors need to know before taking the SPAC plunge:

1. Blank-check alert: You are giving a SPAC sponsor money with no definite plan on if, when, or how the money will be used to acquire an operating company. You are being told as a retail investor that this is your big chance to get in early. But the sponsor can be as vague as simply saying, "I have expertise in this industry and will be looking for a promising company with upside potential in this space." The potential for misinformation, even fraud, is high in these situations.

2. The 18-month rule: The sponsor has between 18- and 24 months to locate, negotiate and close an acquisition deal, or they are required to give the SPAC IPO money back, plus interest. Sounds great, but if the SPAC stock you bought is trading based on rumor, innuendo, and no fundamentals before any acquisition happens, you likely paid a premium for it. The money-back rule only applies when there is no deal, and the refund is at the original IPO offering price, typically $10 per share plus interest, not what an investor paid for it in the open market. Moreover, the rate of "no acquisition" or lousy acquisition outcomes will likely grow. An increasing probability exists that your blank check "investment" will leave you poorer.

3. Competition for private deals: No matter what the SPAC sponsor tells you , the competition to find a diamond-in-the-rough private company to acquire and take public remains intense. Not only are there hundreds of other SPACs looking for a target, but thousands of expert private equity managers with huge portfolios and lots of dry powder -- an estimated $1.5 trillion in private equity and venture capital funds -- are looking for the very same thing, and they have much longer track records. The odds of a SPAC sponsor finding a suitable, undiscovered gem that is fairly priced and ultimately profitable are mixed at best.

4. Understand your piece of the SPAC pie: You must understand that even if a target acquisition is made, the amount of the new public company value that ends up in the hands of the SPAC stock buyers can be dreadfully meager. Your slice of the pie comes after the sponsor cut, the acquired company management's cut, and typically another private investor that tops off the capital needed to close the deal. It is not uncommon for the SPAC investors to end up fighting for scraps.

5. Track record: Take the time to know if the sponsor has any track record in picking private investments. The only way private equity works in the real world of investment management is to find a private equity manager with a demonstrated record of making profitable deals. Picking a SPAC sponsor because they are linked with some sort of celebrity -- but with no real private equity chops -- represents the worst kind of blank check you could ever write.

Margaret Franklin, CFA, is president and CEO of CFA Institute.