: These are the hidden dangers lurking inside SPACs that can hurt you

Other popular SPACs are up by 30% to 50% from their offering prices just a few months ago, including VPC Impact Acquisition Holdings VIH, +0.40%, TS Innovation Acquisitions TSIA, -5.97%, Atlas Crest Investment ACIC, -2.14% and Rodgers Silicon Valley Acquisition RSVA, -7.55%.

Those fireworks are seducing small investors. Bank of America says retail investors account for 40% of SPAC trading on its platform, compared with 21% of S&P 500 SPX, -0.48% stocks and Russell 2000 RUT, +0.04% stocks. But behind the scenes are some big risks and trap doors that you need to be aware of if you are thinking about getting involved in these speculative trading vehicles.

Also by Michael Brush on SPACs: How to find the most promising SPACs and dodge the hidden dangers

SPAC primer

First, a few basics.

SPACs are blank-check “special purpose acquisition companies” that expect to merge with a real company, typically within two years. Sponsors who bring them public collect a fee that can run up to 25% of the deal value, says Bank of America strategist Michael Carrie. For example, if a SPAC raises $100 million, the initial deal is for $125 million and the sponsor pockets $25 million. Wall Street banks that help execute SPAC initial public offerings (IPOs) typically collect 5.5%. SPACs normally come public at $10 a share.

SPAC cheerleaders cite three benefits. 1. They can be a cheaper way for companies to come public. 2. They give IPO market access to companies that don’t otherwise have it. 3. They are “private-equity” investments for small investors who don’t have access to early-stage private companies.

That all sounds good. But there are actually lots of issues and pitfalls for regular investors like you and me who buy in the aftermarket — which can make SPACs far less attractive than they seem.

SPAC issue #1: Hedge funds and Wall Street insiders get a much sweeter deal than you and me.

A “SPAC mafia” of hedge funds, arbitrage funds and other Wall Street insiders see SPACs as safe bets with almost guaranteed upside. It’s easy to understand why. Early investors at the IPO phase often get a free warrant with each IPO share they buy. But you don’t when you buy SPAC shares in the open market. Warrants give IPO investors the right to buy a share at a pre-arranged price. It’s often $11.50 for SPACs that come public at $10. This is a free call option on whatever success the SPAC may have.

These privileged investors aggressively work this angle. They sell or redeem their shares and get all their money back, but still have exposure to their SPACs via the free warrants. That’s a sweet advantage. Or else they can sell the warrants in the open market.

The bottom line: SPACs are an awesome deal for the hedge funds and other Wall Street insiders who buy SPAC IPOs. But not so much for the retail investors who buy in the aftermarket.

SPAC issue #2: Your SPAC position can get diluted big-time.

When you buy in the open market, not only do you miss out on those free warrants, but those warrants may come back to bite you. Here’s why. When SPAC shares do well because of a speculative frenzy or because the SPAC merges with a great company, the original hedge fund investors are going to exercise their warrants. This can create at least 100% dilution for the retail investors like you buying in the aftermarket.

I say “at least” because the actual dilution from the hedge fund warrants can be far worse, says Bank of America’s Carrie, in a research note published this week called “The rise of SPACs — A primer on SPAC structures & impact to capital markets.” The reason has to do with a special catch in SPAC rules. Investors can sell (redeem) their shares to the SPAC any time between when a merger is announced, and when it is finalized.

To see why this creates dilution for investors, consider an example. Let’s say half of the original IPO investors redeem their shares. The problem for other investors is that same number of warrants still exists. If one warrant was issued per share created in the IPO, this doubles the number of warrants per share. Big dilution, and way more than 100%.

Large redemptions happen a lot. A median of 73% of SPAC IPO proceeds were returned to shareholders via redemptions during 2019 and the first half of 2020, according to a study called “A Sober Look at SPACs,” by researchers at Stanford University and New York University School of Law.

The dilution is actually even worse. When investors redeem shares, it bumps up the dilutive effect of the original sponsorship and banking fees. The size of fees does not change, but the funds available in the SPAC and the number of SPAC shares decline. In our 50% redemption scenario, the 5.5% fee doubles to 11%. Sponsor fees also get amplified, says the Stanford study.

It’s true that SPACs typically sell more shares to raise cash when they get hit with a lot of redemptions. This reduces the dilution. But often they don’t get back to the original funding level. And the fees on this follow-on capital raise are also dilutive. Your SPAC has to waste money raising capital to offset the redemption damage. These fees are typically around 7.5% of the new capital raise, says Bank of America.

SPAC issue #3: Your SPAC will probably have less firepower than you think.

When you buy a SPAC, you may be counting on a big war chest of cash to attract some great operating company into the mix. But since your fellow investors can redeem their shares with the SPAC for money, the amount of firepower at your SPAC may wind up being a lot lower than you think. That makes it less effective. SPACs do raise capital when they get hit with a lot of redemptions, but often they don’t get to the original amount of capital you might have thought they have.

SPAC issue #4: Your SPAC may have a hard time finding a good company to merge with.

SPACs can score big victories for shareholders by merging with successful businesses like DraftKings DKNG, +6.43% in gaming or Virgin Galactic Holdings SPCE, -11.86% in aerospace. But so many SPACs are now chasing private company targets, the pickings may be slim — especially in “hot” sectors such as electrical vehicles, fintech and tech. This means you run the risk that sponsors of your SPAC may merge with a subpar company, points out Bank of America’s Carrie. Last year, 248 SPACs came to market, and over 150 have already done so this year, compared to 59 in 2019 and seven in 2010.

This risk can be heightened because sponsors interests are not well aligned with shareholders. A sponsor’s compensation is tied to the amount of capital raised. “The target company’s performance has little bearing on how much sponsors are paid,” says Carrie. “This creates a lot of incentive for sponsors to get a deal done regardless of the terms or quality of the target company.”

SPAC issue #5: With SPACs, you are flying blind.

When you buy SPAC shares, you have no clue what you are getting into because you don’t know what company you will eventually be getting. You rely on the sponsors to make a good decision.

SPAC issue #6: You might get caught up in a speculative frenzy.

In fairness to SPACs, they’re not the only place where speculators and traders whip up excesses. But given the popularity of SPACs, frenzies are more likely to happen in this part of the market. It’s easy to get drawn into the emotion and buy at the wrong time, which can create big losses. Circling back to Churchill Capital, had you bought the top there a few days ago, you are already down 50%.

I’ll tell you how to neutralize all the inherent risks in SPACs, in a column Friday (Feb. 26).

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush hasn’t suggested any of these names in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.