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A special purpose acquisition company (SPAC) is a shell company that is formed to raise money through an initial public offering (IPO) in order to later acquire or merge with a private company. SPACs have become increasingly popular, especially since 2019. In general, they can provide a faster path for private companies to go public and obtain capital than a traditional IPO.
Here’s how SPACs work, the difference between traditional IPOs and SPACs and how to invest in one.
How SPACs work
A SPAC is an entity formed for the purpose of raising money from the investing public and then using that money to acquire or merge with a privately held business. This process allows the business to enter the public market without going through the typically lengthy and expensive process of a traditional IPO.
Like a traditional publicly traded company, a SPAC registers with the Securities and Exchange Commission (SEC) and issues securities to the public. However, it differs in that the SPAC does not have products or services available at the time of the offering. So investors are speculating on the potential upside of the SPAC and whether the SPAC’s sponsors – who are responsible for the selection of a target company to merge with – will find an attractive acquisition target.
After the SPAC raises capital, it will have a certain period of time, typically two years, to identify and acquire a target company and complete the merger. The SPAC’s shareholders will vote on whether they like the acquisition candidate and whether the merger will move forward. A SPAC must use 80 percent of its net assets for an acquisition, or otherwise it must dissolve.
If the SPAC is unable to complete a transaction in the specified time period, any cash remaining with the company is returned to shareholders, less various (usually not extensive) fees.
The SPAC’s sponsor can earn substantial fees and stock – often 20 percent of the SPAC’s stock – if it can complete a transaction, even if the merged company goes on to perform poorly. This compensation structure can create incentives for the sponsor to get any deal across the finish line so that it can earn its hefty fees, misaligning the sponsor’s incentives vis a vis stockholders.
Most SPACs are listed on the Nasdaq or the New York Stock Exchange.
Companies that have gone public through SPACs
The number of SPACs that hit the market since 2019 has been immense, and the market heated up as low interest rates and risk-seeking behavior dominated in the wake of COVID.
In 2019, there were 61 SPAC IPO filings, according to FINRA data. Two years later the number was over 1,000. While the number of SPACs trended downward in 2022 according to S&P Global Market Intelligence, a number of high-profile companies have gone public through SPACS. These include startups such as SoFi, Clover Health, BarkBox, Hims and Hers Health and Billtrust. Virgin Galactic also went public through a merger with a SPAC in 2019.
“SPACs were fashionable in the go-go days post-pandemic when low interest rates meant money was flowing freely, even to entities that lacked an actual business. The subsequent poor performance of many SPACs and a sharp rise in interest rates caused SPACs to largely fall out of favor as investors refocused on the fundamentals of investing in profitable companies with a proven track record,” says Greg McBride, chief financial analyst for Bankrate.
Origins of SPACs
Special purpose acquisition companies (SPACs) have evolved over the years from what were once known as “blank-check corporations” in the 1980s and 1990s. Despite their popularity and potential for growth, these early corporations lacked proper regulation and became notorious for fraud.
While modern SPACs are more highly regulated, they still present investors with conflicts of interest and a misalignment of incentives between the SPAC’s sponsors and its investors.
Advantages and disadvantages of SPACs
SPACs offer some benefits and risks to investors because of their purpose and how they’re structured.
Advantages of SPACs
- Quicker access to funding: One of the biggest benefits for companies merging with a SPAC is that they can get quick access to capital without going through a lengthy process of a traditional IPO.
- Reduced fees and regulation: Because they circumvent the usual IPO process, companies can avoid some of the typical regulations in a traditional IPO, including the increased scrutiny and due diligence of an underwriting bank. That may be good for the SPAC and the private company, but it’s not a good setup for investors.
- Increased share of the company: Investors may be able to get a bigger share of the private company through the SPAC than they otherwise would.
- A “free” look at a deal: Because investors get to vote on any merger that the SPAC proposes and get their money back if they don’t like it, they get a “free” look at a potentially attractive private company.
- Potential gains for a new company: Investing in a private company may offer significant upside if the company goes on to be successful.
Disadvantages of SPACs
- Lack of due diligence: The flip side of faster access to funding is that SPAC acquisition candidates don’t undergo the scrutiny and due diligence that they would if they went through the traditional IPO process. Investment banks closely examine any company when they underwrite its IPO because they could be liable for fraud if it goes poorly. The SPAC merger does an end-run around this traditional process of due diligence.
- No guarantee of a deal: Investors could sit in a SPAC for a couple years without any deal being consummated. Even if they lose little or no money when the SPAC is liquidated, they could have made money elsewhere.
- Lack of clarity on any deal target: Investors may have only a vague idea of where the SPAC may invest its money until a deal is actually announced.
- Severe misalignment of incentives: A SPAC is generally set up with a misalignment of incentives between the SPAC’s sponsors and its investors. The sponsors can earn a nice payday if they can close a deal, even one that is eventually unsuccessful, while they get little or nothing if they can’t close a deal. So they’re incentivized to close even a bad merger, misaligning their incentives with investors, who want an attractive acquisition.
- History of poor returns: Post-merger SPACs have a history of poor returns, with many declining substantially in the months or years after a deal. This result is due to the lack of due diligence and the misalignment of incentives (see above), among other reasons. Managers of some sketchy companies may realize that they can go public via a SPAC and avoid some of the scrutiny of the traditional IPO process while enriching themselves.
What is the difference between an IPO and a SPAC merger?
A traditional IPO process and a SPAC merger may both bring a company public, but they differ in important respects, particularly in how the private company is evaluated during the process.
In an IPO, the underwriting banks conduct their due diligence on the private company and prepare a prospectus with the company’s financial statements, potential risks and other information. They value the private company and set the initial stock price and terms of the offering. Then the underwriters must sell shares in the company to major investors in a process known as a road show, drumming up support and excitement for the IPO. This process means the would-be public company must undergo a lot of scrutiny before it goes public. Underwriters are incentivized to not promote fraudulent companies because they could be held liable.
When a company goes public via SPAC, the process is substantially different, and it largely avoids the intense scrutiny of underwriters and major institutional investors. The SPAC’s sponsors identify a merger target, and then negotiate with the private company to provide their cash for a percentage of the post-merger company. They present this deal and the company’s financials and prospectus to the SPAC’s investors, who can then accept or reject the deal.
If the investors accept the deal, then the SPAC and the private company merge, with shares of the SPAC exchanged for shares in the newly public company.
How to invest in a SPAC
Investing in a SPAC can potentially be a lucrative opportunity for investors, even if it usually isn’t. Here’s how to get started.
1. Open a brokerage account.
If you don’t already have a brokerage account, one of your first steps will be to open one either online or in-person. If you opt to open an account online, then you can complete the process in 15 minutes or so.
2. Find SPACs
Search for SPAC stocks on your broker’s site or a public site such as Yahoo Finance or Google Finance.
You’ll want to take the time to assess the SPAC’s prospectus and other public documents, such as its financial reports, which you can find in the SEC’s EDGAR database. Additionally, it’s key to review the development potential of any deal candidate and the motivations and incentives of the SPAC’s sponsors.
Once you determine which SPAC or SPACs you’d like to invest in, you can buy a SPAC common stock or a SPAC unit, or a SPAC ETF. A SPAC unit typically consists of one share of common stock and a portion of a SPAC warrant. The warrant allows you the option to buy another share of stock later on. Keep in mind warrant terms are not consistent across SPACs and can vary widely. You’ll want to review the terms closely before investing.
SPACs have become a popular way to access public markets faster than a traditional IPO. But investors should be aware of the risks associated with investing in these vehicles and conduct thorough research before making any investment decisions. The track record of SPACs as a whole is unattractive, even if some good deals do eventually emerge.