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Special Purpose Acquisition Companies (“SPACs”) surged in 2021—raising an estimated $161 billion in proceeds—exceeding the combined totals for the period between 2003 and 2019. The year prior, in 2020, SPACs accounted for a staggering 97% of the total money raised in IPOs.
The boost in new SPAC deals results from the unprecedented market volatility generated by the pandemic, which has made traditional IPOs more challenging to pull off with a predictable price point.
While the popularity of SPACs is undeniable, investors on the outside looking in may be wondering if they should invest in this movement and whether SPACs are a better investment than conventional IPOs.
Read on to learn more about what SPACs are, how they work, and the pros and cons of investing in them.
What’s a special purpose acquisition company or SPAC?
With their newfound popularity, you would think that SPACs are a contemporary concept—but they aren’t. They were actually created in 1993 as a way for private firms to access everyday investors.
A SPAC, also referred to as a “blank check” company (although there are differences), is a corporation listed on a stock exchange that has one goal: to become a publicly traded company by acquiring and merging with another private company.
Since SPACs are formed as shell companies, they don't operate commercially. In other words, they don't make products or sell anything. In most cases, the only asset held is the capital SPACs raised in their initial public offerings (“IPOs”) which enables them to move swiftly through the IPO process.
How do SPACs work?
Setting up a SPAC
A SPAC is typically created by a management team or sponsor. The SPAC sponsor’s ownership interest, called ‘founder shares,’ represents around 20% of the SPAC. Public shareholders own the remaining 80% interest through "units'' offered in an IPO.
SPACs are unique because investors have little knowledge of what company will eventually be acquired (if at all). Because of this, SPACs usually are sponsored by institutional investors, hedge and venture funds, and even CEOs like Bill Gates and Richard Branson. These prestigious names help SPACs attract capital.
Pricing a SPAC
SPAC IPOs typically price their shares at $10 a share. The capital raised is held in an interest-bearing trust account until the management team finds a promising private company poised to go public through an acquisition.
The initial share price has a tendency to move once investors are aware of the target company and deal terms. This gives investors a better idea of the value of their shares, which changes the share price.
Going public and finding a target company
Once a SPAC goes public, sponsors have around 18 to 24 months to find and merge with a private company.
If the management team fails to find a target company, it will be liquidated. When this happens, all proceeds will be returned to investors (plus interest). However, investors still risk losing everything if the share price decreases exponentially.
If a target company is selected, they have the right to either accept the offer or reject it. If they accept it, both companies (the SPAC and private company) will undergo a reverse merger—where the private company becomes the publicly traded entity. At this point, the SPAC is dissolved.
After the shareholders of the SPAC vote to approve the transaction, the acquisition can be finalized. At this point, investors have two options:
a.) exchange their shares for shares of the merged company or,
b.) redeem their SPAC shares to recoup their original investment, plus interest.
SPACs by the numbers
As the data from Statista (below) shows, total money raised via SPAC mergers in the U.S. exploded in 2020 and 2021.
Proceeds of SPAC IPOs in the United States from 2003 to 2021
By sector, the tech industry is dominating the SPAC space, followed by healthcare and fintech. In 2021, successful SPAC merger companies included Matterport, Lucid Motors, Enovix, and ChargePoint, who all soared after hitting the public markets.
Total SPAC trust size by target and stage
Source: Spactrack.io
What are the benefits of SPACs for investors?
Investors in a SPAC may choose to redeem their shares for what they paid (plus interest) if they oppose the sponsor’s selected target company.
SPAC investors may also receive an additional incentive called a warrant. In essence, warrants entitle shareholders to buy the underlying stock of the issuing company at a fixed price once they are listed on a public exchange.
SPACs' payoff profile also makes them attractive to investors. There is a belief that those who get involved with a SPAC from the start may be able to acquire a more significant stake in the merged company than they would with a standard IPO.
What are the risks of investing in SPACs?
While IPO investors receive shares and warrants, secondary market investors only get shares. Obviously, this is a huge disadvantage since warrants give holders the opportunity to buy future shares at a fixed price.
If share prices rise above their initial IPO price, secondary buyers must pay a premium (~$10 + {X} price increase). This can be a risky move since share prices typically balloon following their market debut (and sometimes come crashing down shortly thereafter).
And with booms come busts. While many mergers with blank-check acquirers perform well initially, it’s not uncommon for these companies to see major selloffs in the following months.
Such was the case for WeWork, Grab, and BuzzFeed—who all (at the time of this post) trade below their $10 starting price.
What to know before investing in a SPAC
Retail investors should take heed of the following before investing in a SPAC:
Don’t buy the hype; buy the investment
Celebrities like Shaquille O'Neal, Serena Williams, and Alex Rodriguez have recently joined the SPAC game. Their familiar faces have helped curry favor with new investors that might not otherwise care about such opportunities. This has drawn considerable attention from the SEC, who, in early 2021, warned investors that:
“It is never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment.”
Actively monitor, and stay informed
Part of an investor’s job is to scrutinize the sponsor’s actions. If you aren’t willing to be involved in the process of accepting or rejecting the target company, this may not be the investment for you.
Don’t skip the small stuff
As SPACs evolve, new provisions that may benefit investors are being added to the contracts. If you don’t read the fine print, you could miss out on valuable protective clauses.
Invest in experience
Founders with proven track records in the industry will most likely achieve higher returns than celebrities and other influencers.
In summary, SPACs serve as an alternative to conventional IPOs. They provide a path for private companies to enter the public market and expand access to more early-stage growth businesses and private equity-like investment managers.
SPACs provide a way for public investors to ‘partner' with sponsors. Investors are given certain rights and privileges—along with the potential for capital appreciation—in exchange for their investment.
Like any investment, it’s important to conduct thorough due diligence. Be sure to evaluate what rights or protections apply to you, including the financial interests and motivations of the SPAC sponsors and related persons.
