Investing in SPACs

  • Special purpose acquisition companies, are formed to raise money through an IPO to buy another company
  • At the time of their IPO, SPACs are effectively shell companies with no existing business operations or stated acquisition targets
  • SPACs are typically funded at the top by wealthy sponsors and institutional investors before being offered to retail investors around a standard price of $10 per share
  • While investing in a SPAC can have substantial upsides, the plethora of opportunities and structure of each individual SPAC can mean investors are taking on significant risk to seek their rewards

SPACs have become increasingly commonplace in the last five years. Their popularity peaked at the height of the 2020 pandemic, when funding went head-to-head with traditional IPOs in terms of capital raised and the number of companies involved. Presently, the arena is still growing.

Even if you’re not aware of what a special purpose acquisition companies is, you’ve likely heard of them in the recent myriad headlines proclaiming yet another company has gone public courtesy of a “special purpose acquisition company.” But to the uninitiated, that raises more questions than answers:

What is a SPAC, exactly? How do they come about? Why are there so many of them? And if you’re interested in broadening your investment horizons, how do you get on board?

What are Special Purpose Acquisition Companies?

A special purpose acquisition company is a shell company with no commercial operations, cash flow, or investments. Also dubbed “blank check companies,” these are shell companies erected for the sole purpose of raising capital through an IPO. And in recent years, they’re an increasingly prevalent vehicle for carrying various transactions to fruition – in particular, transitioning a private firm to a publicly traded security.

How Do SPACs Work?

SPACs are generally formed by institutional investors (such as hedge funds) or wealthy individuals, called sponsors, with expertise in a certain industry or sector. The goal of a SPAC is to raise capital and then sniff out companies interested in going public via an acquisition or merger. If a SPAC is successful, it will list the newly minted public company’s shares on a stock exchange.

The founder of a SPAC typically has at least one acquisition target or sector in mind upon creation of the shell company. But to avoid extensive filing disclosures during the IPO process, they may avoid identifying an entity until after the first round of funding. Says: Sometimes, a SPAC may identify a specific industry or business in its IPO prospectus – but the company is not obligated to pursue its target after filing.

Typically, the original sponsor will seek capital from underwriters and institutional investors first, then retail investors. The funds raised usually goes into an interest-bearing trust account and cannot be redispersed except to a) complete an acquisition or merger, or b) refund investors in case of liquidation. (Note that the interest earned on the trust is often used as the SPAC’s working capital or to pay relevant fees and taxes.)

After its IPO, a SPAC generally has 18 months to 2 years to complete a merger or acquisition lest it face liquidation proceedings. The average period for a SPAC to find a suitable transaction ranges from a few months to over a year.

Once a SPAC finds an operating company of interest, management negotiates the terms of a deal for a potential initial business combination (the merger or acquisition). It’s not unusual to see these structured as a reverse merger wherein the operating company becomes part of the SPAC or a SPAC subsidiary.

The Origin of Blank Check Companies

SPACs were an early 1990s brainchild of investment banker David Nussbaum and lawyer David Miller. At the time, Nussbaum was chairman and CEO of now-defunct investment bank GKN Securities. The company launched its first blank check company in 1993 as a way for private firms to increase access to retail investors.

By the mid-1990s, GKN Securities owned and operated about a dozen blank check IPOs, which they dubbed “special purpose acquisition companies.” (GKN even applied to trademark the name.) However, the company’s monopoly on the SPAC market crashed in 1997 when the firm and 29 employees were ordered by the National Association of Securities Dealers (NASD) to pay over $2 million in fines and restitution.

NASD alleged that GKN Securities overcharged investors who bought shares in eight newly minted stocks – and that the firm excessively marked up shares in post-IPO trading. As a result of the accusations, Nussbaum was fined $50,000 and suspended from the brokerage business for 30 days. In the wake of his troubles – not to mention the dot-com bubble and subsequent bear market – blank check IPOs faded from public view for several years.

The next time blank check companies emerged on the market was 2003, in no small part thanks to David Nussbaum’s latest venture EarlyBirdCapital. This SPAC-focused investment firm helped these purpose-driven shell companies grow from an obscure method of raising capital in the tech and healthcare sectors to a market-wide phenomenon.

Today, SPACs snatch up contracts in any market deemed potentially profitable, from homeland security and government marketing to energy, construction, finance, and even high-growth emerging markets.

The Surging Popularity of SPACs

Until recently, SPACs were often used as a last resort for small companies that otherwise would have struggled to raise funding on the open market. And while the companies have been increasing in popularity since around 2014, the pandemic vaulted this method of capital funding to new heights.

The reasoning is fairly straightforward: launching an IPO in the middle of a pandemic subjects a company’s new stock to incredible volatility and uncertainty. By letting a SPAC do the heavy lifting, the underlying operations gain increased certainty, the ability to bargain for better deals, and a faster influx of cash. Says: SPACs are able to close a deal in just a few months due to their “blank check” IPOs. By comparison, it may take a private company as long as six months to complete the IPO registration process with the SEC.

Just How Common are SPACs?

Between 2016-2019, SPACs more than quadrupled their fundraising dollars from $3.2 billion to $13.6 billion. In that time, these IPO funding firms attracted such big-name underwriters as Goldman Sachs, Credit Suisse, and Deutsche Bank, as well as a handful of retired senior executives looking for their next cash cow.

Moreover, a few high-profile deals – such as the $800 million paid to Richard Branson for a 49% stake in Virgin Galactic – cemented SPACs as potentially profitable ventures.

And then 2020 raised the stakes.

Between January 1 and December 31 of 2020, 200 SPACs raised more than $64 billion in IPOs, compared to $67 billion raised by 194 firms in traditional IPOs. Of this, $4 billion alone was raised on July 22 by Bill Ackman, the founder of Pershing Square Capital Management and his newly sponsored SPAC Pershing Square Tontine Holding, in the largest-ever SPAC IPO to date.

Since then, the SPAC frenzy has taken on a life of its own, with companies from all sectors taking the short path to a public listing. Notably, big names like Buzzfeed, Acorns, and Talkspace have all entered deals in the last 12 months. Dozens of companies in tech and self-driving vehicles like Nikola, Embark, and Origin Materials have followed suit.

A Warning Well-Heeded

However, not everyone is thrilled about the emergence of SPACs as a means to a publicly listed end. Former Goldman Sachs CEO Lloyd Blankfein told CNBC that investors need to exercise caution if they’re considering signing up to a SPAC:

“You’re getting companies public, but you’re getting them public in a two-step process where one of the elements of an IPO is dropping out,” he said. “When the initial SPAC goes public, you are scrutinizing a shell company, possibly the reputation of a sponsor. When that company then de-SPACs and merges, it’s a merger, it’s not an IPO that carries with it a lot of diligence obligations.”

Blankfein also noted that SPAC participants are not incentivized to prevent overpaying for target businesses due to the structure of a SPAC. As such, he mentioned, this leads to situations where “some people make a lot of money and investors lose money.”

Of course, acquired companies are the most likely to benefit from a SPAC merger, as they get to jump straight to the cash. For them, SPACs provide a method of going public without wading through mountains of SEC filings for a traditional IPO. Moreover, some market participants believe that SPACs offer small companies more certainty in pricing and IPO terms.

But from the investor’s point of view, SPACs are slightly riskier.

SPAC Risks from the Investor’s Point of View

For instance, IPO investors have no idea what company they’ll ultimately invest in – if they invest at all. And depending on the structure of the SPAC, investors may not have a say in whether the SPAC acquires a particular operating company.

Moreover, standard practice for an SPAC is to list IPO shares at $10 apiece. But investors who buy in after the initial offering pay the current market price – and if a deal goes belly-up, they’ll only receive the pro rata rate of $10 per share.

Additionally, SPACs are often structured so that profits go first to sponsors with retail investors picking up the trimmings. SPAC sponsors generally purchase equity at more favorable terms than IPO investors. As such, while most of an SPAC’s capital comes from IPO investors, sponsors and institutional backers benefit the most – and may have an incentive to complete transactions on less favorable terms for their retail investors.

Plus, SPACs are not usually profitable for retail investors. Advisory firm Renaissance Capital discovered that, between 2015-2020, the average returns from SPAC mergers fell short of average post-market returns for IPO investors.

Not only that, but among the 114 companies that went public via SPAC mergers in the past decade, investors who bought common stock on the first day of trading lost an average of 15.5% over 3 years. At the same time, hedge funds and sponsors took advantage of better prices and warrants to unload their shares at the beginning and drive down prices further.

The last point to consider here is that, as SPACs become increasingly competitive, companies may merge because they believe they can net a better valuation. While this may benefit companies, retail investors will see reduced upside potential as sponsors compete for lower-quality companies – some of which haven’t produced a product.

How Can Retail Investors Get Involved?

Of course, SPACs aren’t without their rewards, as well. The main upside for retail investors is getting in on a reputable SPAC (or a SPAC with reputable sponsors) that selects a company with solid upside potential. This has the potential to generate significant returns for retail investors and the original sponsors.

And have some SPACs have done well in this way – just look at Virgin Galactic and DraftKings.

So, if you want to get in on a SPAC, where do you start?

Like anything else in investing, the answer is: with a little research. Look at SPACs with high-quality management teams that are targeting competitive industries ripe for the picking. You’ll also want to get an idea of how big the SPAC is. While larger SPACs have their choice of target companies, they probably won’t go for smaller firms that have potentially larger upsides.

After that, it’s simply a matter of investing in the SPAC of your choice. If you’re interested in pre-IPO stock, for instance, you can look for filings on platforms like SPAC Insider and SPAC Research and contact prospective investments directly. Your wealth broker may also be able to link you into the SPAC investing community.

Or, if you can’t access a SPAC’s stock pre-IPO, you can get in on the ground floor when the stock goes public on the NYSE or Nasdaq.

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