SPACs, or Special Purpose Acquisition Companies, are shell companies that have no business or assets of theirs own, but these companies are designed to raise money through an initial public offering, or IPO. Later they use that money to merge with or acquire a private operating company.

Here’s how it works:

  • A management group of people, called Sponsors, decides to form a SPAC. They raise money through an IPO by selling units, which are typically priced at $10 per unit and are usually made up of 1 share and a warrant or a partial warrant.
  • A warrant is a contract that allows investors to buy a certain number of additional shares of common stock at a certain price at some time in the future. Because SPAC units trade like stocks, investors can buy or sell shares for the current market value after the IPO.
  • The money raised by the IPO goes into a trust. The trust account typically invests in money market funds or short-term U.S. government securities.
  • The sponsors usually have 18-24 months to buy a company that they think shows tremendous promise. If an acquisition isn’t made, the SPAC is dissolved, and, in most cases, investors will be entitled to an amount of the total trust proportional to the number of shares they own.
  • But, if a target is identified and approved, the SPAC and the target business combine into a publicly traded company. This is known as the De-SPAC process. As part of the De-SPAC process, shareholders can decide whether to stay invested or pull their money out. If investors stay through the acquisition, then their investment will rise and fall with the share price of the company.

Why would a private company want to go public through a SPAC?

Many see it as a way to get the cash influx of public markets while bypassing some of the regulatory hoops and hazards of a traditional IPO. Additionally, there’s greater price certainty and control over the private company compared to a company taking the traditional IPO route because there’s less guesswork in determining at which price to offer the shares.

The management expertise that may be part of the sponsor group can also be key in helping companies continue to grow. Some investors like SPACs because they give them the ability to get in early on an IPO, which may have enormous potential. If the SPAC is successful, the price should appreciate, and investors will make money. In fact, investors may be able to exercise their warrants and buy more shares at a lower price. Of course, there’s also the possibility the investment could lose value.

SPACs have been around for decades, and in the past, they had a bad reputation for scamming investors. However, the SEC started regulating SPACs in an attempt to reduce fraud. The regulation granted investors the right to redeem units before an acquisition. While SPACs remained relatively unpopular for years, in the last decade, they’ve experienced tremendous growth with IPO counts moving from one in 2009 to 248 in 2020. Examples of high-profile SPAC companies include DraftKings (DKNG), Nikola (NKLA), and Virgin Galactic (SPCE). More than $83 billion were invested in SPACs in 2020. This dwarfs the $13.6 billion in 2019.

However, as with any early stage investment, there’s risk.

So, how does an investor determine whether to invest in a SPAC?

Here are three things investors should consider.

Management team or Sponsors:

  • Because there’s no company to start with, no assets, no product, and no track record, investors are betting on management. In recent years, SPACs have used high-profile sponsors like Chamath Palihapitiya, a former Facebook executive, or Bill Ackman, a famous hedge fund manager. Many investors look for these executives to strike pay dirt once again and take their investors with them. SPACs can be very lucrative for sponsors.
  • Sponsors are paid by the success of the SPAC through share ownership called the promote. The promote allows sponsors to buy 20% of the outstanding shares at a heavily discounted price. For example, Chamath Palihapitiya’s SPAC, Social Capital, allowed sponsors to purchase shares for less than a penny per share while regular shareholders purchased shares at $10. There can be a major disparity in payouts between sponsors and investors.
  • The high number of sponsor shares at a low price dilutes investor value because the sponsors aren’t putting up nearly as much money as the investors, but they’re taking a large chunk of the gains. Some SPAC sponsors compare the investment cost to those of a regular IPO. With that being said, sponsors don’t get paid unless the SPAC performs well. So, they’re incentivized to maximize the business acquisition.
    Investors who are interested in SPACs should spend time researching the terms of the investment. A good place to start would be to carefully read the SPAC’s IPO prospectus, as well as the periodic and current reports filed with the SEC.
  • Investors may also want to evaluate the SPAC’s management team to better understand its expertise, experience, and personal track records.

Good Investment or not

  • If a target company is identified, investors need to decide if it’s a good investment. One benefit of the traditional IPO route is companies and management teams undergo scrutiny from investors, underwriters, and regulators. This scrutiny can be helpful in weeding out some prospects. For example, the company WeWork failed to go public because the scrutiny revealed numerous irregularities with the company and its management.
  • SPAC shareholders should carefully evaluate the target company when an acquisition is announced. This is when they have to determine if they want to stick with the SPAC or redeem their funds. It’s important to note that if you buy SPAC shares on the open market and choose to redeem them, you’ll only receive the original IPO value of the shares, which may be different than what you paid on the open market.
  • The SPAC will provide shareholders with an official statement about the proposed merger, including historical financial statements and corporate governance matters. Examining this info is an essential part of determining if the deal is acceptable. Finally, as with any investment, investors should weigh the opportunity costs. Understanding the track records of SPACs can help.
  • While some SPACs have been very successful, one study from 2010 to 2017 followed 92 SPACs and found that they underperformed a broad market index by 3%. Another study found that between 2015 and 2019 the majority of SPACs were trading below the $10 IPO price.
  • A little more than half the companies had actually made an acquisition, 15% were in the process of making an acquisition, 29% were still searching for a deal, and 4.8% had dissolved the SPAC and returned money to the investors in proportion to their shares. Like most investments, the results are mixed.

In the end, SPACs can offer an opportunity to speculate on something new and exciting. However, investors must always weigh the risks and determine how the SPAC fits in to their overall portfolio strategy.