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Special Purpose Acquisition Companies (SPACs) have exploded in popularity over the last few years as an alternative for private companies to go public and access capital markets. As more retail and institutional investors consider investing in these “blank check” companies, it’s important to understand precisely what SPACs are and the potential risks and rewards they present.
What are SPACs and How Do They Work?
A SPAC is a company with no commercial operations that is formed strictly to raise capital through an Initial Public Offering (IPO) for the purpose of acquiring an existing private company. The SPAC itself does not do anything except seek out acquisition targets.
The SPAC raises money by selling units, typically priced at $10 per unit, which consist of one share of common stock and some portion of a warrant to purchase additional shares. That capital is held in a trust account until the SPAC identifies a private company to merge with or acquire.
Once a target is identified, shareholders vote on whether to approve the acquisition. If approved, the companies merge, and the target becomes publicly traded under the SPAC’s stock ticker. If no deal occurs within the SPAC’s specified timeframe, usually 2 years, the SPAC is dissolved, the trust funds are returned to shareholders, and the SPAC units stop trading.
The Rise in Popularity of SPACs
SPACs have become an increasingly popular vehicle for companies looking to enter public markets as an alternative to a traditional IPO for several reasons:
- They provide certainty of valuation and funding upfront before identifying the acquisition target.
- They may allow companies to hit public markets faster with less red tape than the IPO process.
- Targets can make forward-looking projections and estimates normally restricted during an IPO.
- SPAC sponsors typically have industry expertise or business connections that targets can leverage.
In 2020 and 2021, over 600 SPACs raised approximately $190 billion, up from $13 billion in 2019. However, some experts worry we’ve hit “peak SPAC” and the space is oversaturated.
Key Benefits and Risks for Investors
For investors, SPACs provide some unique advantages but also pose some substantial risks to consider:
Benefits
- Exposure to private, venture-backed companies earlier in their lifecycle.
- Ability to participate in acquisition target selection. Investors can redeem shares and get their money back if they don’t like the proposed deal.
- Potential for high returns if the SPAC selects a promising acquisition target or effectively leverages industry expertise.
Risks
- The target company, management team, financials, and valuation metrics are unknown at IPO. Investors essentially trust the SPAC sponsor’s ability to identify a good target.
- After announcing the proposed merger target, SPAC stock prices can be very volatile and risky.
- If the acquisition deal falls through after the announcement, share prices generally crash, leaving investors with big losses.
- Redemption rights go away after a deal is announced, eliminating investors’ ability to recoup their original investment pre-merger.
Lending companies like CreditNinja offer financing to small businesses that may benefit from merging with a SPAC in order to access growth capital. But overall, SPACs remain a speculative investment with substantial downside risks for retail investors.
Tips for Investing in SPACs
For investors interested in gaining exposure to SPACs despite the risks, here are a few tips:
1. Research the Management Team
A SPAC is essentially a blind investment pool entirely dependent on the ability of its management to identify and perform due diligence on acquisition targets. Focus investments on SPACs with experienced, proven dealmakers with expertise in the target company’s industry.
2. Understand Redemption Rights
Investors can typically redeem shares for their original cash value before a proposed merger target is announced, eliminating downside risk. But study the redemption conditions carefully, as some SPACs place restrictions or deductions on redemptions.
3. Pay Attention to Warrant Terms
SPAC unit shares usually come bundled with warrant derivatives, allowing investors to buy more shares at a discount. However, these warrants have expiration dates and conditions that determine their value. Review them carefully before investing.
4. Consider Buying After Announcement
Once a SPAC announces the target acquisition company, perform your due diligence on the merits of the deal rather than relying on the SPAC sponsor. If the deal looks strong, consider investing post-announcement.
5. Diversify and Allocate Prudently
Given their risk level, SPACs should only be a limited portion of an overall investment portfolio appropriate to an investor’s goals and risk tolerance.
Outlook for SPACs
The surge in SPAC IPOs over the last 2 years has led to inevitable saturation. Many experts expect down cycles and consolidation if the current pace continues amidst rougher public market conditions in 2022. Failed deals and dissolved SPACs could lead to investor losses and cool future appetite.
However, regulators have also vowed tighter oversight and guidance around SPAC disclosures to protect investors better. If these policy changes can instill more public confidence, SPACs have the potential to become an established alternative path to public markets.
As the SPAC landscape continues to evolve, investors stand to benefit by staying informed, being selective in the SPAC sponsors they trust, and mitigating risks by not over-exposing their portfolios. SPACs offer unique opportunities but also pose pitfalls for the unaware.
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