What Is a SPAC? Are They a Safe Investment?

Investing
Updated: 25th Feb 2021
Written by Ryan Barnes
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Investing
February 25, 2021
Written by Ryan Barnes

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Wall Street loves to find new ways to get old tasks done. This financial innovation leads to more, and better opportunities for investors.

Other times, the innovation flames out spectacularly – and investors take it on the chin.

Today we are looking at this decade’s most noteworthy innovation – the SPAC – which has become a viable competitor to the Initial Public Offering.

What is a SPAC?

SPAC stands for Special Purpose Acquisition Company. As the name implies, it’s a company set up with a singular purpose – and that purpose is to pool together a bunch of investors’ money, then go out and buy one company. Just one.

SPACs are often called “blank check companies” as they essentially do just that, write a big blank check, and look to fill in the name later.

The lifecycle of a SPAC has several distinct phases.

First is the incorporation of the SPAC itself. This is a company spinning itself into being fast, but it has no products to sell and no services to offer.

All the SPAC has at the outset is a small group of founders, and the intent to buy an existing, established company that operates in a specific industry or sector.

The founders themselves will generally invest 15-20% of the amount eventually raised, into what is known as “Founder’s Shares.” The remainder of the SPAC – “blank check” – being raised from public investors via an initial public offering (IPO) on a stock exchange.

The second phase is this IPO of the SPAC “shell” itself. The SPAC will have filed registration documents with the Securities Exchange Commission, and in those documents the SPAC will have announced who the founders are (these are typically industry heavyweights, successful entrepreneurs, and large asset managers) and what industry/sector the SPAC is looking to make their acquisition in.

During the IPO, instead of issuing only common shares, the SPAC typically offers both common shares and some warrants (an offer to buy more shares of a specific company at some date in the future, and at a set price).

The warrants are offered because people who buy into the SPAC IPO don’t know yet what company they’ll ultimately be invested in. The warrants give existing investors the chance to invest more in the SPAC once the acquisition target is announced and the deal size is finalized.

Learn More: How to Start Investing

SPAC Stock Trading

Once the IPO is complete and the amount available to spend (the blank check amount) is known, the SPAC then goes looking for its target.

The target is most likely a private company that was considering going public themselves in the next couple of years (sometimes sooner).

But if that company instead decides to merge with the SPAC and receive that blank check, the company can make it to a public stock exchange faster (by about half the time), and cheaper, than if the company went through the IPO process by themselves.

SPACs have a limited timeframe to make their acquisition (typically 18-24 months) or else they must return the investor money raised during their IPO.

Once the acquisition and target are officially announced, the company being acquired is merged with or officially bought out by the SPAC, and the SPAC will generally change its name and ticker symbol to one representing the target company.

In this interim, while the SPAC is shopping for a target, the SPAC shares will still trade every day on the stock exchanges.

Some will go up, if there are rumors of who they may buy and if people are excited about the possible target company.

Others will fall, as there may be uncertainty over who the target company is going to be, or if general stock market conditions weaken.

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The History of SPACs

The whole notion sounds kind of strange, doesn’t it? Just hearing what a SPAC is brings up an instinctual reaction of “well, why go through all that?”

SPACs have actually been around for years. Most SPACs that were created before 2018 were small and in some instances shady.

Initially, SPACs were looked down upon.

Why would a company not just have their own IPO?

What CEO wants a group of other founders to waltz into their company and start controlling everything?

But in 2019, things started to shift. Several factors played into this shift. Here are a few:

  1. Several large companies in sectors traditionally shunned/feared by Wall Street went public via a SPAC merger, and shot higher right out of the gate (such as DraftKings, EV-maker Nikola, and Virgin Galactic). This led to a positive feedback loop in an already bullish overall stock market
  2. A strong IPO market had existed for several years, making private companies desperate to go public and “strike while the iron is hot”. But filing for an IPO and going through all the hurdles is expensive and time-consuming. Having someone wave a check in your face with a promise to get to a stock exchange listing faster and cheaper is very enticing.
  3. Several large tech companies had come to market via non-traditional IPOs such as direct listings (“Dutch auctions”) with success, cracking the old narrative that a traditional IPO was the only way to go about things.

These shifts, and a rising stock market for many years which increased the risk appetites of investors, led to a couple of successful, large SPACs in 2019.

From there, momentum just kept building in 2020 – and the pandemic that ironically sped up growth in new SPACs.

The COVID-19 pandemic shut down most travel, thereby shutting down the financial industry “meet & greet”, “press the flesh” processes that are key to getting deals done.

SPACs were already around and gaining traction when the business world was driven into hibernation.

Suddenly joining up with a black check company became seen as the fastest way to get to market, as most of the travel-intensive steps of an IPO could be avoided.

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SPAC Mania From 2020 Continues in 2021

Consider this – in 2013 SPAC IPOs made up about 4% of all IPOs to hit the market. By late 2020, that number was up to 45%.

For the full year 2020, SPACs raised over $80 billion in IPOs, with 250 new shell companies formed.

In just the first six weeks of 2021, over $50 billion has been raised by over 150 new SPAC stocks.

Even though the individual performance (compared to say, the broad Nasdaq index) of SPAC stocks hasn’t been great in recent months, investor interest continues to be rampant, and deals continue at a feverish pace.

Look no further than a headline of “Alex Rodriguez to lead group of Founders in a SPAC” to wonder if too many people are hoping that name recognition alone is enough to get a SPAC IPO under the wire before a bubble somewhere pops.

Are SPACs Worth Investing in?

As with any stock you may buy – whether it’s a long-term holding or just a quick trade – there’s inherent risks involved.

“Post-SPAC” trading – buying only once you know what the actual acquisition target is – is overwhelmingly the best way to go about things.

There is just no reason to buy the SPAC IPO right away before knowing what they’re going to do with the money. If the company is a success story, you will have plenty of upside by buying and holding.

The success rate of SPACs during this wave of the past 2 years is mixed, at best. At least during a typical IPO process, the company going public has to convince thousands of investors that they are a company worth investing in. Otherwise, no IPO.

Contrast that with a SPAC founder walking into the door with a blank check because “they just love you” (and they need to spend the check, or else!).

Now you, as a CEO, only have to convince one person that you are a company worth investing in – the guy with the check. Sub-par performance is often a by-product of less vetting and less homework.

Learn More: How to Research Stocks

Can I Buy SPAC Shares at My Broker?

Yes, once the SPAC has their initial shell company IPO, the shares will trade on a major exchange like any other stock.

All major online stock brokerages allow access to SPACs post-IPO; they are more volatile than other stocks, so you may see a warning about elevated risk associated with buying the SPAC, but you’ll be allowed to trade the shares.

If you own SPAC shares before they make their acquisition, you will see the ticker symbol change to represent the new (combined) company once the deal is complete. This is normal and your ownership remains the same.

Are SPACs a Safe Investment?

SPACs are not inherently riskier than any other stock once they have made their acquisition. Once the shell SPAC buys its target, they are essentially that company going forward. Just another company with a ticker symbol.

And when the SPAC is trading as just a blank check company (before they make their acquisition), current shareholders can rest easy knowing that there is a specific floor on the SPAC stock.

If the SPAC founders don’t make an acquisition before the clock runs out, the company is essentially dissolved and the blank check is torn up.

All investors will get back their original cost basis (typically $10/sh). If the SPAC stock had been bid up to $17 on just optimism, then the price will inevitably fall back to the floor level in this scenario.

So, SPACs have some safety value before they make their acquisition, but afterwards they’re pretty much like any other company.

The risk will depend on how risky the underlying business is. It is worth noting that most SPACs in 2020-2021 have been in emerging technologies, which are inherently hit or miss.

Bottom Line: What Are SPACs?

SPACs are blank check firms that go shopping for one company to buy in a particular industry. They are likely to be looking at emerging technologies and services that offer the chance for rapid growth in the coming years.

SPACs are currently the hottest trend on Wall Street. Whether SPACs are still popular in five or ten years from now depends on just one thing – how well this current crop of SPACs perform.

If most of the “vintage” SPACs from 2020 end up being success stories (by outperforming the broad stock market as a whole), then more private companies will feel comfortable coming to market that way. And investors will keep on funding those SPAC IPOs so long as the returns are good.

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Ryan Barnes
Ryan Barnes
Ryan is a certified Chartered Financial Analyst (CFA) with over 15 years of experience managing and steering hundreds of millions in client assets through complex and dynamic financial markets. Ryan’s work has appeared in the Wall Street Journal, Barron’s, Forbes, Nasdaq.com, Investopedia, and Bloomberg. Additionally, he has multiple citations in peer-reviewed papers for reporting done on the U.S. housing market preceding the Great Financial Crisis.