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A Special Purpose Acquisition Company (SPAC) is a shell company created to raise money through an initial public offering (IPO) to later acquire or merge with a private company. SPACs have become increasingly popular, especially since 2019. In general, they can provide private companies with a faster path to going public and raising capital than a traditional IPO.
Here’s how SPACs work, what the difference is between traditional IPOs and SPACs, and how to invest in them.
How SPACs Work
A SPAC is an entity created for the purpose of raising money from the investing public and then using that money to acquire or merge with a private company. This process allows the company to enter the public market without going through the typically lengthy and expensive process of a traditional IPO.
Like a traditional publicly traded company, a SPAC registers with the Securities and Exchange Commission (SEC) and issues securities to the public. The difference, however, is that the SPAC has no products or services available at the time of the offering. So investors are speculating about the potential benefits of the SPAC and whether the SPAC’s sponsors – who are responsible for selecting a target company to merge with – will find an attractive takeover target.
After the SPAC raises capital, it will have a set period, typically two years, to identify and acquire a target company and complete the merger. The SPAC’s shareholders will vote on whether they like the takeover candidate and whether the merger goes through. A SPAC must use 80 percent of its net assets for an acquisition or be dissolved.
If the SPAC fails to complete a transaction within the specified time period, the remaining funds with the company are returned to shareholders, minus various (usually non-extensive) fees.
The SPAC sponsor can earn significant fees and equity – often 20 percent of the SPAC’s stock – if it can complete a transaction even if the merged company continues to perform poorly. This reward structure can create incentives for the sponsor to get whatever deal across the finish line so it can earn its high fees, misaligning the sponsor’s incentives versus shareholders.
Most SPACs are listed on the Nasdaq or the New York Stock Exchange.
Companies that have gone public via SPACs
The number of SPACs coming to market since 2019 has been staggering, and the market has heated up as low interest rates and risk-seeking behavior dominated in the wake of COVID.
In 2019, there were 61 IPO filings, according to SPAC FINRA data. Two years later the number exceeded 1,000. While the number of SPACs showed a downward trend in 2023,… S&P global market informationA number of high-profile companies have gone public via SPACS. This includes startups such as SoFi, Clover Health, BarkBox, Hims and Hers Health and Billtrust. Virgin Galactic also went public via a merger with a SPAC in 2019.
“SPACs were in vogue in the post-pandemic go-go days, when low interest rates meant money could flow freely even to entities that had no real business. The subsequent poor performance of many SPACs and a sharp increase in interest rates caused SPACs to largely fall out of favor as investors refocused on the fundamentals of investing in profitable companies with a proven track record,” said Greg McBride, chief financial analyst of Bankrate.
Origin of SPACs
Special Purpose Acquisition Companies (SPACs) have evolved over the years from what were once known as “blank check companies” in the 1980s and 1990s. Despite their popularity and growth potential, these early companies lacked proper regulation and became notorious for fraud.
Although modern SPACs are more heavily regulated, they still create conflicts of interest and misalignment of incentives between the SPAC’s sponsors and its investors.
Pros and cons of SPACs
SPACs offer investors a number of benefits and risks because of their purpose and the way they are structured.
Benefits of SPACs
- Faster access to financing: One of the biggest benefits for companies that merge with a SPAC is that they can quickly access capital without having to go through the lengthy process of a traditional IPO.
- Lower fees and regulations: Because they bypass the usual IPO process, companies can avoid some of the typical rules in a traditional IPO, including the increased scrutiny and due diligence of an underwriting bank. That may be good for the SPAC and the private company, but it’s not a good setup for investors.
- Increased share of the company: Investors may be able to acquire a larger share of the private company through the SPAC than they would otherwise.
- A “free” look at a deal: Because investors get to vote on any merger the SPAC proposes and get their money back if they don’t like it, they get a “free” look at a potentially attractive private company.
- Potential profits for a new business: Investing in a privately held company can provide significant benefits if the company remains successful.
Disadvantages of SPACs
- Lack of care: The downside to faster access to financing is that SPAC takeover candidates do not undergo the research and due diligence they would undergo if they went through the traditional IPO process. Investment banks scrutinize every company when underwriting an IPO because they could be liable for fraud if it goes poorly. The SPAC merger puts an end to this traditional due diligence process.
- No guarantee of a deal: Investors could sit in a SPAC for a few years without a deal closing. Even if they lose little or no money if the SPAC is liquidated, they could have made money elsewhere.
- Lack of clarity on any deal objective: Investors may have only a vague idea of where the SPAC might invest its money until a deal is actually announced.
- Severe misalignment of stimuli: A SPAC is generally set up with a misalignment of incentives between the SPAC’s sponsors and its investors. The sponsors can make some nice money if they can close a deal, even if it ultimately doesn’t work out, while they get little to nothing if they fail to close a deal. They are therefore incentivized to complete even a bad merger, misaligning their incentives with investors who want an attractive takeover.
- History of poor returns: Post-merger SPACs have a history of poor returns, many of which have fallen significantly in the months or years following a deal. This result is partly due to the lack of due diligence and the misalignment of incentives (see above). Executives at some sketchy companies may realize that they can go public through a SPAC and avoid some of the scrutiny of the traditional IPO process while enriching themselves.
What is the difference between an IPO and a SPAC merger?
A traditional IPO process and a SPAC merger can both take a company public, but they differ in important ways, especially in how the private company is evaluated during the process.
In an IPO, the underwriting banks conduct their due diligence on the private company and prepare a prospectus containing the company’s financial statements, potential risks and other information. They value the private company and set the initial share price and terms of the offering. Then the underwriters must sell shares in the company to major investors in a process known as a roadshow, gathering support and excitement for the IPO. This process means that the future listed company must undergo a lot of research before going public. Insurers are incentivized not to promote fraudulent companies because they could be held liable.
When a company goes public via SPAC, the process is substantially different and the intensive scrutiny of insurers and large institutional investors is largely avoided. The SPAC sponsors identify a merger target and then negotiate with the private company to provide their money for a percentage of the company post-merger. They present this deal and the company’s financials and prospectus to the SPAC’s investors, who can then accept or reject the deal.
If the investors accept the deal, the SPAC and the private company will merge, with the SPAC’s shares being exchanged for shares in the new publicly traded company.
How to invest in a SPAC
Investing in a SPAC can potentially be a lucrative opportunity for investors, even if this is usually not the case. Here’s how to get started.
1. Open a trading account.
If you don’t already have an investment account, one of your first steps is to open an investment account, either online or in person. If you choose to open an account online, you can complete the process in about 15 minutes.
2. Look for SPACs
Search for SPAC shares on your broker’s site or on a public site like Yahoo Finance or Google Finance.
3. Research
You’ll want to take the time to review the SPAC’s prospectus and other public documents, such as its financial reports, which can be found in SEC filings. EDGAR database. Additionally, it is critical to assess the development potential of each deal candidate and the motivations and incentives of the SPAC’s sponsors.
4. Invest
Once you have determined which SPAC(s) you want to invest in, you can purchase a regular SPAC share or a SPAC unit or a SPAC ETF. A SPAC unit generally consists of one common share and a portion of a SPAC warrant. The warrant gives you the option to buy another share of stock later. Please note that warrant terms are not consistent across SPACs and can vary widely. Before you invest, you must read the conditions carefully.
In short
SPACs have become a popular way to access public markets faster than a traditional initial public offering. But investors should be aware of the risks associated with investing in these vehicles and do thorough research before making any investment decisions. The track record of SPACs as a whole is unattractive, even if some good deals eventually materialize.
