What are SPACs and should I invest in these companies' stocks?
Recently, a type of asset that’s been around for decades has been making headlines. Special purpose acquisition companies, or SPACs, are all the rage these days.
Not only are these investment opportunities seeing quite a bit of popularity, they seem to be generating significant gains for investors, bringing companies like DraftKings and Virgin Galactic to the public stage.
What are these investment vehicles and are they worth your time?
What Are SPACs?
SPACs, also known as blank-check companies, are an interesting asset that, at first glance, appears to have absolutely nothing to offer to its investors.
These companies are publicly traded but don’t have products, services, or any way to generate revenue. Not to mention, they generally come with pretty slim management teams made up of Wall Street pros.
So, why would you want to invest in one?
SPACs are shell companies with one goal in mind: to acquire a private equity company that has the potential to generate profits for investors through a SPAC merger.
Essentially, these special-purpose companies spend months or even a couple of years raising funds from the investing community with the ultimate goal of acquiring an active, operating company.
Once the acquisition is complete, the combined company takes on the life of the company the SPAC acquired, bringing the once-private company to the public market.
When investing in these vehicles, you’re essentially investing in an initial public offering (IPO) of a company that likely doesn’t know it’s going to be part of that offering quite yet.
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How Do SPACs Operate?
Although there’s quite a bit to take in here, the process is actually quite simple. A SPAC starts when a management team — generally a group of institutional investors, high net worth individuals, hedge fund managers, and other Wall Street pros — gets together and decides that they’d like to launch a shell company.
Once the shell company is launched, the special purpose company works with the United States Securities and Exchange Commission (SEC) to bring shares of the SPAC to the public, generally with the goal of trading on the Nasdaq or New York Stock Exchange (NYSE).
Once the SPAC launches its IPO, funds raised through the offering are held in a trust account or escrow account that generates interest income. These IPO proceeds are not to be touched by the management team of the company until the acquisition of an active company takes place.
Once the company has raised capital through the sale of SPAC shares, the management team of the company starts its search for target companies. These are generally active private companies that are generating profits, or are nearly profitable, that may have an interest in going public.
The SPAC makes an offer to the private company, and if negotiations go well, the acquisition happens without issue. At this point, the acquisition company changes its name to the name of the company it acquired and adopts its ticker symbol and takes on the life of the acquired company.
What Happens if the SPAC Can’t Find an Acquisition Target?
When a SPAC issues its prospectus — the document explaining the potential risk and rewards associated with an investment — it will outline a time frame in which it expects an acquisition to take place. In most cases, the goal is for a deal to happen within two years of the SPAC’s initial public offering.
But what happens if a deal is never solidified? Do investors lose their money?
Not at all!
If the acquisition company is unable to ink a deal with a private equity company within a reasonable amount of time, the company will liquidate and dissolve. In the event of a liquidation, SPAC shareholders are returned their initial investment plus the interest generated through the trust or escrow account.
So, even if a deal isn’t made, the investor will generate a return. However, given the interest rate environment as of July 2021, the returns in the event of a liquidation aren’t going to turn any heads.
Are SPACs Better Than IPOs?
There are obvious benefits to SPACs over IPOs for the private company looking to go public and for the investor, but there are also some disadvantages to consider.
From the Private Equity Perspective
Private companies make their way to public markets all the time. There are two ways to do so. Either the company needs to work with regulatory authorities and launch a public offering, or it needs to merge with an already public company that’s listed on public markets.
Working with the SEC to bring a new company to market is a daunting process that can take up to six months. Many companies that want to go public look to SPACs to avoid the formal IPO process altogether.
With deals that can close within a matter of three months, mergers with special purpose companies are one of the fastest ways to get listed on major stock exchanges.
From the Investor’s Perspective
For investors, there are significant differences between SPAC IPOs and traditional IPOs to consider. Some of the most important include:
- Knowledge of What You’re Investing in. When you invest in a traditional public offering, you know exactly what you’re investing in and at what price. When investing in a SPAC, you’ll have no idea what you’re investing in until the company unveils its target, making it impossible to make an educated decision as to what to expect from your investment.
- An Expert Team. When you choose your own investments, the only experts on your side will be those you hire. On the other hand, when investing in a special purpose company, you’re investing with a team of Wall Street professionals who have made the stock market their life’s work. Although you may not know what you’re investing in, there’s a strong chance that the investment will result in ownership of a quality company.
- Money Back. If you invest in a traditional stock and the value of the company tanks, you lose your money. However, if a SPAC doesn’t keep its promise to invest your funds in a quality company, you are returned your investment plus interest, adding a level of safety to the investment. However, once an acquisition is done, if the value of the target company falls, you’ll experience losses as usual.
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There have been plenty of successful special purpose acquisitions, and there are plenty of open SPACs on the market to choose from today. Here are some examples of these companies:
Completed SPAC Mergers
Some of the most popular recently completed SPAC mergers include:
- DraftKings (NASDAQ: DKNG). DraftKings is an online fantasy sports and betting service that merged with Diamond Eagle Acquisition Corp and SBTech. Since the merger, the stock has grown more than 400%.
- Virgin Galactic (NYSE: SPCE). Founded by Richard Branson, Virgin Galactic is a space exploration company that was part of a SPAC acquisition by Social Capital Hedosophia in 2019. Today, the space exploration startup is worth well over 400% of its initial value in the merger.
- QuantumScape (NYSE: QS). Finally, QuantumScape is a company focused on the development and manufacturing of batteries for electric vehicles. The company was acquired by Kensington Capital Acquisition Corp. The stock is currently trading at nearly 300% gains since its acquisition.
Risks of SPACs
Despite the promise to return your initial investment plus interest should the management team not be able to follow through with its promises, there are some significant drawbacks of investing in SPACs to consider:
Special purpose acquisition company management teams are under significant pressure. These teams must find a quality company to acquire, negotiate a deal, and close that deal within a “reasonable amount of time.” Sometimes, business doesn’t happen efficiently within what you may expect to be a reasonable amount of time.
The management teams know that they must produce results or pay back their investors with interest. As a result, these teams may feel pressured to close a deal that may not be the best possible outcome for investors, simply because they’re under pressure to get something done.
Although you can wait until a definitive agreement is reached to invest in a SPAC, the vast majority of investors jump in before they know exactly what they’ll be investing in.
While this has benefitted investors who dove into Draft Kings and Virgin Galactic early on, it can also result in investments in companies that you never would have considered based on your strategy.
Lack of Regulation
According to Lloyd Blankfein, the regulatory due diligence that takes place during the IPO process is rigorous, and SPACs circumvent this process. That’s a scary thought.
While both paths result in a private company becoming a public company, there’s more research and scrutiny involved in the traditional IPO path. With less due diligence by the investment banks and underwriters involved in SPAC acquisitions comes increased risk.
Should You Invest in SPACs?
If you’ve read the risks above and are still interested, you may be a prime candidate for a SPAC investment. The key is being willing to accept the risk involved.
Sure, you may get your money back with interest, or you may generate significant gains. But there’s also the potential for you to blindly follow stock market pros through their next big mistake, ultimately finding yourself holding shares in a company that aren’t worth the paper they’re printed on.
When investing in any SPAC, it’s important to consider the risks. While risky investments have their place, they should never make up a significant percentage of your investment portfolio.
If you decide you have the ability to stomach the risk, keep investments in SPACs limited, never amounting to more than 10% of your portfolio’s value.
What to Look For in SPACs
If you’re looking for SPACs to invest in, there are a few things that you’ll want to look for:
A Definitive Agreement
There is a way to know what you’re investing in with a SPAC, for the most part. All you need to do is look for open opportunities that have announced a definitive acquisition agreement.
While they are subject to customary closing conditions, once these agreements are signed, there’s a strong chance that the acquisition will be finalized.
A Strong Management Team
Before investing in a special purpose company, it’s important to dive into the team that runs it. After all, this team will be determining what companies to target and be charged with negotiating on your behalf.
A SPAC can only afford to buy a quality company if the investing community stands behind it. If the company lacks popularity, it won’t be capable of raising enough funds to buy a leading player in just about any industry.
So, it’s important that the SPAC you invest in is one that’s gaining steam among the investing community.
SPACs are an exciting concept — a form of gambling without actual gambling. When investing in these companies, you could end up owning the next stock that’s destined to experience 400% gains in less than a year.
Then again, you could end up owning a stock that drops like a brick after an acquisition target is announced.
If you do decide to invest in these relatively risky assets, it’s important to do your research and get to know the history of the management team in charge of the company and the decisions it makes.
It’s also best to wait until a definitive agreement is signed before investing. This way you have the opportunity to research the company that’s likely to be acquired.