Are SPACs a Good Investment?

Following the initial devastation of the COVID-19 pandemic, one of the major developments in the equities market has been the rise of special purpose acquisition companies or SPACs. Also known as blank-check firms due to their lack of operations, they have two basic functions: initiate their own initial public offering (IPO) and identify a reverse-merger target to combine with.

Typically, SPACs represent a quicker and streamlined alternative to the traditional IPO, which made them especially attractive due to the pandemic. But it also begs the question: Are SPACs a good investment? Let’s find out.

How to Invest in SPACs

Similar to participating in any public market debut, you have two main options. First, if you’re an institutional investor or a sophisticated private buyer with deep connections, you may have an opportunity to buy SPAC shares in the primary market, where issuing entities create equity units. In this channel, you buy shares directly from the underwriters.

However, most investors don’t have this privileged access. Instead, they must buy shares in the secondary market, also known as the public or open market. SPAC creators, better known as sponsors, usually price their blank-check firms’ equity units at $10 a pop.

Once a SPAC goes public, you can buy its shares like you would any other publicly traded stock. From a mechanical perspective, no difference exists between a SPAC stock and a regular stock. Fundamentally, though, SPACs have no underlying business. Instead, they serve merely as a vehicle to merge with a privately held enterprise, which is typically but not always a startup.

Each blank-check firm has its own provisions regarding the timeline it has to identify a merger target and what happens if it is not successful. In most cases, the timeline is around 18 to 24 months. Should a SPAC fail to find a viable candidate, it returns the money it raised from early investors.

On the other hand, following a successful merger, the SPAC assumes the identity of the private enterprise. As well, the ticker symbol changes to one that reflects that company’s brand or business. A SPAC, then, is a backdoor method of taking a private firm public, which is why many analysts refer to this process as a reverse merger.

While SPACs share many similarities with traditional IPOs, they’re also distinct. What makes them appealing to retail investors is that you can buy these blank-check firms in the early phase, hoping that they identify a great business. Thus, SPACs are about the closest thing you can get to being an early bird IPO investor.

Where to Invest in SPACs

Since SPACs are themselves publicly traded entities, you can use any brokerage to buy them. That said, some brokerages are more SPAC friendly than others. Below is a list of where you can invest in SPACs.

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How SPAC Investors Make Money

As is the case with other investment categories, you have several ways to make money through SPACs. Still, you should be aware that institutional investors and high-net-worth individuals enjoy the biggest advantages when it comes to blank-check firms.

First, SPAC sponsors enjoy hefty rewards for their services. According to the Financial Industry Regulatory Authority, “SPAC sponsors take on reputational risk to take a SPAC public and find a suitable target company. As a result, the SPAC sponsors are generally compensated for this risk in the form of a bigger discount to the price that a target company may obtain if it opted for a traditional IPO.”

In most cases, sponsors receive 20% equity in the combined entity. You should consider compensation terms before buying a SPAC because they may impose a dilutive effect down the line.

Second, institutional players make money by investing in SPACs in the primary market. In many circumstances, hedge funds robustly capitalize a SPAC’s IPO. In return, they receive both shares and warrants, which give holders the right to buy more shares at a specified price before their expiration.

Essentially, hedge funds have a limited risk opportunity with SPACs. If a SPAC fails, they get their money back. If it succeeds and the stock price jumps higher, hedge funds have both shares and warrants to profit from.

Third, retail investors can buy SPAC shares before merger announcements. If the SPAC doesn’t carry much hype, they may be able to buy shares at or near the initial $10 price. However, much-hyped SPACs jump higher in the secondary market, often based on the sponsors’ reputation.

Finally, public investors can also gamble on a SPAC post-merger announcement. The idea here is that they can speculate on an enterprise with strong upside potential. But this is the riskiest way to make money from SPACs as no protections exist if things go awry.

Advantages of SPAC Investments

Even with much controversy, you will find many reasons why SPACs can potentially deliver the goods for stakeholders.

• Early opportunity: Under the traditional IPO process, underwriters deliberately leave out retail investors from buying shares in the primary market. Why? Retail investors represent the least profitable source of capital. Instead, underwriters seek out institutional investors and affluent private buyers, who bring in the big bucks. Therefore, the average investor only has the option to participate in the secondary market, after all the hype has been built up. SPACs turn this paradigm on its head by allowing anyone to buy shares before a merger announcement.
• More choices: Though many startup enterprises prefer going public via the traditional IPO, some companies simply don’t have the resources to go through this route. The “normal” process requires substantial oversight such as financial disclosures. Moreover, this method takes time. With SPACs, the process can be much more streamlined and initially cheaper for the startup enterprise (though giving up 20% equity to sponsors can be a long-term drag). The end result is that retail investors have more choices regarding investment opportunities.
• Risk mitigation: While traditional IPOs often benefit from the phenomenon known as the “IPO pop,” where public investors in the secondary market bid up shares of hotly anticipated offerings, you never really know what will happen. Sometimes, IPOs can be duds. But with SPACs, retail investors can mitigate some of the risks of the unknown by buying SPAC shares before a merger announcement. If a deal doesn’t go through for whatever reason, early shareholders get their money back at the $10 initial offering price.

Disadvantages of SPAC Investments

While SPACs certainly open the floor to possibilities for public investors, they may also find the risks unacceptable.

• Deceptively democratic: On the surface, SPACs allow the everyday investor to enjoy wagering on a ground floor offering. In reality, you’re really trading in the lobby, which is better than a regular IPO. But make no mistake as privileged investors received the choicest deal (shares plus warrants) in the primary market first. Thus, SPACs represent little-risk opportunities for the affluent, not for you.
• Dilution central: One of the dynamics that tend to catch rookie SPAC investors off guard is dilution. Particularly, warrants present a minefield for those who are not paying attention to the finer details of a blank-check firm. Should a SPAC rise significantly in market value, the warrants become extremely attractive. Their exercise allows warrant holders to extract more profitability from the same deal, which means a flooding of stock in the secondary market, imposing downside pressure.
• Questionable potential: With so many juicy incentives for institutional investors to pump, dump and run from SPACs, they don’t necessarily have the greatest track record. A recent example is Virgin Galactic (NYSE: SPCE). In March, reports circulated that chairman Chamath Palihapitiya sold his entire personal stake in SPCE stock. This led to a crumbling of the share price which has yet to cease at time of writing. Sadly, many investors that bought into the Virgin Galactic hype suffered catastrophic losses.

So, are SPACs a Good Investment?

It depends  — examine each SPAC. Should you find an ethical and reliable sponsor, betting on that expert’s reputation to find high-value merger targets could yield tremendous profitability. Clearly, if you’re able to participate in SPACs in the primary market, they offer great rewards for little risk.

The picture becomes murkier when you consider longer-term sustainability. So far, SPACs generally have not generated encouraging results following their mergers, as the Virgin Galactic fiasco demonstrated. That doesn’t mean SPACs can’t offer long-term rewards but investors should be extremely careful.

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