What are the Risks of SPACs?

For most people, 2020 was the year of the COVID-19 pandemic but for investors, 2020 was the Year of the SPAC. Special purpose acquisition company (SPAC) mergers raised approximately $64 billion in funds closing in on the $67 billion raised by IPOs in 2020. Today the trend is still on with a growing number of venture capital operators and private equity (PE) firms forming more SPACs.

We draw the spotlight on blank check companies or SPACs — Are they in a bubble? Why are they appealing to investors? And what are the risks involved?

SPACs: An Overview

A SPAC is a company formed solely to merge with another company to take it public. SPACs raise money through an initial public offering (IPO) and investors usually do not have an idea of what company it will merge with. Sometimes investors have to wait for as long as 2 to 5 years for the SPAC to choose or identify the merger company. If no company is selected, funds are returned to the investors according to SEC guidelines.

The shell company or SPAC raises funds from investors, typically around $300 million to a few billion and then searches for a suitable partner to merge with. For CEOs, going public is a way to increase the company’s brand awareness, provide shareholder liquidity and raise capital and resources to further expand their businesses. More companies are increasingly adopting mergers with special purpose acquisition companies instead of a traditional IPO to achieve these objectives.

SPACs vary in terms of size, costs, terms and other factors. Though some elements of the SPACs merger processes are consistent, each one has its peculiarities.

Brief History of SPACS

SPAC mergers are not a new concept — they were first created in the 1990s but only gained popularity with blue-chip investors recently. According to PwC’s analysis of dealogic data, the number of SPACs as a share of IPOs rose to 30% in 2019 from 4% in 2013. The boom came as more deep-pocket sponsors, blue-chip private equity firms and high-profile personalities like Shaquille O’Neal formed a SPAC, attracting private companies looking to go public.  

Are SPACs a Good Investment?

Historically, SPACs are interesting for two major reasons: the potential to rally after a deal announcement and the freedom to cash out your shares if you do not like the target company selected. 

The potential to rally

Usually, when a SPAC finds an attractive merger partner and a deal is announced — if the market views the deal positively — the value of the SPAC rallies above the offer price on the prospect. In this case, the investor may make money. They can cash out at that point and enjoy a potential profit.  

Note that not all deal announcements are viewed favorably. A SPAC can trade down the offer price if the market doesn’t receive a deal positively. An example of a high-profile SPAC is Social Capital Hedosophia. Silicon Valley Investor Chamath Palihapitiya founded Social Capital Hedosophia Holdings, a $600 million SPAC that eventually acquired a 49% stake in Virgin Galactic.

The freedom to cash out

SPACs generally invest their money conservatively until they announce a deal. So, if your SPAC ends up merging with a company you are not comfortable with, you can sell your stocks and cash out.  This happens at around the initial offer price. SPACs usually take anywhere between 2 months to 3 years for a deal to fail; during that time your stocks might have earned some returns at least better than 0.

SPAC Risks

Most people view SPACs unfavorably due to their risk potential. Notably, Jim Cramer in a series of viral criticism-laden tweets expressed his dislike for SPACs — a criticism that is borne partly out of his inability to comprehend the process and the risks involved. Some of the common risks are:

An uncertain outcome

With a SPAC you don’t know what you are going to get. As an investor, you commit your funds in blind faith with no guarantee. Financial Times reports that the majority of American blank check companies currently fall below their IPO prices.

Limited options for everyday investors 

After an IPO, institutional investors get to vote over a SPAC’s pick while everyday investors do not get that chance. Institutional investors can also get their money back if they don’t like the SPAC’s pick — or they feel the share price will not increase — they can get all their investment back but this does not apply to everyday investors. Yes, everyday investors can sell their shares but share prices might have dipped lower than the original price the SPAC was bought. 

Loss of time

For as long as it takes the SPAC to find a suitable target, capital invested is inaccessible. Time is money, and while the capital is tied up the money could be elsewhere bringing in higher returns. Also, if the deal never goes through — although investors can get their money back — that does not compensate for the time wasted.

SPAC Considerations

A SPAC is different from a traditional IPO in that the latter merges with an identified, independently-owned company through an IPO procedure. These procedures require extensive registration processes with the Securities and Exchange Commission (SEC), which involves providing comprehensive financial disclosures, business history, risks, and more. Special acquisition companies, by comparison, don't have a recognized business to purchase, and therefore, increase capital with more limited disclosure.

A SPAC is formed through a sponsor, which consists of a management team that will invest initial capital alongside outside investors. The sponsor's responsibility is to identify a private business, purchase it at an attractive valuation, with the end goal of taking the private company public through a merger. A SPAC performs the vital function of taking a private company public through the means of a merger or an acquisition.

SPACs raise capital through an IPO to acquire an existing company. Founders or sponsors of SPACs are entitled to a 20% interest on nominal invested capital, commonly referred to as a founder fee. The other 80% interest is offered in units through an IPO to the public. Each unit is a share of common stock. 

There is growing concern among experts that the increasing number of SPACs could lead to sponsors picking just any company to complete the deal before the stipulated time. Experts also argue that founders of SPACs are more concerned about the 20% interest after the acquisition than they care about choosing the right target.

How to Reduce Risk on SPACs  

Since a SPAC is a blank check company with no operating cash flow and no identified business at the time of their IPO, it becomes necessary for investors to make informed decisions to reduce risks. The most reasonable solution is for Investors to always consider the reputation of the sponsor. Ideally, SPAC sponsors should be high-level management executives and equity players with years of experience in mergers and acquisitions. 

Until recently, a significant number of SPACs have attracted sponsors from celebrities in the worlds of politics, sports and other fields. Investors are advised to tread with caution and carefully carry out research on the credibility and track record of any SPAC sponsor before investing money. 

Best Online Brokers for SPACs

Here’s a list of some of the best SPAC online brokers for your consideration.

Key Takeaway

No financial instrument, entity or a vehicle is perfect. So SPACs have their peculiar risks. But with a record 248 SPAC IPOs in 2020 — an over 300% jump from 2019 — SPAC IPOs definitely cannot be ignored. While we believe investing in SPACs could be highly profitable, selecting the right SPAC is essential. 

Frequently Asked Questions

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