Should you invest in SPACs?
In a traditional IPO, a private company issues new shares and, with the help of an underwriter, sells them on a public exchange. In a SPAC transaction, the private company becomes publicly traded by merging with an already-listed shell company — the SPAC. Rather than go public through an initial public offering, more private companies are opting to debut on stock exchanges via an acquisition at the hands of a SPAC.
What's a SPAC stock?
A special purpose acquisition company (SPAC), also known as a "blank check company", meaning an entity with no commercial operations that completes an initial public offering (IPO). After becoming a public company, the SPAC then acquires, or usually merges with, an existing private company, taking it public.
A special purpose acquisition company really only exists to seek out another firm that it can bring to the public markets via a merger. Until that happens, the SPAC’s only assets are its cash and its stock market listing. When a SPAC raises money, the people buying into the IPO do not know what the eventual acquisition target company will be. Institutional investors with track records of success can more easily convince people to invest in the unknown. Even if its sponsors have their eyes on a specific target, this is not disclosed (to simplify and speed up the process of listing the SPAC). This is why SPACs are sometimes called ‘blank cheque companies’ or ‘cash shells’. Once the IPO raises capital, that money goes into an interest-bearing trust account until the SPAC’s founders or management team finds a private company looking to go public through an acquisition.
However, SPAC sponsors also have a deadline by which they have to find a suitable deal, typically within about two years of the IPO. Otherwise, the SPAC is liquidated and investors get their money back with interest.
How does a SPAC work?
Initially, a sponsor of a particular SPAC takes the shell company public just to raise cash for an acquisition. To sweeten the pot, SPAC sponsors go on a roadshow, similar to an IPO. During this time, they make a pitch to institutional investors (like hedge funds or private equity firms) to spike interest and gain capital.
A typical SPAC IPO structure consists of a Class A common stock share combined with a warrant. A warrant gives the holder the right to buy more stock at a fixed price at a later date. The typical IPO price for a SPAC common stock is $10 per share. The typical IPO price for a SPAC common stock is $10 per share. The exercise price for the warrants is typically set about 15% or higher than the IPO price. A few weeks after the IPO is completed the warrant is spun off and trades separately from the SPAC stock.
Following the funding process, At least 85% of the SPAC IPO proceeds must be placed in an escrow account for a future acquisition. In practice, closer to 97% of the capital raised goes into the escrow account, while 3% is held in reserve to cover IPO underwriting fees and SPAC operating expenses, including due diligence, legal, and accounting fees.
If the SPAC sponsors identify a potential target firm, they make a formal announcement. The day the public is notified about the potential acquisition is called the announcement date. These can cause rampant speculation among retail investors. After the announcement, the SPAC sponsors perform additional due diligence and negotiate the acquisition structure. The U.S. Securities and Exchange Commission also reviews the acquisition terms.
Once the business combination is approved and the additional capital raised, then the transaction closed and the acquired firm is listed on the stock exchange.
Why so many companies are choosing SPACs over IPOs
SPACs are a flexible and less burdensome route to a stock market listing for a private company than a traditional initial public offering (IPO). Startups or other private companies looking to list on Wall Street can really shortcut the process this way. Why court investment banks and potential investors for months or years in pursuit of an IPO, when you can just shake hands with a SPAC and become a publicly traded company as part of the deal?
Should you invest in a SPAC before merger?
The success of SPACs in building equity value for their shareholders has drawn interest from investors. SPACs typically raise more money than standard reverse mergers at the time of their IPO. SPACs can also raise money faster than private equity funds. The liquidity of SPACs also attracts more investors, as they are offered in the open market. SPAC IPOs have seen resurgent interest since 2014, with increasing amounts of capital flowing to them. According to SPAC Research, public offerings through special purpose companies raised more than $83 billion in 2020. By June 2021, SPAC-facilitated IPOs have already raised more than $108 billion through the debut of close to 350 new companies on the stock market.
Some of the famous names to go public through SPACs include DraftKings Inc. (NASDAQ: DKNG), ChargePoint Holdings, Inc. (NYSE: CHPT), Virgin Galactic Holdings, Inc. (NYSE: SPCE), Nikola Corporation (NASDAQ: NKLA), QuantumScape (NYSE: QS), and Opendoor Technologies Inc. (NASDAQ: OPEN). SPACs lined up for 2021 include Butterfly Network, 23andMe, and eToro. There is also buzz that digital media companies like BuzzFeed, Vice Media, Bustle Media Group and others could use SPACs to finally bring in money for their investors.
Nevertheless, investors should take note that not all SPACs are created equal. There’s a chance you could burn your investment without proper research and due diligence.
How to Invest in SPACs
If you’re interested in adding SPACs to your portfolio, it’s possible to buy them through an online brokerage account. Fidelity and Robinhood are some examples of online platforms that offer SPACs to investors.
Despite becoming a hugely popular investment in recent times, SPACs aren't actually legal in some countries. To invest in SPACs from these countries, you'll need to open an account with a global or US brokerage. One of the best brokers for international trading you can choose is eToro. eToro has become one of the world's biggest social trading platforms, trusted by millions of users from more than 140 countries.
Final thought
Remember that these are largely speculative ventures and you’re putting your trust in the expertise of the SPAC sponsors. Unlike traditional IPOs, SPAC share prices are typically not a reliable indicator of valuation. So it can be difficult to predict with any degree of certainty what type of performance you might be able to expect once the acquisition is complete.
To mitigate the risk, you may wish to consider SPAC exchange-traded funds (ETFs) featuring a basket of SPACs with startup prospects or shell companies seeking their target acquisitions. ETFs spread risk so that a calamity in 1 SPAC won’t completely derail your portfolio. On the flip side, the gains are also spread wide, limiting upside potential.
