One of the hottest trends on Wall Street today is the SPAC market. Although SPACs are not new to the market, their recent rise in popularity has captured the attention of investors and financial media.
What Is a SPAC?
A SPAC, which stands for special purpose acquisition company, is a corporation formed for the single purpose of raising capital through an initial public offering, or IPO. Ultimately, the raised capital is intended to be used to identify, target and acquire an existing, privately-held business.
How Do SPACs Work?
SPACs are created by a team of institutional investors and experienced executives, often coming from the world of private equity, investment banking, or hedge fund management. Since the SPAC is only a shell company, these founders use their expertise and reputations to attract interest from potential investors.
The SPAC founding members, with the help of an investment bank, will offer shares of their company to the public through an IPO. The SPAC will then use the proceeds of the IPO to acquire a privately-held company.
Because the private company being acquired by the SPAC is often not specified at the time of the IPO, SPACs have been referred to as "blank check companies."
Here are basic steps describing how SPACs work:
- Founders create the SPAC.
- The SPAC raises capital through an IPO.
- The securities sold at the IPO are offered to investors in "units," which represent shares of common stock in the SPAC. Investors also receive "warrants," which give shareholders the right to buy shares of an acquired company in the future at a pre-determined price.
- Proceeds from the IPO are held in an interest-bearing trust account, typically invested in Treasury bonds.
- The SPAC founding members and team have a certain period of time, ranging between 18-24 months, to identify and target a private company to acquire.
- Once the target company is acquired, the SPAC founding members profit from their stake, while investors receive an equity interest in the acquired target company.
Pros & Cons of SPACs
SPACs are a rising trend in the world of investing. But like any other type of investment security, there are pros and cons of SPACs for investors to know about.
Pros of SPACs
- Alternative to traditional IPO: Taking the SPAC route can offer the owners of the target acquisition company a faster path to being listed on a public exchange, compared to the traditional IPO route.
- Early access to IPO for investors: Average investors have access to shares of a SPAC as soon as they go public; whereas, buying into a traditional IPO is typically reserved for high net worth, accredited investors.
- Growth potential: SPACs offer the opportunity to potentially share in outsized growth often associated with start-up companies.
Cons of SPACs
- Lack of information: Since the acquisition company is often unknown at the time of the SPAC's IPO, investors are not able to research the financials of the company in advance. All that is publicly known in advance is the background of the SPAC founding members and possibly a mention of the specific industry or business that it will target.
- Shareholder dilution: The SPAC founding members, or sponsors, receive up to 20% equity in the acquired company after the IPO. This dilutes the shares of the common stockholders, potentially diminishing their value.
- Potential for underperformance: In the past, many SPACs have performed below stock market averages and have underperformed traditional IPOs.
How Do You Buy SPAC Stock?
Since SPACs are publicly-traded companies, you can buy shares the same way as you could buy an individual stock. For example, once you open an account with an online brokerage, such as Charles Schwab, TD Ameritrade, or Robinhood, you may select the SPAC, identified with a ticker symbol, and execute a trade to buy shares.
Investors also have the option of buying SPACs through anexchange-traded fund (ETF). Buying SPACs through an ETF can help to reduce risk by providing diversified exposure to multiple SPACs in one fund, rather than in an individual SPAC.
Important: Since SPACs have up to 24 months to identify and acquire a target company, your initial investment may be tied up in a trust account during that time, usually held in low-paying Treasury bonds, when you could have invested elsewhere.
What Happens To SPAC Stock After a Merger?
The sole purpose of a SPAC is to identify a target acquisition company and acquire the company with capital raised through an IPO. Once the target company is identified, the SPAC will need to gain approval of the shareholders to complete the merger with the target acquisition company.
Here's what happens to SPAC stock after the merger:
- After the closure of the merger, the target company becomes a public entity listed on a stock exchange.
- SPAC company stock issued to public shareholders at the original IPO, called "units," may be sold to cash out their shares of the newly acquired target company. Shareholders are also free to hold on to their new shares of the acquired company.
- Shareholders may also exercise warrants, which gives them to right to buy shares of stock at a pre-determined price.
SPACs have existed for decades. Some of the more recent and prominent of examples of SPACs include DraftKings (DKNG) and Richard Branson's Virgin Galactic (SPCE). The largest SPAC, as of this point in time, was Bill Ackman's Pershing Square Tontine Holdings (PSTH), which raised $4 billion in capital.
Should You Invest In SPACs?
Like any other individual stock investment, there is always the potential for returns that are higher than a broad market index, such as the S&P 500. However, the potential for higher returns is associated with higher market risk, especially considering the speculative nature of SPACs.
Given the level of risk, SPACs may be most appropriate for investors with long-term time horizons, such as 10 years or more, and a high relative tolerance for fluctuations up and down in price.
Important: While SPACs have recently enjoyed tremendous popularity and financial media attention, they still carry market risk and are not appropriate for every type of investor. SPACs can be speculative in nature. For example in many cases, the target company to be acquired by the SPAC is not known at the time of the IPO.
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