What are SPACs? Do they live up to the hype?

Imagine someone famous asks you to invest your money in a company. You would surely have some follow-up questions on what the company does, the financials of the company, etc. since you are investing your money. Though the catch here is that there is no company, well at least not yet.

Will you part with your money?

What is a SPAC?

SPAC or Special Purpose Acquisition Company is a shell company with no commercial operations and is formed strictly to raise capital through an initial public offering (IPO) to acquire an existing company. After becoming a public company, the SPAC then merges (or acquires) with an existing private company, thereby making it public. Before the merger (or acquisition), the SPAC provides no indication of the potential acquisition target company, hence for the investors it’s like a black box and they are investing in an unknown, and for this reason, the SPACs are also known as the ‘blank check companies’.

A couple of notable examples of SPACs and their target acquisitions:

  • Virgin Galactic, Richard Branson’s space tourism startup, was taken public using the SPAC route. Venture capitalist Chamath Palihapitiya formed a SPAC called Social Capital Hedosophia Holdings which merged with Virgin Galactic, taking it public. Shareholders of Social Capital Hedosophia Holdings received a 49% stake in the combined company, while Virgin Galactic received about $800 million in cash and a public ticker.
  • Draftkings, a company focused on fantasy sports, merged with Diamond Eagle Acquisition Corp., a SPAC with a market cap of roughly $500 million, to trade as a public company on NASDAQ

But a SPAC has no commercial operations — it makes no products and does not sell anything. In fact, the SPAC’s only assets are typically the money raised in its own IPO, according to the SEC.

So, why would anyone invest their money in a SPAC?

Because investors are betting on management (or sponsors) — the ‘famous’ business executives who are confident that their reputation and experience will help them identify a profitable company to acquire. That’s why in recent years SPACs have used high profile sponsors like Chamath Palihapitiya, a former Facebook executive and the face of the SPACs renaissance, or Bill Ackman, a famous hedge fund manager.

Buying shares in a new SPAC amounts to a leap of faith, but the payoff can be substantial. The change in share price can occur immediately once a deal is announced, and the only way for an individual investor to fully benefit from that rapid price increase is to invest when the SPAC is still searching for a company to acquire/merge.

How do SPACs work?

The money is raised from the investors by selling common stocks at usually $10 a share and a warrant — which gives investors the preference to buy more stocks later at a fixed price. The money raised goes into an interest-bearing trust account (this money usually invested in government bonds or other safe investments to earn a modest return) until one of the two things happen:

  1. The management team (or sponsors) of the SPAC identifies a private company that is looking to go public through an acquisition (and which they think shows tremendous promise), using the capital raised in the IPO
  2. If a SPAC fails to merge or acquire a company within a deadline (typically 2 years), the SPAC will be liquidated and the investors get their money back with interest

What’s the difference between the SPAC IPO and a traditional IPO?

  • If a company decides to go public through the route of the traditional IPO, it’s subjected to regulatory and investor scrutiny of its audited financial statements
  • SPAC IPO has fewer risks involved since it’s a shell company with no commercial operations, no financials — hence depends entirely on the reputation of the management team
  • The process of listing is longer (usually 4–6 months) if a company goes public via the traditional IPO route since this time is required by companies for roadshows to drum up the demand in its shares. SPAC IPOs can skip roadshows (because of the reputation of the management team), hence shortening the time to list

The above explanation is courtesy of this super informative video on SPACs by CNBC: SPACs explained — CNBC

Enough jargons, what are SPACs in simpler terms?

In super simple terms, SPAC is like a fund where investors invest because some famous/smart people (private equity or hedge fund managers, or wall street professionals, etc.) own this fund. What’s in it for different people?

  • Investors invest because of the hope of high returns on their investment because hey Chamath is saying so
  • Sponsors do it because they get a significant amount of shareholding (~20%) in the final merged public company at a heavily discounted price
  • Private companies agree to go the SPAC route because it’s a shorter route with less regulatory scrutiny

But if it really is a win-win for all the parties involved, why isn’t every private company on the planet following this route?

SPACs critics

  • Since there is a lack of scrutiny in the SPAC IPOs, the investors are wary to invest. The scrutiny can be helpful to weed out some prospects. For example, WeWork failed to go public since the scrutiny revealed numerous irregularities with the company and its management
  • The major disparity in the payouts to the investors and the sponsors. The high number of sponsor shares at a discounted price dilutes investors value because the sponsors in spite of putting less money are taking the significant chunk of the gains
  • A study from 2010 to 2017 that followed 92 SPACs found that they underperformed the market index by 3%. Another study found that between 2015 and 2019, the majority of the SPACs were trading below the $10 IPO price

While SPACs offer exciting opportunities to invest, do the risks outweigh?