RV Blog What is a Special Purpose Acquisition Company (SPAC)?

What is a Special Purpose Acquisition Company (SPAC)?

What is a Special Purpose Acquisition Company (SPAC)?

Special purpose acquisition companies (SPACs), or blank-check companies, have become increasingly popular among investors over the last few years. Companies can save time and money when issuing their shares to the public by investing in a SPAC instead of filing for a traditional initial public offering (IPO) through the Securities and Exchange Commission (SEC).

Unlike traditional companies, SPACs don’t have commercial operations. The founders create the company with the sole intention of being acquired by or merging with a target company in a specific industry.

These kinds of investments are appealing to investors, but some of this hype may be overblown. SPACs don’t always perform according to expectations. Learn more about how special purpose acquisition companies work, and how to tell if they are a good investment.

What Is a SPAC?

A special purpose acquisition company (SPAC) is a for-profit company that is designed to be acquired by a target company in a specific industry. The company doesn’t offer any products or services. It only exists to become a part of another company. It is funded by underwriters and institutional investors before going public.

The founders of the SPAC are typically well versed in the target industry. They may bring a lot of experience to the table. However, the founders usually won’t disclose the name of the target company to maintain leverage in the negotiation process and avoid extensive oversight from the SEC.

Celebrities and big-name investors like Goldman Sachs and Deutsche Bank will also create buzz in the industry, leading more people to invest. Retail investors are free to buy shares as they would if they were investing in any other company, but they usually have no idea what the company does or which target company it’s looking to merge with.

The SPAC will then hopefully merge with or be acquired by the target company. If the SPAC fails to strike a deal within two years, it will be liquidated, and the funds will be returned to the original investors.

Once the company has merged or been acquired, it will be listed on one of the major stock exchanges.

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How Does a SPAC Work?

SPACs give companies an alternative to going public. Instead of filing for a traditional IPO, which can take six months to a year, the company can go public in just a few months by merging with or being acquired by another company. The initial investors will typically invest based on the founders’ reputation, skillset, or intention to merge with or acquire another company.

The funds are kept in an interest-bearing trust account, and can only be used to fund an acquisition or merger. If the SPAC is liquidated, the funds are returned to investors. In some cases, any interest earned on the trust account may be used to fund a merger or acquisition.

The SPAC only has two years to merge with or be acquired by a target company, otherwise it will be liquidated, and the funds will be returned to the original investors.

Why Would a Company Use a SPAC Instead of a Traditional IPO?

SPACs have become increasingly popular among companies looking to go public. During a traditional IPO, the company may have to wait months or years to reach an estimated value of $1 billion, or unicorn status. The founders can save time and money by setting up a SPAC instead. Once the SPAC has been purchased, it will be listed on the stock market just like any other public company.

Because the company doesn’t have commercial operations, fewer disclosures are required compared with traditional IPOs. This can work to the founders’ advantage. They can focus on raising capital and negotiating with target companies instead of worrying about quarterly profits.

The target company will likely benefit from this transaction as well. By purchasing or merging with the SPAC, the target company will gain visibility in the marketplace. It will also inherit the experience of the founders and the financial backing of its original investors. If the SPAC is close to the end of its two-year timeline, the target company may be able to negotiate a lower price.

Potential Benefits of Investing in SPACs

SPACs have become an increasingly hot commodity during the COVID-19 pandemic. Facing uncertain market conditions, many companies and executives used SPACs to go public and raise money. SPAC IPOs raised $83.4 billion in 2020 and $162.5 billion in 2021, compared to just $3.5 in 2016.

And investors are taking note. SPACs can often overperform when it comes to the acquisition and merging process, landing massive deals with the target company. Big name investors and celebrities, including actors, pundits, and professional athletes have also been investing in droves, generating additional buzz in the industry.

Due to the hype, retail investors may be tempted to buy shares of the SPAC or target company once the merger or acquisition is complete. “Being in the know” can help some investors capitalize on these kinds of deals before the company’s share value takes off.

Potential Risks of Investing in SPACs

But all this hype can be short lived. Many economists believe the SPAC bubble may be starting to burst.

According to strategists at Goldman Sachs, of the 172 SPACs that closed a deal since the start of 2020, the median SPAC outperformed the Russell 3000 index from its IPO to deal announcement. However, six months after the deal closed, the median SPAC underperformed the Russell 3000 index by 42% points.

According to Renaissance Capital, around 70% of SPACs that went public in 2021 were trading below their $10 offer price as of Sept. 15, 2021.

The potential returns for SPACs can be overblown, especially when major celebrities get involved. The SEC even issued an “Investor Alert” in 2021 on the dangers of investing solely based on celebrity involvement.

SPACs face less oversight than traditional companies looking to go public, but this lack of disclosure can put investors at risk. Individuals may not have enough information about the company to know whether it is going to be successful in merging with or acquiring a target company. The value of the SPAC may also be overblown, leaving the target company with an expensive acquisition that offers little market value. That’s why investors are encouraged to do their due diligence when investing in SPACs and target companies that are either merging with or acquiring them.

Regulators are also cracking down on SPACs. The SEC released new accounting regulations for SPACs in April 2021, which led to a dramatic drop in investor demand.

The Bottom Line: Are SPACs Worth It?

In the end, the SPAC heyday may be coming to an end. These stocks tend to face increased volatility. Investors may feel more comfortable investing in shares of a public company that is required to report its earnings on a regular basis. Companies that went public through a traditional IPO have put in the leg work to get where they are today. They sell products and services with tangible value and have a proven track record of success.

SPACs can also leave investors in the dark in terms of the founders’ true intentions. In some cases, the company or investment may even be fraudulent.

Not all SPACs are risky investments, but many haven’t performed as well as investors had hoped. Individuals should research the company in question to see if it is a good idea.