What is a SPAC Or Special Purpose Acquisition Company?

What is A Special Purpose Acquisition Company (SPAC)?

A special purpose acquisition company (SPAC) is an alternative to the traditional initial public offering (IPO) process that public companies use to raise capital and having its stock traded publicly on a major stock exchange. SPAC’s have been around for a long time, but have become increasingly popular in recent years. There are a couple of reasons for this:

• One is that the market’s appetite for IPOs has diminished
• The other is that the market itself is getting very overbought.

SPACs give retail investors (i.e. individual investors) an opportunity to buy a company’s stock in its early stages. This is one way that a SPAC is different from a traditional IPO.

However with that chance for a reward comes a fair amount of risk. And that makes these a speculative investment that should not make up a significant portion of an investors’ portfolio.

Introduction into SPAC’s

When a company goes public via an initial public offering (IPO), the stock price typically spikes in the day after, and sometimes for several days after. When that happens, retail investors are left paying a much higher price than the IPO price.

• This is because the company that is issuing a traditional IPO is looking for large amounts of capital. This requires the kind of capital that is typically reserved for large investment banks. In very rare cases, if an individual investor is a client of an investment bank, and has the financial resources to do so, they may be invited to participate in the IPO through their broker.
• A special purpose acquisition company (SPAC) is an alternative that benefits the sponsor, but also can benefit retail investors. This is because, unlike a traditional IPO, a SPAC allows investors an opportunity to get in on the ground floor. Also in contrast to a traditional IPO, there are minimal regulations with a SPAC so, once a deal is made, the process tends to move much faster.

In this article we’ll review what a special purpose acquisition company is and describe the process that a SPAC takes to go to market. We’ll also look at the controversial history of SPACs and the regulations that are in place that makes them safer, and more mainstream investments today. We’ll also look at the benefits and the disadvantages of a SPAC. And finally, we’ll go over ways investors can identify SPACs to invest in.

What is a Special Purpose Acquisition Company (SPAC)?

For the uninitiated, the name is sort of self-explanatory. It may help to read it backwards. A special purpose acquisition company is one that is established with the intention of acquiring or merging with another company for a single (special) purpose. In this case, the purpose is to bring the acquired company public.  This is typically, but not always, done by way of a reverse merger.

1. Actually the term acquisition is the most misleading. A SPAC is more of a silent investor. Investors will frequently hear the words “blank check company” used to describe them. This is because a SPAC has no operations; it has no assets other than the cash that its founder (or founders) brings to the SPAC.
2. The founder or founders are called sponsors. Traditionally, these sponsors will be targeting a particular industry or business sector in which they have a strong background. When the SPAC launches, these sponsors raise money from other investors which it then uses to bring an existing company public.

What Is the SPAC Process?

A SPAC is a less expensive, and most importantly faster, alternative to an initial public offering (IPO) for a company that wants to go public.

Sometimes the sponsor(s) will know who the target is but they don’t want to disclose it to avoid Securities & Exchange Commission (SEC) regulations. However, in many cases, when a SPAC is initially formed, the sponsors may not know which target they have in mind.

In 2020, activist investor hedge fund manager Bill Ackman launched Pershing Square Tontine Holdings (NYSE:PSTH) as a spinoff of his hedge fund. However, in the first nine months of its creation, Ackman was still looking for a target company. In fact, a SPAC can take up to two years to target and buy another firm.

• For this reason, the phrase “betting on the jockey not the horse” can apply to a SPAC. Without a clear idea of how the sponsors plan to spend their investment capital, investors are banking on the reputation of the sponsor. And sometimes investors may have to wait for up to two years for the sponsor to find/announce its target. In rare instance, the SPAC won’t find a partner. In this case the SPAC will be liquidated and investors would get their money back, although it may take some time.
• The good news for investors is that most SPACs will only initiate trading for $10 per share. Yes, the price may soar once the target is identified. However, once this occurs investors can begin to cash out or even perhaps continue to invest in hope of the SPAC going higher.

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Are SPACS controversial?

For a long time, a SPAC was considered to be an out-of-favor, back-door way for a company to go public. In the 1980s, these companies frequently were shell companies for penny stocks that are extremely volatile (and frequently fail). And at this time, many of these companies did just that, and investors lost a lot of money.

• However SPACs have become less controversial in the twenty-first century. Since 2010, SPACs have become more fashionable and have been sponsored by big-name entrepreneurs, hedge-fund managers, mutual fund companies, investment banks, and even celebrities.
• Because of this, the number of SPACs has been increasing steadily. And in 2020, SPAC research reports there were 128 SPACs, which raised a total of $49.1 billion. The Covid-19 pandemic has certainly been a factor. SPACs tend to be a better choice for private companies in times of market volatility because they only have to convince one sponsor (or a handful of sponsors) to launch the SPAC as opposed to filing for an official IPO.

Another reason is that, unlike a traditional IPO, a SPAC has more streamlined disclosure requirements to save time and money.  This is not to say the SEC has imposed no regulations on a SPAC. The most important of them being that a SPAC now has to place any initial investor money in a trust or escrow account.

This will keep it secure until the sponsors announce their target company. Once that occurs, an investor can back out of the investment if they feel the deal is bad. And SPACs also have to register with the SEC although they do not have to file all the paperwork required in a traditional IPO process.

This lack of transparency means that SPACs are still controversial. When a company goes public via a traditional initial public offering (IPO), they are required to post a series of filings along the way. This gives investors a degree of comfort when investing in the company.

Why SPAC’s appeal to investors?

The largest appeal of a SPAC to investors is the opportunity to get in on the ground floor of a potentially big stock. While it’s true that institutional investors generally will be offered shares first, there are ample shares available for retail investors.

• And the typical price of around $10 per share is well within the means of retail investors.  And unlike when a SPAC names its target, the price tends to stay low for some time.
• Another reason that SPACs are popular is that the sponsors usually invest in some of the most popular or, high-growth areas. For example in 2020, a host of companies with links to electric vehicles (EVs) went public via SPACs.

What are the risks or disadvantages of SPACs?

Of course with that potential for an outsized reward comes with an outsized risk. A SPAC, at least initially, is a blind investment. Initial investors don’t know how their investment will be used. And as we mentioned above, it can take up to two years for a sponsor to find a partner and bring it public.

During that time, investors can’t sell their shares. That’s a long time for an investor to wait for a return on their capital.

• And one of the largest risks is that SPACs have a spotty track record at best. In July 2020 the investment bank Goldman Sachs (NYSE:GS) analyzed the performance on 56 SPACs that merged with their targets no later than January 2018.
• The SPACs that Goldman analyzed were across a cross section of sectors. Sachs concluded that during the one-month and three-month periods following the acquisition announcement, the SPACs on average outperformed the S&P 500 and Russell 2000. However, that performance was not repeated in the 3-, 6-, and 12-month periods after the merger was complete.

How can investors profit from SPACs?

The key is to move fast. And that means knowing when a SPAC is available for investment. That’s because once a SPAC decides on an acquisition target, shares in the SPAC generally rise. But you can’t find a list of SPACs on most financial websites.

• And although hedge fund managers, mutual fund managers, and institutional investors learn of SPACs first, individual investors can still find out about SPACs in a number of ways. One way is to ask your investment advisor to keep an eye out for SPAC offerings. If you’re more of a do-it-yourselfer, you can go to the site Early Bird Capital which frequently posts companies that are actively seeking targets.
• Also if you look on the NASDAQ website, upcoming IPOs, including SPACs, are listed under a ticker symbol that ends with a “U.”

The final word on special purpose acquisition companies

Investing in a special purpose acquisition company is a speculative investment. It should not take up a significant part of your portfolio, particularly if you’re at an age when you may need to have access to your cash. Investors could be tying up their cash for up to two years without knowing what their investment will ultimately fund.

• The nature of this blind investment, including the fact that SPACs generally invest in volatile, growth companies makes these investments much riskier than investigating in established companies.
• However, a SPAC is a low-cost way for retail investors to get in on the ground floor of an initial public offering. And with the ability to buy shares for $10 per share, may allow them to risk a small portion of their portfolio for a large payoff.