Special Purpose Acquisition Company (SPAC)

What Is a Special Purpose Acquisition Company?

A special purpose acquisition company (SPAC) is a publicly traded entity that is established for the purpose of acquiring or merging with a yet-to-be-identified, privately held company. Essentially, a SPAC provides its founders, which are known as sponsors, the means to raise cash from a broad base of equity investors.

Once an appropriate target company is identified, the sponsors use the money to take a privately held company public. In doing so, they bypass the traditional initial public offering (IPO) process, thereby avoiding extensive red tape and regulatory requirements that can be costly and time consuming.

How Does a SPAC Work?

At a high level, the process of a company going public through a SPAC works as follows:

1. The SPAC is legally formed by a group of sponsors, which typically includes institutional investors, high-net-worth individuals or professional money managers. It is a shell company, which means it does not have an underlying operating business and does not have assets other than cash and limited investments.
2. At the time it is formed or after, the SPAC raises money via a streamlined IPO. Standard offerings are priced at an affordable $10 per share, with the potential for the share price to rise, depending on demand. The relatively low share price makes the SPAC accessible to a broad range of investors.
3. Following the IPO, the cash that is raised is held in a trust, and the SPAC’s sponsors begin the process of searching for a promising, privately held company with which to merge or to acquire. Generally, this process is legally allowed to last up to two years.
4. If a SPAC hasn’t executed a merger or acquisition within two years, the money that was raised is returned to the investors.
5. If the SPAC’s sponsors identify a company for merger or acquisition, a formal announcement is made and a majority of shareholders (generally, more than 70%) must approve the deal. In some cases, the SPAC may need to raise additional money to facilitate the proposed deal.
6. If the vote is affirmative and all financing needs are addressed, the deal is executed and the SPAC begins trading under a new ticker symbol.

PwC, the global audit, assurance and advisory firm, summarizes the process with the timeline illustration below.

How To Invest in a SPAC

You can invest in a SPAC the same way you’d invest in any publicly traded company — via a brokerage firm such as Charles Schwab, E-Trade or Fidelity Investments. That said, there are a few notable differences between buying a share of a SPAC, commonly referred to as a unit, and buying a share of a regular stock.

• When you buy a unit of a SPAC, you generally receive one share of common stock and two warrants. A warrant is a contract that grants you the right — but not the obligation — to buy more common stock at a specified price later.
• SPACs generally reflect the letter “U” at the end of their ticker symbols, which clearly differentiates them from regular stocks.

Should You Invest in a SPAC?

The primary advantage of a SPAC is its accessibility. At $10 per share, a SPAC offers the average retail investor the ability to establish an ownership position and participate in price appreciation resulting from a downstream merger and acquisition transaction.

Essentially, this opportunity gives everyday investors a roundabout way of participating in an IPO, which is something they’d never be able to do in a traditional sense. IPO allocations are typically reserved for institutional investors and high-net-worth individuals — not retail investors.

The only way for a retail investor to buy shares of a hot, new, publicly traded company is after the IPO, when the stock is trading in the secondary market. Unfortunately, at this point, the share price is likely to be well above the IPO level.

Pros of SPACs

A SPAC is generally a more efficient way to take a company public than a traditional IPO. Taking a company public with a traditional IPO involves extensive red tape and additional costs associated with underwriting, marketing the offer and complying with burdensome financial reporting requirements.

Cons of SPACs

The primary drawback of investing in SPACs relates to their ambiguity. Since most SPACs are formed without specific targets in mind, investors often don’t know the types of companies they’re ultimately buying. For this reason, SPACs are often referred to as blank check companies.

That said, investor-oriented SPACs aim to be as transparent as possible, and they clearly articulate their areas of focus, such as the medical supplies industry or blockchain-focused technologies. This clarity can provide some assurance for your personal finance situation, but it doesn’t warrant a blind investment.

Some level of consideration is always necessary when investing in SPACs. The best way to do your due diligence is to research the SPAC sponsors, assessing their professional reputations and evaluating their track record of success with previous SPACs.

A second drawback of SPACs relates to their performance relative to the broader stock market. According to a January 2021 report from Goldman Sachs, the average annual return of SPACs from IPO to a merger and acquisition deal (or a SPAC liquidation, if no deal happens) was 9.3% over a roughly 10-year period. A return of 9.3% isn’t bad, considering the risk-free nature of SPACs that do not execute a merger and acquisition deal, but the return lagged behind the performance of the Standard & Poor’s 500 index (commonly known as the S&P 500) by a whopping 24%.

The comparison is just as disheartening when looking at performance in the year following a merger and acquisition deal. After the deals take place, SPAC-acquired stocks still underperform the broader market by an average of 24%.

A third drawback relates to the two-year timeframe a SPAC is granted to execute a merger or acquisition. Two years sounds like a long time, but the process of searching for a target company can take several months. Once a viable target is identified, the process of due diligence and dealmaking can take well over a year.

When you consider how long each of these steps takes, the ticking clock becomes apparent. The relatively tight timeline can pressure sponsors to move quickly, which can lead to rushed decisions. It can also lead to suboptimal deal pricing, as the owners of the privately held target will seek to negotiate a premium sale price, knowing that the SPAC is facing a limited time window.

Closing Thoughts

This information is not intended to either encourage or discourage you from investing in SPACs. SPACs are not universally good or bad, and their performance varies widely from stock to stock. For this reason, any potential SPAC investment calls for careful consideration of the sponsors and a realistic forecast of the return potential.

Taking individual positions in SPACs may not be ideal. Consider diversifying your exposure by investing in a SPAC exchange-traded fund (ETF). One such vehicle is offered by Defiance ETFs (under the ticker symbol SPAK). Launched in 2020, its portfolio is allocated to companies in the pre-deal phase at 40% and to companies in the post-merger phase at 60%.