What Is a SPAC and Should You Invest In One?

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If you feel like you’re reading about SPACs with every investment article you click, it’s not your imagination. SPACs are red hot right now, they’re trending, and unfortunately, they’re surrounded by all kinds of misinformation. The aim of this article is to dispel some of that misinformation and explain exactly what you need to know about this unique kind of investment before you plunk down any cash.

SPAC stands for “special purpose acquisition company,” and they’re unlike any other kind of business in existence. They don’t make anything, sell anything, provide any service, or conduct any commercial operations whatsoever. But since they’re publicly traded on the open market, you can invest in SPAC shares just like you would Coca-Cola or Amazon.

Their profit potential is undeniable — a lot of people are making a lot of money from SPAC investments — but they’re also risky, and they come with plenty of downside worth considering.

What Is a SPAC?

Investors form special purpose acquisition companies for one reason — to acquire or merge with another company for the express purpose of taking that company public. Since SPACs are publicly listed and the companies they target are privately held, these kinds of acquisitions are called reverse mergers. Regular mergers involve the target company merging into the acquiring company and gaining the acquiring company’s stock shares. SPAC mergers are the other way around.

How Do SPACs Work?

Experienced and well-heeled investors with expertise in a specific business sector form SPACs, sometimes with one or more target companies already in mind, sometimes without selecting any target company at all. Either way, the SPAC’s creators don’t reveal which companies they’re targeting to avoid disclosure rules.

This unique setup means that investors are completely unaware of what company they’re buying into. This is true for both the institutional investors and underwriters who come first and the IPO investors in the general public who get on board later.

For that reason, SPACs are commonly referred to as “blank check companies.” Investors buy into SPACs almost solely on the reputations and records of the SPAC’s founding investors. Once launched, SPACs have two years to acquire their target company. If they fail, Securities and Exchange Commission regulations require them to liquidate and return the money to the investors.

What Are the Pros of SPACs?

SPACs offer benefits to both the investor and the SPAC’s target company, including the following:

• They’re affordable and accessible: Most SPACs trade at $10 a share, putting them within reach of the average individual investor. The same cannot be said for traditional initial public offerings. SPACs offer retail investors an unrivaled opportunity to buy into a potentially hot IPO on the ground floor.
• They’re exciting: SPACs tend to target trending companies in hot sectors. Electric automaker Nikola, for example, went public through a SPAC, as did Virgin Galactic and Opendoor.
• They can turn small piles of money into big piles of money: The trade-off for buying into SPACs blindly is that investors expect that if the IPO goes through, their $10 shares will soar — and they often do when things go right.
• They can benefit the target business: For the company on the other end of the acquisition, merging with a SPAC can make a lot of sense. The process offers a much simpler, easier and more manageable way to take a private company public than by raising funds through a traditional IPO. Also, SPACs generally pay a premium, meaning that small companies that sell to SPACs can generally expect to get much more for their startups than they would have gotten out of a standard private equity deal.

What Are the Cons of SPACs?

It’s not all roses. SPACs are complicated investments that are not for everyone. Consider the following drawbacks:

• There’s the whole blind investment thing: As previously stated, SPACs require blind investments. Putting up money without a prospectus, without a detailed description, or without even a vague idea of what kind of company you’re investing in is not for everyone. SPAC investments are driven by trust in the founding investors — and little else.
• There’s a big delay: Also as previously stated, SPACs have up to two years to complete their mission of acquiring their target company. For many average investors, two years is too long to wait for returns.
• They divide investors into unequal classes: Founding investors — institutional investors with cash and connections that create SPACs in the first place — receive Class B shares. They get Class B shares for a nominal fee, but those shares come with outsized power and control. They also serve to dilute Class A shares, which regular people buy for $10 each.
• Their results are mixed at best: Two economics faculty members from the University of Hohenheim conducted a study of SPAC-sponsored IPOs that went public between 2013-2015. They found that the performance of the SPACs as a collective was underwhelming. Not only did they lag behind the overall stock market as a whole several years later, but they came up short behind traditional IPOs.
• They’re much riskier than standard investments: A Financial Times report found that most SPAC-backed public companies end up trading below their IPO price, in many cases because the SPAC simply paid too much for the companies upfront. Grammy-winning musician John Legend was among a group of investors who lost their entire investment in a SPAC-backed IPO of a music-streaming company.

2020 Was the Year of the SPAC

In 2013, according to CNBC, SPACs raised a combined $1 billion. That number doubled the following year to $2 billion in 2014, which then doubled to $4 billion the following year in 2015. By 2017, SPACs had raised $11 billion, then $13 billion in 2019. Just one year later in 2020, that dollar figure soared more than fivefold to $70 billion.

That astonishing growth — and the huge influx of retail investors who have jumped on the bandwagon without fully understanding the nature of the investment — have stoked talk of a rapidly forming bubble that is bound to pop. On the other hand, major players like Goldman Sachs have stated that 2021 will likely see the SPAC market grow even bigger.

Why Are SPACs so Popular?

SPACs have soared in popularity in part because they open up the long-exclusive IPO market to the common investor — but they’re also wildly popular because they have star power. John Legend was hardly the only big-time celebrity whose name was recently associated with SPACs. Bill Ackman, Richard Branson and Michael Jordan are all in the game.

While stars lent SPACs their celebrity, big shots of the financial world lent SPACs their credibility. How bad could an investment be, after all, if it attracted the likes of Goldman Sachs, T. Rowe Price, Fidelity, Credit Suisse and Morgan Stanley?

How Do I Invest In SPACs?

Part of what makes SPACs so attractive is that regular people can buy their shares on the familiar open stock market. Just like the stocks regular people invest in all the time, you can buy into SPACs by purchasing shares of individual securities, or you can buy several securities at the same time by purchasing an exchange-traded fund. Among the hottest SPAC ETFs trading right now are:

• Morgan Creek-Exos SPAC Originated ETF (SPXZ)
• Next Gen SPAC Derived ETF (SPAK)
• SPAC and New Issue ETF (SPCX)

Since you’ll be investing blindly and writing a blank check without any clue which company you’re even investing in, many experts suggest first focusing on an industry or sector that you’re excited by and that you believe is primed for big-time growth. That could include emerging industries like legal weed, electric vehicles or renewable energy.

As with any investment, experts recommend never putting your eggs in the same basket and hoping for a home run with one deal — particularly with an investment as unfamiliar and risky as a SPAC. Hedge your bets, diversify — and research, research, research before you pull the trigger.

Should You Invest In a SPAC?

Like stocks, bonds and real estate, the decision to invest in a SPAC or not is a personal one. In the end, the decision — and the outcome of that decision — is on you. The majority of average investors, however, would probably be better off steering clear.

Takeaway

Warren Buffett has long insisted that one of the cardinal rules of the market is never to invest in something you don’t fully understand. The Oracle of Omaha was referring to companies — don’t invest in companies if you don’t understand their business models or exactly what it is they do. When it comes to SPACs, you don’t even get to know what company it is you’re investing in.

It’s a blind gamble made through a highly specialized, class-segregated and fleeting acquisition company that was designed to be liquidated in two years. The process is completely alien to most investors and is based purely on faith in a small group of skilled, experienced and self-interested professional investors you don’t know and will never meet. There is zero transparency, it’s highly risky, and it’s designed primarily to benefit the institutional investors who sponsor the SPAC, not the common $10 IPO investor.

In fact, MarketWatch recently interviewed financial experts who think public SPAC investing — and blind, blank-check investing in general — is so risky that it should be illegal.

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