What is a “SPAC” and what is all the fuss about?
Easy part first… A SPAC is a “special purpose acquisition company” also sometimes known as a blank check company. Quite simply, a SPAC creates a way for a private company to go public/get money more easily and more quickly than by undertaking an IPO (initial public offering). In actuality, a SPAC is a shell company with no commercial purpose except to raise money through its own IPO in order to merge with/acquire a privately held company. These SPACs are created and owned by “sponsors” who are usually institutional investors, private equity or hedge funds, often with expertise in a specific industry.
Although SPACs have been around for decades, they became very popular in 2020 because of the economic uncertainty caused by the pandemic. SPAC mergers have created many well-known, now publicly held, companies, including Virgin Galactic, DraftKings, and Opendoor.
How does a SPAC actually work?
After the SPAC is created, the sponsors undertake their own IPO to get investors. Investors in a SPAC have no idea which privately held company will eventually be acquired, so they are essentially handing over money to SPAC sponsors, who also do not usually know which company they will be buying. A share in a SPAC usually sells for $10 and that share will ultimately be exchanged for a share in the acquired company, often with a right to buy additional shares at a discounted price. In general, a SPAC sponsor has two years to find a merger candidate and close the deal. If the deal isn’t closed in two years, the initial investment, plus a small interest payment, is returned to the SPAC shareholders.
Once a privately held merger candidate is identified and vetted, the SPAC shareholders vote to approve or deny the merger. If the merger is approved, the SPAC shares are exchanged for shares in the new company. The sponsors generally retain 20% equity in the public company.
What are the benefits and risks of SPACs for investors?
Since SPAC shareholders have no real input into merger candidate selection, there is always a possibility that the company selected will be a company that investors do not like or an industry they do not want to participate in.
There is also more risk for investors because there is much less due diligence required for a SPAC to merge with a privately held company, than there is for a privately held company to undertake its own IPO with the SEC requirements. However, that lack of SEC oversight means that the merger can be done in a matter of months, instead of the multiple years often required for an IPO, which also means the privately held company gets a cash infusion much more quickly.
Historically, the biggest risk to SPACs has been the over-payment for the privately held company. Critics believe that since it’s not actually the sponsor’s money being spent to acquire, the valuation efforts done by the sponsors might be less robust. In truth, over the last 5 years, the returns from SPAC mergers have been significantly lower than the returns for traditional IPOs.