What is a special purpose acquisition company (SPAC)?

A SPAC is a shell company created to raise money to fund mergers and acquisitions. Here's a look at how SPACs function and whether they are suitable investments.

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How does a SPAC work?  

A special purpose acquisition company, or SPAC, is created solely to acquire a private company and take it public. Someone with advanced knowledge or industry expertise will sponsor a SPAC, using their skills to find profitable target companies to take over.

Using the SPAC as a vehicle and based on the sponsor's reputation, attempts are then made to raise cash from investors to finance activities. This 'war chest' money funds merger and acquisition (M&A) activity in the sponsor's chosen sector (or sectors).

The SPAC is used to raise money through an initial public offering (IPO). It then generally has a limit of two years to use the funds raised to finance M&A deals. If the SPAC can't get any deals off the ground within that timeframe, the company must be liquidated, and the money returned to its investors. 

Who invests in SPACs?

SPAC investors can range from institutional investors to the general public. High-net-worth individuals and celebrities, such as American sporting icons Serena Williams and Shaquille O'Neal, sometimes spruik certain SPACs.

Analysts often refer to SPACs as 'blank cheque' companies because they generally won't disclose their potential acquisition targets during the IPO process. Sometimes they may not even have any firm targets in mind at the time of their IPO. 

Ultimately, a successful SPAC will merge with or acquire a private company (or companies), and the newly formed entity or entities will then list on a major stock exchange. We call this process a "reverse merger", allowing the target company to go public without launching its own IPO.

But investors have no way of knowing whether their SPAC will be one of the lucky ones that will succeed in finding a promising target company and complete a reverse merger. They must simply put all their trust in the industry expertise of their SPAC sponsor. And if that sounds risky to you – you're right!

Who manages the money raised?

The funds raised through the IPO process are placed in an interest-bearing trust account, with the interest payments sometimes providing the SPAC with a portion of its working capital.

The funds in the trust account can only be used to finance M&A activity or repay investors. A SPAC has no other business operations at the time of its IPO.

What's in it for the target company?

On its face, a SPAC's activities can seem particularly predatory: a sponsor with bags of cash looking to take over someone else's start-up. But there are some pretty strong incentives for junior companies to want to be targets of a SPAC. 

The primary benefit is that the SPAC process can provide a private company with a cheaper and faster route to go public. Being gobbled up by a SPAC means that a junior company can avoid paying all the costs of launching its own IPO (think underwriting, legal and listing fees, among many others). 

The time savings can also be significant. A private company acquired by a SPAC can often be publicly listed within months, whereas launching its own IPO can sometimes take more than a year.

How many SPACs are out there?

Currently, SPACs are prohibited from listing on the ASX. Rules brought in after the 1987 stock market crash prevent companies from listing without a substantive business model or where more than 50% of their assets are made up of cash – what the ASX refers to as 'cash box companies'. 

However, SPACs are common overseas, particularly in America, where their use exploded in 2020 and 2021. Quantitative easing programs implemented during the COVID-19 pandemic meant investors were cashed up. Historically low interest rates also meant they had to seek increasingly risky investments to earn a decent return.

The backing of many major institutional underwriters, such as Goldman Sachs, Credit Suisse, and Deutsche Bank, has also added credibility to the industry.

In this environment, SPACs seemed particularly attractive. With the prices of many high-growth tech stocks and other speculative investments surging, a SPAC enabled many to be groundfloor investors in the next big thing. 

Investor FOMO (fear of missing out) helped the SPAC industry raise an eye-watering US$145 billion in cash in 2021.1 

What about economic impacts?

More recently, high inflation, rising interest rates, and a general souring in the economic outlook have caused speculative investment prices to tumble. Investors are no longer as interested in high-risk investments like SPACs, instead choosing blue-chip stocks and safe-haven commodities like gold.

In 2022, US SPACs raised just US$13 billion2, a far cry from the heady days of 2021. And there are now many stories racking up of SPACs launched during the pandemic that hit their two-year time limit without locking in a deal. 

For example, in June 2022, the New York Times reported that a SPAC called Omnichannel returned the US$206 million it had raised to its investors after its deal to acquire a fintech company fell through.3 And the Financial Times reported that 86 SPACs were liquidated in December 2022 alone.4

Not only that but as the failures have started to pile up, regulators (like the US Securities and Exchange Commission) have begun to clamp down.

New rules could make it easier for investors to sue companies involved in dodgy SPAC deals, including situations where target companies have inflated their revenue potential.5

How does a successful SPAC reward its investors?

If a SPAC can't land a deal within two years, it is liquidated, and the money raised through the IPO is returned to investors. But what happens if a SPAC successfully acquires or merges with another company? How does the SPAC reward its shareholders?

Investors who buy ordinary shares through the SPAC IPO are typically also issued warrants. These warrants give them the right to buy more shares in the future – in whatever newly listed company is created through the SPAC's M&A activity – for a prespecified price. 

In a typical SPAC, ordinary shares will be sold to investors for US$10 a share, while the associated warrants can be exercised for US$11.50 – although this can vary. The number of warrants issued can also vary between SPACs, with a higher number typically indicating that the SPAC is considered a higher risk.

When a deal is struck with a target, investors in the SPAC can choose to go ahead with it or withdraw their money with interest. However, they can keep their warrants, which they can exercise or sell on the open market. This allows investors to evaluate the deal struck by the SPAC sponsor before committing to it.

While these arrangements appear to give investors different ways to profit from SPACs, it's important to note that SPAC shares can be just as volatile as any other share on a stock exchange.

In September 2021, Goldman Sachs strategists looked at the share price performance of the 172 SPACs that had successfully closed a deal since the beginning of 2020. They concluded that in the six months following the deal closure, the median SPAC underperformed the Russell 3000 – a benchmark index that seeks to represent the performance of the entire US stock market – by a whopping 42%.

This weak performance isn't great news for shareholders. It would indicate that those who participated in these SPACs – particularly those who chose to exercise their warrants – could have made significantly higher profits by simply investing their money in the broader market.

Are SPACs a new investment vehicle?

Blank cheque companies have been around in some form since at least the 1980s, if not earlier. However, before the 1990s, this market section was largely unregulated, and many early investors fell victim to fraud and lost significant amounts of money.

By the mid-90s, US Congress put new rules in place to try and regulate the industry. This included the condition that funds raised through the IPO process had to be set aside in escrow. These new, more tightly controlled SPACs were popularised in the 90s by now-defunct brokerage firm GKN Securities. 

GKN's founders David Nussbaum, Roger Gladstone and Robert Gladstone, were instrumental in creating the template for the modern SPAC and have founded other brokerage houses specialising in these investment vehicles, including EarlyBirdCapital.

What are some examples?

One of the more famous SPAC sponsors is prominent venture capitalist Chamath Palihapitiya, founder of California-based investment firm Social Capital. Over the past decade, the firm has invested in several emergent tech companies, including Yammer and Slack Technologies.

In one of the more high-profile SPAC deals in recent years, one of Social Capital's SPACs (the Social Capital Hedosophia Holdings Corp) bought a 49% stake in Richard Branson's commercial space travel company, Virgin Galactic, for US$800 million. It took the space company public in 2019.

In 2020, another of Social Capital's SPACs – Social Capital Hedosophia II – merged with real estate technology disruptor Opendoor Technologies. 

Opendoor buys properties from owners quickly for cash and then performs any necessary repairs and relists the properties for sale on its online platform. Opendoor was also taken public through the SPAC process, and its shares now trade on the US tech-centric NASDAQ exchange.

American hedge fund manager Bill Ackman – founder of Pershing Square Capital Management – launched his own SPAC in 2021. His SPAC, Pershing Square Tontine Holdings (PSTH), raised an astounding US$4 billion from investors – the most significant amount ever collected from a blank cheque IPO. 

However, after a failed bid to acquire a stake in Universal Music Group, the fund was liquidated, and the entire US$4 billion was returned to shareholders in 2022. The rise and fall of PSTH captures the 'boom and bust' trend in SPAC investing over the past couple of years. It shows that even the most high-profile SPACs can quickly collapse if they can't land a significant deal.

What are the risks of SPACs to investors?

The major risk to investors is the lack of transparency in a typical SPAC IPO. The SPAC sponsor generally won't disclose its acquisition targets – and in many cases, it may not have even decided on a particular target by the time of the IPO.

For example, many investors thought the Social Capital Hedosophia Holdings Corp SPAC that acquired Virgin Galactic intended to merge with a software technology company like Slack Technologies. While many investors probably made substantial money from the deal with Virgin Galactic, they likely never envisaged investing in a burgeoning commercial space travel company.

There is also the potential for SPAC deals to be overvalued or overhyped. SPAC acquisition targets understand that the SPAC needs to close a deal within two years. Therefore, they can often negotiate a premium price due to this time pressure. While the potential to earn a premium provides an extra incentive for a company to engage with a SPAC, it can mean the SPAC shareholders lose out on the deal.

Finally, the SPAC sponsor typically receives up to a 20% stake in the newly created public company. This can turn into a significant payout for the sponsor, but it may also earn next to nothing or even generate a loss due to expenses if it cannot close a deal within two years. 

Critics of this remuneration structure argue that it could incentivise sponsors to close deals that guarantee them a significant payout, even if it may not be in the best interests of the SPAC shareholders.

However, if the sponsor is well known and has a good track record of success, their equity stake can present a compelling reason for people to invest in the SPAC in the first place. For some investors, the sponsor's industry expertise can be a vital ingredient in ensuring the success of the newly listed public company.

The Foolish bottom line

SPACs are high-risk investments that play into investor FOMO. They promise early access to the next up-and-coming company but regularly fail to live up to the hype. Many SPACs close without ever reaching a deal — and even those that succeed don't necessarily guarantee their investors huge returns. Instead, many SPAC investors end up holding shares in junior, unprofitable companies. 

SPACs are so risky they are prohibited from listing on the ASX. This means risk-hungry investors have to look offshore to get their SPAC fix. Although investing overseas has never been easier, thanks to a proliferation of discount trading apps and platforms, you should carefully consider whether investing in a SPAC suits your risk appetite and financial goals.

The SPAC industry's recent boom and bust cycle is a great investing lesson. When investors have lots of cash at their disposal and interest rates are low, they will chase higher returns by investing in increasingly risky assets. This will inflate the prices of those assets, causing more investors to jump on board to avoid missing out on the latest craze.

However, as we've seen this year, the bubble has to burst eventually — and it's usually those investors that bought in at the height of the market that are punished the most. This shows how important it is to do independent research to ensure an investment suits you before buying in.

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