Published on April 2, 2021 in the Rochester Business Journal

Former New York Stock Exchange President, Tom Farley, recently described 2020 as “The Year of the SPAC” during an interview on CNBC’s Squawk Box. Indeed, these Special Purpose Acquisition Companies attracted gross investment proceeds of approximately $80 billion last year, far surpassing the money raised through more traditional Initial Public Offerings (IPOs). But what exactly are SPACs, how are they similar to and different from an IPO, and what are some of the implications for investors who get involved with this type of financing?

A SPAC is essentially a shell company, sometimes called a “blank check” company, that raises capital by issuing stock for the sole purpose of purchasing a private company and taking it public. SPACs were first introduced by investment banker David Nussbaum and lawyer David Miller in 1993 to give private firms another way to raise capital in the public market. Their predecessors were called “blind pools”, which date back to the 1980’s and were sometimes associated with penny stock fraud.

In the process of taking a private company public, a SPAC sponsor contributes capital to a shell company and places the proceeds in Trust. Shares of the SPAC then begin to trade publicly. Once this takes place, the SPAC sponsor generally has about two years to identify a merger candidate and publicly announce its target. Ultimately, the SPAC sponsor enters into a Letter of Intent with the target company and a merger ensues. Coincident with these events, a SPAC sponsor may also arrange for supplemental institutional financing called Private Investment in Public Equity, or PIPE financing. If the merger closes, the once private company begins to trade publicly. If the merger never closes or if the SPAC sponsor can’t find a suitable merger candidate within two years or so, the SPAC is typically liquidated and the SPAC investors get their money back – at least the $10 per share that the pre-merger SPAC shares were first offered at.

SPACs are similar to IPOs in that they both provide private companies with access to capital in the public market. Accordingly, both mechanisms allow for a private company’s shares to trade publicly. While pursuing a SPAC is typically more expensive than an IPO, the process of taking a private company public with this type of investment vehicle is much quicker – generally accomplished in two months as opposed to six or more. It’s essentially a one-on-one deal between a SPAC sponsor and the target company, as opposed to what’s been characterized as a one-to-many deal between a target company and the public market in an IPO. The COVID pandemic significantly stunted the practicality of roadshows to drum up support for more traditional IPOs and, accordingly, SPACs have become much more popular over the last year or so.

SPACs are attractive to sponsors and retail investors alike. For as little as a 3-4% investment in a shell-company-stage SPAC, a SPAC sponsor usually ends up with 20% of the underlying equity of the post-merger SPAC – obviously, very lucrative. Retail investors also find SPACs appealing, as they provide improved access to newly public companies, which might not otherwise have been available via a more traditional IPO.

Shares in a SPAC are initially offered at $10 each, but they can trade much higher, based on the speculation surrounding a potential target. Once a target has been identified, investors are also afforded the opportunity to get their $10 per share back, should they not be pleased with or not wish to accept the shares of the post-merger SPAC. In this instance, it should be noted that only $10 per share would be returned to the investor, even if they initially paid much more for the shares. Similar to investing in an IPO, the potential for incurring a loss with a SPAC investment is significant.

Some of the more successful SPACs of 2020 involved companies like DraftKings (online sports betting), Quantumscape (lithium batteries for electric cars), and Iridium (cross-linked global satellites). Other familiar companies born from SPACs include Nikola (battery electric and hydrogen electric vehicles) and Virgin Galactic (commercial spaceflight). While many SPACs have succeeded over the years, there are certainly many others that have failed, and the performance of post-merger SPACs has generally lagged its post-IPO peer group. The reason has to do with the large cut of equity the sponsor reaps in underwriting a SPAC, which is also called “the promote”.

In the investment world, newly formed companies are riskier than older companies with established track records of earnings. The fact is that many post-merger SPACs or those companies spawned from IPOs don’t have any earnings. Without earnings, it becomes very difficult to assign an appropriate market value to a company and its shares and, absent an appropriate valuation methodology, one might consider participating in a SPAC or an IPO more of a speculation than an investment. Do speculations have any place in one’s investment portfolio? Working with a trained financial professional can help you answer that question and decide whether investing in a SPAC or an IPO is right for you.

To see this column in the RBJ, click here.

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