If you are reading this blog, you must be curious about SPACs. It is not a commonly heard term in the stock markets, but it is a fast-growing investment category. We will tell you what a SPAC is, it’s advantages and disadvantages, and whether you should invest in one or not.
What Does SPAC Stand For?
SPAC stands for Special Purpose Acquisition Company. The sole purpose of a SPAC is to acquire companies. It has no assets or any operations. Hence to raise capital for acquiring companies, SPACs list their shares publicly.
A group of Investors who have expertise in a particular sector come together to form a SPAC. They are known as Sponsors. While forming the company, they might have a target company in mind but they don’t disclose it because it can increase the paperwork and the price of the target.
Why Are SPACs Formed?
SPACs have gathered popularity recently. Late-stage funding through IPOs has become difficult due to Covid. Companies such as WeWork did not have the desired IPO they wanted. A SPAC solves this problem. The time required for disclosures is reduced and the IPO process can go smoothly and quickly. Virgin Galactic Holdings is a very good example. The company got listed through a SPAC in October 2019. The stock price has increased by more than 140% since then.
According to SPAC Research, the IPOs via a SPAC have risen from 10 in 2013 to 172 in 2020 so far. And the amount raised has gone up to $63.4 billion in 2020 from $1.4 billion in 2013. Many notable underwriters such as Goldman Sachs, Credit Suisse, Deutsche Bank, and Institutional Investors have been showing an increasing interest in SPACs.
How is a SPAC formed and how does it function?
The formation of a SPAC is similar to a company looking to raise capital through a traditional IPO. The shares are offered at $10 per share, generally. The money which is generated through the IPO is kept in a trust or an escrow account. This money can only be used either for acquiring a company or returning it to the investors. SPACs have a window (2 years normally) in which to acquire a company or else they need to return the money to the investors. This helps to protect the investors from any fraud the promoters of the company may commit. Their money is safe.
Since it is formed by investors who have expertise in the particular sector or company they are targeting, the management of a SPAC is experienced. The money kept in a trust earns interest which can be used as working capital for the SPAC.
What are the advantages and disadvantages?
Advantages:
1. An easy way for an IPO for a Company.
Covid has halted the IPO plans for a lot of companies. But going public through an IPO helps the companies to utilize the expertise of the management of the SPAC. The direction provided by SPAC can result in a smoother IPO. It saves time and also the uncertainty which happens when there is more time spent. Smaller companies who are looking to go public can especially benefit from SPACs and their investors.
2. The price is reasonable to invest in.
As it is normally priced at $10 per share, retail investors can invest in it too. The stock has movement when it decides to acquire a company. You can always keep looking for an entry in a SPAC at its original price as the acquisition may take place anytime in the future but within 2 years of the SPAC’s listing.
The main aim of SPACs is to acquire a company that will be profitable to the sponsors. So they select companies that have the potential to grow exponentially in the future. But this can potentially backfire on them as the companies they target are new.
Disadvantages:
1. Money may stay Idle for a long time.
Since the acquisitions take time and may not happen as soon as the SPAC is listed, the money will stay idle in the trust. You can miss other opportunities that can generate more returns. There might be no acquisition at all and your money will be returned after the time ends to make a deal.
2. Investments may not always be profitable
The investors don’t know which target company the SPAC is looking to acquire. Evaluation is a problem for them. If the sponsors of the company invest in a company that is not profitable or a company that is for their own benefit, this will affect the investors investing in the SPAC.
Should you Invest in a SPAC?
This is the most important question. The interest is increasing in SPACs and they have generated huge amounts of money in recent years. There are pros and cons to investing in SPACs. Retail investors are the ones who can be the most vulnerable here because Institutional Investors might have an idea which company the SPAC will target. Remember, if you invest in a SPAC you are investing in the management of the SPAC and their decision- making abilities for selecting target companies.
Also, the investors get their money back if no deal happens within the allotted window. Hence, this would not be ideal for people looking for a longer investment horizon and a stable dividend.
If you are looking to enter an IPO and can take the risk, SPACs can be a good investment for you. However, you need to do your research about the SPACs and check the management.
Expert Tip: Before investing in a SPAC, check out every officer and director and make sure that their talents and experience align with the type of industry you want to invest in.
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References:
Connie Liozos. ‘Almost Everything you need to know about SPACs’. August 22, 2020 https://techcrunch.com/2020/08/21/almost-everything-you-need-to-know-about-spacs/
Julie Young. ‘Special Purpose Acquisition Company(SPAC)’. Updated August 3, 2020 https://www.investopedia.com/terms/s/spac.asp
Martin Daks. ‘A SPAC is a high-risk but potentially profitable way to get in on the ground floor of a new stock — here’s everything you need to know’. October 19, 2020. https://www.businessinsider.com/what-is-a-spac
