Investing in Special Purpose Acquisition Companies (SPACs)

We’re currently recovering from one of the most destructive economic shocks in history… but you wouldn’t know it from the number of companies that have gone public recently. 

There has been a surge of initial public offering (IPO) activity in recent weeks; IPO Authority editor Monica Savaglia wrote about Airbnb’s plans for an IPO last week.

But perhaps the more interesting phenomenon is the growing number of companies sneaking their way onto exchanges without going through the conventional IPO process. Many, including Nikola (NASDAQ: NKLA) and DraftKings (NASDAQ: DKNG), are circumventing the process through mergers with special purpose acquisition companies (SPACs). 

Let’s look at how these mysterious shell corporations work and the pros and cons of investing in newly public companies through SPACs. 

What Are Special Purpose Acquisition Companies (SPACs)? 

SPACs, also called shell corporations or “blank check companies,” are publicly traded companies that have no operations of their own. They raise capital strictly for the purpose of acquiring an existing company and taking it public, hence the name. 

SPACs are generally formed by activist investors and executives who have experience in a particular industry and have a few acquisition targets in mind. But in order to avoid certain regulatory requirements, they go public without a specific acquisition plan in place.  

When a SPAC goes public it typically sells shares for $10 each, and then puts that money into a trust where it accrues interest while the SPAC’s management tries to find an acquisition target. 

If the SPAC doesn’t acquire a company within a limited time frame (usually two years), then the trust is liquidated and returned to investors. Those who buy shares of the SPAC at a discount to its trust value per share can earn a small but safe return this way.

But if the SPAC does acquire a company, then investors can convert their SPAC shares into shares of that newly public company, giving themselves a shot at far greater returns. DraftKings, for instance, trades at more than $36 at the moment. Some of its pre-merger SPAC investors are sitting on returns of more than 260% in just two and a half years. 

The Risks of Investing in SPACs

As we’ve discussed, even unsuccessful SPACs can provide early investors with modest returns at liquidation — and successful SPACs can provide extremely inexpensive entry points into public companies that are usually only available to venture capitalists. 

But that doesn’t mean SPACs are risk-free investments. There are several things that can go wrong before, during, and after the acquisition process. 

For one thing, pre-acquisition SPACs usually IPO at $10 per share, and investors who buy at that price are almost guaranteed to earn a small profit, even if the SPAC liquidates. But shares can trade at a discount or premium to their trust value between the IPO and the merger or liquidation. So, investors who buy in at a higher price during this interim period risk losses.

Suppose that a SPAC goes public at $10 a share and quickly increases in price due to rumors of a big acquisition in the works. And suppose that you buy in at $12 a share after these rumors emerge. 

Now, imagine that acquisition falls through and the SPAC is liquidated at its trust value of, say, $11 per share. That’s a loss of 8.3% for you. 

What’s more, SPACs that fail to acquire a company within their time limit are obligated to liquidate their trusts and return the money to investors, but that doesn’t mean full redemption at trust value is guaranteed. During the Great Recession, some SPAC investors suffered substantial losses on failed SPACs due to mismanagement or trust underperformance. 

Finally, it’s worth considering that many companies go public through mergers with SPACs to avoid the regulations surrounding the IPO process, which isn’t necessarily a good thing for investors. 

Those regulations can be onerous and expensive, but they exist for a reason. Many pieces of IPO-regulating legislation, like the Sarbanes-Oxley Act, were put in place after the dotcom bust to prevent a future recurrence of a similar situation (investors getting fleeced by new companies with lots of media attention but no concrete business prospects). 

And some of the companies that have recently gone public through mergers with SPACs look a lot like those sham tech companies from the late ’90s. 

Nikola, for instance, is an electric vehicle company that hasn’t produced a single truck or even started construction on its factory. Yet after its SPAC merger, it rode a wave of social media hype that briefly made it more valuable than Ford. I wrote about Nikola’s worrying lack of real-world progress last Sunday. 

Should You Invest? 

All things considered, SPACs provide an interesting alternative route to the stock market for young companies, and SPACs with credible acquisition plans can give ordinary investors very lucrative entry points into the hottest stocks of tomorrow. 

But they’re risky, and most people who are interested in early-stage investments would be better served by carefully researching IPOs. 

The IPO Authority is a research service that is tailor-made for those investors, and as we mentioned earlier, editor Monica Savaglia has gotten the scoop on several high-profile IPOs, including Airbnb before they hit the mainstream media. 

Learn more here.

Until next time,

Samuel Taube

Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.