Four letters have gained significant traction and momentum since the start of 2020. Those letters are SPAC, which stands for “special purpose acquisition company.” In 2020 alone, companies such as Virgin Galactic (space tourism), DraftKings (online betting), and Nikola (electric trucks) went public through this method.

The question is, what are SPACs, and what risks do they present?

What Is a SPAC?

Traditionally, when a company desires to go public, it does so via an initial public offering (IPO). This process is time-consuming and costly, which can discourage some corporations from proceeding down this path.

The formation of SPACs helped change that process. In a nutshell, SPACs pool together investor money through an IPO to buy a private company and merge it with the SPAC.

The result is the private company goes “public” without being subjected to the lengthy IPO process. SPACs are commonly referred to as “blank check” companies. They generally raise capital and keep it conservatively invested until they find deals worth pursuing.

Why?

For the company being acquired, a special purpose acquisition company is often the most cost-effective and quickest route to a public listing while avoiding the complexities and time required for the IPO process.

SPACs aren’t necessarily new, but their use has dramatically increased over the past few years. They raised nearly $73 billion in proceeds in 2020, which was a 462% increase year over year. Furthermore, they raised $6 billion more than the traditional IPO process.

SPACs typically allow investors a “cash out” option if they don’t like the deal they are presented with. The catch here is that they tend to rally on potential deal announcements, and because of this, few cash out prior as FOMO kicks in.

Risks

While SPACs help companies that otherwise may never go public, they present plenty of risks.

Of the 107 SPACs that have gone public since 2015, the average return on the common stock has been -1.4%, compared with 49% for companies that went public via an IPO. Things improved in 2020 as the annual common stock return was ~17%, but much of that was due to two companies’ performance.
As the number increases, the market will likely become less attractive as the supply will outweigh the demand. We are already witnessing this as many recent acquisitions seem questionable at best. The bigger concern is whether SPACs acquire companies with no legitimate business plan or path to profitability but want to cash in while markets are red-hot.
While I will be the first to admit that the IPO process is quite cumbersome, it serves a purpose in that it typically ensures that companies don’t go public too soon. Plus, it weeds out companies that have no business going public. SPACs can acquire a company at any stage and take it public. When markets are performing well, these risks tend to be hidden but reappear when market volatility spikes.
Many argue that the Federal Reserve’s action of keeping interest rates near zero and pledging unlimited stimulus has promoted excess speculation/risk-taking and that SPACs are part of that excess. There is some truth to this. When a respectable risk-free return is no longer available, investors look elsewhere to achieve a higher return. This involves taking on a higher degree of risk. If the economy were to take a turn for the worse or supply were to dry up, they could face immense pressure.

With that being said, SPACs serve a purpose and help some companies that otherwise may have no alternative or cannot afford the cost or time required for the IPO route. SPACs serve an important function as many private companies never end up going public because of the complexities of the IPO process.

Investors need to be aware of the risks with SPACs and ensure they can handle the volatility. The key is proper diversification and making sure that you are not taking on excess risk in relation to your financial goals and personal risk tolerance.

Discuss your situation with a fee-only financial advisor.

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