A SPAC, or special purpose acquisition company, is a type of shell company specifically designed to raise capital through an IPO. SPACs have become a way to invest in private companies going public because, after the IPO, the shell company uses the raised capital to merge with or acquire another company.
Between Jan. 1, 2020 and Aug. 21, 2020, SPAC IPOs in the U.S. raised a record $31 billion through 78 transactions, reportedly outpacing traditional IPOs in the summer months. And in January and February of 2021, there were 70 SPAC mergers globally—six times the amount during the same period last year—with the combined value of February deals reaching an all-time record of $108.6 billion, according to Thomson Reuters, which had access to a March 1 report from financial markets data company Refinitiv.
But despite the recent popularity of SPACs, their high risk and poor historical returns make them an unsuitable investment for most individual investors.
What Are SPACs?
A SPAC is a firm that goes public through an initial public offering (IPO) without having a full business operation in place. It is a type of “blank check company,” or one that’s in its developmental stage and exists with the intention of merging with or acquiring another company.
The life cycle of a SPAC looks very different from a traditional company. Most companies form with a specific product or service as the focus and put in the leg work to prove the worth of the business model. Once the company does this, it might go through an IPO to help raise capital and scale its operations.
As a shell company, a SPAC only exists on paper and would go through an IPO without a product or service. It raises capital by selling public shares with the purpose of either merging or acquiring another company, known as its initial business combination or reverse merger.
When a SPAC goes public, all of the capital it raises goes into a trust account. The money remains in the trust either until the SPAC completes its initial business combination, or it liquidates and pays the funds out to the shareholders. If the combination goes through, the shareholders can choose to either remain a shareholder of the new combined company, or redeem their shares.
Why Investing in SPACs Probably Isn’t Worth It
SPACs gained a lot of attention in 2020 and 2021, and that has many investors wondering whether SPACs are worth adding to their portfolio.
The answer for most investors? Probably not.
SPACs are recognized as a blank check company because you’re essentially writing a blank check by investing. At the time you invest in the company, you don’t know what firm it will ultimately acquire, or even whether or not it will make it through a successful initial business combination. And often, they don’t pay off for investors.
There are a few key problems with SPACs that potential investors need to be aware of. First, SPACs aren’t subject to as much regulation as companies going through traditional IPOs. As this becomes a more popular means of taking a company public, the lack of regulation could cause individuals and companies to take advantage.
The other critical problem with SPACs is their mixed performance record—just look at the data:
- A report by the Congressional Research Service indicates that between 2015 and 2020, shares delivered an average loss of 18.8%. Traditional IPOs conversely showed an average, after-market return of 37.2% since 2015.
- A Harvard Law School study found that despite an average share price of $10 during the SPAC stage, shares after the merger are, on average, valued at $6.67.
- In a report from Goldman Sachs, Michael Klausner, the Nancy and Charles Munger Professor of Business and a Professor of Law at Stanford Law School, said that the median SPAC shareholder returns over the three, six, and 12 months following a merger are -14.5%, -23.8%, and -65.3%, respectively, as of October 2020.
SPACs are not always unsuccessful. In 2020, 248 SPAC IPOs were introduced, raising more than $83 billion in proceeds—that’s almost double the amount raised of every previous year combined, according to data from SPACInsider. The average size of a SPAC in 2020 was just under $335 million, almost 10 times the amount it was in 2009. And while not every IPO translated into profit for investors, some of them certainly did.
In one highly publicized deal, Boston-based sports betting company DraftKings merged with the SPAC Diamond Eagle Acquisition. Since the deal closed, DraftKings has seen its stock price triple, from around $20 per share at the end of April 2020 to around $68 at the start of March 2021. SPACs have also gained the interest of famous stars, including athletes Serena Williams, Shaquille O’Neal, and Alex Rodriguez, all of whom have a stake in SPACs.
A SPAC typically has a two-year period to go from IPO to initial business combination, although some SPACs have opted for shorter periods such as 18 months in the past.
While SPACs raised a considerable amount of money in 2020, Goldman Sachs estimated that over $80 billion in equity IPO proceeds were still in trusts at the end of January 2021, searching for target companies to merge with or acquire. And if the historical performance of SPACs is any indication, most of those investors won’t see a return on their investment.
No one can predict the future, though, and it’s entirely possible that the newfound excitement around SPACs will inspire more success.
How Do I Invest in a SPAC?
By this point, you know that SPACs are a risky investment and that, more often than not, they don’t result in a return for investors. But everyone has a different investing style and risk tolerance, and many individuals are willing to take on that extra risk for a greater potential return. Here are a few steps to follow when investing in SPACs.
Do Your Research
When you invest in a SPAC, you’re trusting that management will turn the IPO into a profitable merger down the road. There’s no product, service, or business performance to look to. Instead, you should do as much research as you can into the founder and their plans. SPAC founders often have a particular industry or company in mind as a target, which they identify in their prospectus.
One useful tool to use in your research is EDGAR, a database compiled by the Securities and Exchange Commission (SEC) that provides information to investors on publicly traded companies.
Know the Timeline
SPACs generally have two years to go from IPO to initial business combination. If a merger hasn’t taken place by the end of that time period, the company will typically be liquidated, and the money returned to the investors. When you decide to invest in a SPAC, be aware that you’ll likely wait at least two years before either getting part of your investment back or seeing a return on your investment.
Treat It as a Speculative Investment
The SEC considers SPACs and other blank check companies to be speculative investments, in that they come with a significant risk of losing your initial investment. As a result, it’s important that you invest in SPACs only with money you can afford to lose.
Diversify Your Portfolio
Diversification is one of the most important components of investing. If you decide to add SPAC shares to your portfolio, be sure to invest in lower-risk investments as well to mitigate your risk of loss.
The Bottom Line
Because of their high risk and poor historical returns, SPACs probably aren’t a suitable investment for most individual investors. But given attention seen in 2020 and 2021, and the increase in successful SPAC IPOs, the tide may change. If you decide to invest in SPACs, proceed cautiously and do thorough research ahead of time.