Special purpose acquisition companies (SPACs) have become a popular alternative to traditional initial public offerings (IPOs), which are typically reserved for high-net-worth and institutional investors. “SPACs allow regular folks to get in on the ground floor of private equity investments they might otherwise be shut out of,” says Kevin Gordon, a senior investment research specialist at Schwab.
How do they work?
A SPAC raises capital through an IPO for the express purpose of merging with an existing company in order to take it public. With a traditional IPO, a company typically has to jump through numerous regulatory hoops and demonstrate past performance, and it’s constrained in what it can claim about its future prospects. A SPAC IPO, on the other hand, isn’t subject to the same requirements, making it easier and faster for fledgling companies—including startups and others with limited operating experience—to enter the market.
What are the risks?
There are several:
- Because a SPAC issues shares before it identifies an acquisition target, investors don’t know what company they’re actually investing in.
- The lack of regulatory oversight can lead to problems down the road. For example, in January the Russian founder and CEO of Momentus Space resigned after potential foreign ownership and national security concerns threatened the company’s attempt to go public through a SPAC.
- A SPAC must find a merger candidate within two years of going public or return the money raised to investors, incentivizing its sponsors to get a deal done regardless of its terms or quality.
- Because of their popularity—these so-called blank-check companies raised $83.3 billion from 248 IPOs in 2020, up from $13.6 billion from 59 IPOs just a year earlier—there may be too many SPACs hunting for too few acquisition targets, driving up prices and/or driving down the likelihood of striking a high-quality deal.
What should investors do?
If you’re willing to accept the risks of investing in a SPAC, Kevin says to look for one with a proven management team sponsoring the deal.
However, Kevin’s also quick to note that the risks associated with individual SPACs may not be appropriate for most investors. “It might be best to wait and see how the market evolves over the next few years,” he says. “In the meantime, investors may want to look into diversified SPAC exchange-traded funds and mutual funds that are less reliant on individual blank-check companies.”