A discussion around IPO investing (see blog on what is an IPO? ) can lead to a discussion around SPAC investing. In fact, there seems to be even more frenzy around SPACs, an alternative to the traditional IPOs this year as the amount of money and the number of SPACS outpace the traditional process. According to the Wall Street Journal, SPACs have accounted for 70% of the initial public offerings this year.
Let us Explain SPACs.
The acronym SPAC stands for special-purpose acquisition companies, but they are also referred to as “blank-check companies’’ because the companies are just a shell with no products or services. The founders create a public company and then subsequent investors, invest money to be held in trust, until the founding members identify a “good deal” in the private sector.
The SPAC uses a combination of IPO proceeds and additional financing to fund the acquisition of a private operating company and effectively take it public. The proceeds raised in the IPO are placed in a trust account while the SPAC’s management team seeks to complete the acquisition. Usually the “target” company is in a specific industry or geography and ideally the company produces a positive EBITDA although recently many SPACs are targeting pre-revenue companies. In other words, these acquisitions can be very speculative in nature.
The SPAC’s governing documents usually allow 18 to 24 months for the SPAC to identify a target company. If the SPAC successfully completes an acquisition, the private operating company target effectively becomes a public company. If the SPAC is unable to complete an acquisition in the allotted timeframe, the cash held in its trust account is returned to its investors unless the SPAC extends its timeline via a proxy process.
The founders who create the SPAC are experienced financial executives who rely on their reputation and experience to identify nascent companies to acquire. They provide the starting capital and they also rely on their reputation to attract investors.
The Attraction of SPACs
Taking a business public is a great way to finance and grow a business without incurring too much debt. It can also make it easier to raise capital in the future and often improves perceptions and relationships with vendors and customers. But the IPO process is very time consuming and expensive and the process involves disclosing a lot of detailed aspects of the business, from financial statements to information about the management team to the government and for public perusal. A company going public via a SPAC must meet the same regulatory requirements, but they need to satisfy these requirements in a shorter period, typically a few months, not the year or two that a typical IPO can take.
It is important to point out that the founders usually claim a 20% ownership as their compensation for managing the SPAC process, they then contract an investment bank who will receive a cut, usually around 10% ownership and then there are lawyer fees. Creating a SPAC can provide big paydays for everyone involved on the ground floor of this initiative.
Investors who provide the capital are both institutional and retail investors and they receive ownership in the form of stock and warrants which can be traded in the public market.
Should Investors invest in SPACS?
Again, these deals generate big profits from their creators, who are hedge funds, venture capitalists and big-name underwriters such as Goldman Sachs, Deutsche Bank and Credit Suisse. Basically, they create accelerated pathway to get in on the ground floor of a hot new company and as the excitement turns into reality, the first ones in will have made their money, particularly if they are able to sell right after an announcement of a deal. Over the past year the average SPAC has continue to rise in value which makes some investors think there is no way to lose. However, investors take on more risk if they hold onto shares after the deal goes through since now the company which has never turned a profit, must perform.
We learned about SPACs in the 90s (first created by an investment banker in 1993) as hot new investments and then again in the 2000s until market crashes dampened speculation and the appetite for SPACs. Coincidentally this current new interest in SPACs corresponds with the boom in technology stocks, bitcoin and the exuberance in the stock market that give responsible investors pause. Sure, enough many of the current SPACs are looking for deals in Technology, Health Care and Energy Transition with promising futures that have yet to materialize.
So What Should You Do?
If this is beginning to sound familiar that means you are paying attention. It is all a game, a gamble, not based on a company with a solid business model that has proven to provide goods and services people want and therefore are expected to earn future profits. This cannot be called an investment. When the bubble bursts, it is the individual investor that will lose.
Smart investing is about finding companies who can create value over the long run. Focus on companies that create value and then invest for the long run.