What Are SPACs and Should You Invest in Them?

SPAC, which stands for Special Purpose Acquisition Company, is a publicly-listed shell corporation that is explicitly created to pool funds to finance a merger or acquisition opportunity within a set timeframe. 

This blank cheque company gets listed on a stock exchange as a SPAC stock. According to the U.K. Financial Conduct Authority and the U.S. Securities and Exchange Commission (SEC), SPACs initially do not have underlying business operations. Their assets comprise the capital generated from the initial listing. The reverse merger that combines two separate businesses is also known as de-SPACing.

When the reverse merger completes, the new entity becomes a regular public company subject to local regulations. As a result, the operational and financial background of the private entity becomes the focus of investors. 

We should note that SPACs are not a new corporate structure. Yet the use of SPACs to list on stock exchanges has been booming since 2020. A flood of equity, as well as a growing appetite among retail investors, meant 248 SPAC listings in 2020, raising over $83 billion. 

The data from 2021 was even more impressive. SPACs raised over $160 billion in 613 listings. Wall Street witnessed 274 SPAC reverse-merger announcements. A large number of them came from the tech sector. 

Europe, the U.K. included, has seen fewer such listings due to previous regulation making the SPAC structure unattractive to both investors and issuers. However, some three dozen SPACs listed in 2021, and the pace of listings has accelerated as the U.K. and some European jurisdictions such as the Netherlands have aligned their rules more closely with the U.S.’s.

In particular, new rules set out by the U.K. Financial Conduct Authority last year have improved investor protections by forcing SPACs to offer redemption rights to investors who don’t like a proposed acquisition, and by forcing a stricter ‘ring-fencing’ of a SPAC’s assets.

A SPAC is initially formed by a group of sponsors, such as seasoned investors or private equity firms. These creators usually have a particular investment focus. It could be a specific sector like health care or a narrow geographic location like a corporation in one of the emerging markets. A SPAC could also come from another investment sphere based on a sponsor’s know-how. 

SPACs go through the typical IPO process, although their sponsors do not publicly identify companies they are eyeing for an acquisition. Instead, these sponsors set up a shell company with no operations or assets and sell units (both shares and warrants) to raise money for the IPO. 

The sponsors submit a registration form, known in the U.S. as the S-1 Form, with the SEC when they initially launch the SPAC. Funds raised via the SPAC IPO are kept in a segregated, interest-bearing trust account and can only be used to execute the acquisition of the target company. 

The unique setup of SPAC stocks means retail investors do not initially know what type of a company they’re investing in. Thus, they basically buy into the reputation and records of founding sponsors. For that reason, SPACs are frequently referred to as blank cheque companies.

On the stock exchange, the SPAC stock is assigned a ticker symbol. In the U.S., most SPAC stocks start out with share prices of around $10. In Europe, prices have tended to be around £10 or €10. Warrants are typically issued to entice potential investors and enable them to buy additional shares. 

The SPAC then has a defined amount of time, or closing date to put investors’ funds to work by identifying a suitable target (a private company) to merge with or acquire. In the U.S., this is typically 18 to 24 months after the initial IPO date. 

In the U.K., as part of a package of measures designed to make the SPAC vehicle more attractive to issuers and investors, the FCA said it will allow an extension of the maximum time to three years from two years, if shareholders approve it. A six-month extension without shareholder approval is also now possible in certain conditions. 

The FCA also introduced redemption rights for shareholders who don’t like a deal proposed by the SPAC’s board. That removed a key drawback to investing in a U.K. SPAC, in as much as the old rules locked investors in until an FCA-approved prospectus had been published for the enlarged business.

However, SPACs remain more tightly regulated in the U.K. than in the U.S. SPACs are not allowed in the Premium segment of the London Stock Exchange’s Official List, for example.

Following the completion of such a reverse merger, the private company becomes publicly listed on one of the major exchanges, typically under a new ticker. This reverse merger process can also be called de-SPACing.  

Investors have the right to redeem their shares for a pro-rata portion of the trust account if they do not want to own the new company. If the SPAC needs to raise additional money to complete an acquisition, it may issue debt or additional shares.

If a SPAC fails to complete the acquisition by the closing date, it will have to liquidate and return the funds to its shareholders. At that point, the SPAC can usually request an extension of the timeframe. Meanwhile, the shareholders have the right to approve or deny that request.

For the initial sponsors of the SPAC stock, early involvement could lead to sizable gains. Prior to the SPAC IPO, sponsors are allocated “founder shares,” generally classified as Class B. The total amount is typically capped at 20% of total shares available. Following the acquisition of the target company, these Class B shares would generally see significant returns. Understandably, those returns would depend on the structure as well as the size of the IPO.

SPAC stocks are public companies listed on major exchanges. Thus, investors looking to add SPACs to investment portfolios can buy them through their online brokerage accounts, like any other publicly traded stock. 

In previous years, buying shares of a SPAC before the announcement of the target company have at times given retail investors the opportunity to participate in significant growth opportunities many associate with traditional IPOs. However, past returns do not mean future deals will lead to similar positive gains. Therefore, retail investors should do proper due diligence before committing capital into SPAC stocks.

Those who wish to take a diversified approach can also buy into a basket of SPACs through an exchange-traded fund (ETF). Examples of SPAC ETFs in the U.S. – an innovation still to reach Europe – include:

• CrossingBridge Pre-Merger SPAC ETF (NASDAQ:SPC)
• Defiance Next Gen SPAC Derived ETF (NYSE:SPAK)
• Morgan Creek-Exos SPAC Originated ETF (NYSE:SPXZ)
• SPAC and New Issue ETF (NASDAQ:SPCX)
• The De-SPAC ETF (NASDAQ:DSPC)

Potential investors should also research these SPAC funds in depth before hitting the ‘buy’ button. Many of these funds are relatively small and new with little trading history. Like other niche ETFs, most of these SPAC ETFs also have high annual expense ratios.

Private companies planning to go public can consider the SPAC route or a traditional initial public offering (IPO). Although the end result of becoming listed on an exchange is the same, there are differences between the two procedures.

• SPAC vs. IPO: Initial Process

A SPAC is a non-operational public company. The aim of this blank cheque company is to purchase (or merge with) a private business through a process also known as de-SPACing.  

However, in an IPO, a private company raises capital in the public market.  

Such a private company that is planning an IPO needs to prepare itself for an increase in public scrutiny and file paperwork and financial disclosures to meet the requirements of the SEC. 

To that end, it typically hires an investment bank to consult on the IPO and help set an initial price for the offering. Thus, an IPO involves banks that underwrite the deal, roadshows for potential investors, and detailed financial statements.

• SPAC vs. IPO: Costs

A traditional IPO can be very costly and time-consuming for a private company. For instance, one study found that investment banks can take between 3.5% to 7% of gross IPO proceeds in fees.

By agreeing to be purchased by a SPAC stock instead, a private company could reduce the red tape and costs associated with a traditional IPO. A SPAC deal generally needs a lot less money, particularly on legal fees and financial consulting. And the blank cheque shell entity, which has already raised a significant amount of money in its IPO, typically provides cash for the new stock. 

• SPAC vs. IPO: Time involved

The conventional IPO process is typically more time-consuming and costly compared to a SPAC transaction. Although both options go through an official approval process with the relevant regulator, taking the SPAC route for a private company is usually shorter. 

A SPAC merger requires 3–6 months on average, while an IPO generally takes 12–18 months. 

• SPAC vs. IPO: Financial and Operational Scrutiny

The IPO process involves a rigorous review of the private entity’s operations and financial statements. In addition, the roadshow is a time-consuming detailed process en route to fulfilling the reporting requirements necessary of a public entity. 

The share price valuation is an ongoing negotiation process that can change significantly as a result of supply and demand during the process. The offering price and the initial filing price can be significantly different.

SPAC reverse mergers are not typically subject to the financial audit linked to a traditional IPO. Sponsors of the initial SPAC stock complete the due diligence process and decide on a target company. There is also less volatility in terms of the initial share price. 

• SPAC vs. IPO: Management

When investors invest in a blank cheque SPAC stock, they typically rely on the expertise of the SPAC sponsors. But the target company is often unknown at the time of the SPAC’s initial IPO. Thus, investors cannot perform due diligence on the private company. 

However, SPAC sponsors are not obligated to stay on board following the de-SPACing, or reverse merger. Therefore, investors have to rely on the management of the target company for operations, leading to potential question marks. 

But, in the case of a traditional IPO, potential investors can conduct in-depth research about the company. In most cases, founders of private companies stay on board following the IPO, providing continuity of operations.

In 2020 and 2021, SPAC stocks were hot and a number of them made the headlines. Hundreds of SPAC IPOs occurred, many of which subsequently led to de-SPACing.

Examples of companies that have become public through a SPAC reverse merger

Some high-profile U.S. SPACs have already completed the reverse merger and started trading on the stock market under a different ticker. They are (in alphabetical order):

Dave (NASDAQ:DAVE): Dave and VPC Impact Acquisition Holdings III merger in 2022 was valued at $4 billion.

DraftKings (NASDAQ:DKNG): DraftKings and Diamond Eagle Acquisition merger in 2020 valued the company at $3.3 billion. 

Lucid Group (NASDAQ:LCID): LCID completed a reverse merger with Churchill Capital Corp IV in July 2021. The deal valued Lucid at $24 billion. 

Nikola Motor (NASDAQ:NKLA): Nikola and VectoIQ acquisitions merger in 2020 was valued at $3.3 billion. 

Opendoor Technologies (NASDAQ:OPEN): The iBuying platform agreed to go public in 2020 via de-SPACing with Chamath Palihapitiya’s Social 

Capital Hedosophia Holdings Corp II. The deal valued Opendoor at $4.8 billion. 

Payoneer (NASDAQ:PAYO): Payoneer and FTAC Olympus Acquisition Corp. merger in 2022 valued the company at $3.3 billion. 

Virgin Galactic (NYSE:SPCE) Virgin Galactic and Social Capital Hedosophia merger in 2019 valued the company at $1.4 billion. 

WeWork (NYSE:WE): WeWork and BowX Acquisition Corp merger in 2021 raised $9 billion to get the deal over the line. As of April 2022, it has a market cap of $5.5 billion.

An IPO lock-up is a contract signed by those investors who own shares prior to an IPO. As such, shareholders, or insiders, are prevented from selling their shares for a while after the IPO to protect the share price. Insider information could potentially lead to information asymmetry.

In the case of SPACs, when a target company is announced, shareholders have the possibility to retain or redeem their shares. Retained shares get converted to shares in the target company upon completion of the merger. 

In the U.S., following an affirmative vote by SPAC investors to complete the proposed merger, there are several legal steps to be completed. Finally, after the Super 8-K filing with the SEC, shares and warrants become subject to the lock-up period.

Although this waiting period might vary on a case-by-case basis, lock-up periods for SPACs generally last 180 days to one year, with the latter being more common. In comparison, standard IPOs generally require 90 to 180 days. 

Yet, in each case, there could be negotiations whereby SPAC sponsors and shareholders become subject to different lock-up periods. The U.K. has now dropped its previous insistence on an automatic lock-up if the SPAC has raised over £100 million. There could also be different arrangements in place for estate planning, gifts or trusts.  Therefore, potential investors need to research the requirement for the SPAC stock they are analysing.

When the merger is first announced, the initial $10 (or £10) share price of the SPAC stock tends to change significantly. SPAC share prices have often soared in recent years. However, how the SPAC stock price may react depends on numerous factors that relate to the target company in question, as well as the broader market sentiment. 

But the announcement of the target company gives sponsors, as well as investors, a chance to assess their holdings. 

After a SPAC successfully completes the merger, the company’s common stock automatically converts into the new company publicly listed on a stock exchange.

Post-merger, many investors hold on to their shares and continue to trade through their brokerage accounts. One topic that gets extra attention is exercising the warrants. 

The Financial Industry Regulatory Authority (FINRA) provides detailed information on the topic of SPAC warrants. Similarly, the SEC has issued information regarding accounting analysis of warrants. Potential investors who want to purchase warrants should do further due diligence on these complex instruments. 

U.K. tax authorities have yet to make clear how they will treat SPAC warrants, although private-sector advisors have attempted to clarify some of the issues at stake. The International Financial Reporting Standards council is also still finalizing its guidance on how to account for them.

Research, as well as market metrics, suggests that most SPAC stocks underperform the broad market and eventually drop below the original SPAC IPO price. 

The Edge Consulting Group looked at 115 completed SPAC mergers from 2016 through the end of 2020. They found that almost two-thirds of these SPAC stocks had declined a month after their merger closed. In addition, over 70% of SPAC stocks were down a year later. 

After the reverse merger closes, founder shares start trading, and SPAC  warrants can be exercised. For most non-redeeming shareholders, post-merger returns have been poor. Recent academic research highlights that this devaluation averages 25.2%, from the SPAC share price of $10 to an average of $7.48.

As a result of such returns, shareholder redemption rates are on the rise. In 2021, redemption rates were around 20%-25%, and rose even higher in 2022. Such high rates mean a number of SPACs do not have enough money to meet the requirements of the proposed transaction. 

There are several explanations for these poor returns. For starters, SPAC sponsors and managers do not get a salary during the initial SPAC creation and IPO process. They roughly own a fifth of the SPAC and get paid only when the reverse merger is closed. Therefore, there is an urgency to de-SPAC, even if it is not a favourable transaction. From a corporate governance standpoint, there is a potential misalignment of interests.

There have been several high-profile instances where investors found out that SPAC stocks have acquired private companies with lacklustre financial results. Wall Street has also witnessed misrepresentations of actual company operations. As a result, investor appetite has fallen for SPACs, leading to share price declines.

Another academic study suggests, “Although SPACs raise $10.00 per share from investors in their IPOs, by the time a SPAC merges with a private company to take it public, the SPAC holds far less in net cash per share to contribute to the combined company.” In other words, shareholder value gets diluted significantly. 

Other analysts highlight the cost of a SPAC listing, which gets borne by those who do not redeem their shares. For instance, in recent years, the average cost of a SPAC stock listing “was 14.6% of the post-issue market cap, while it was 3.2% for traditional IPOs.” 

Finally, regulators are increasingly scrutinising the SPAC space. For example, the SEC has recently made a proposal to enhance disclosure and investor protection. As a result, financial statements required of target private businesses in a proposed SPAC deal are likely to be as rigorous as those required of companies filing for a traditional IPO. 

In summary, the SPAC segment is evolving as it grows. Therefore, potential investors need to do detailed research before committing capital into SPAC stocks.