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What Is Special Purpose Acquisition Company (SPAC)?

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by José Oramas · 6 min read
What Is Special Purpose Acquisition Company (SPAC)?
Photo: Depositphotos

SPAC IPOs have their detractors and supporters. To better understand what SPACs can offer to you as an investor, read this guide.

A special purpose acquisition company is the result of combining venture capitals and equity investments. Markets from the United States launched this instrument in 2003. The creation of SPACs allowed mid-market investors to support experienced managers so they could give entrepreneurs alternative means to secure capital and financial development combined with private capital, of course.

At the same time, the rapid growth of hedge funds, managed assets combined with the lack of compelling returns available in traditional asset classes led institutional investors to popularize the structure of SPACs given their relatively attractive risk-reward profile. By 2007, SPACs already accounted for 27 % of Initial Point Offerings on US exchanges, reaching European markets shortly thanks to their increasing popularity.

Originally, SPACs only accounted for a small segment in the equity markets. Now they have grown to become popular alternative routes for companies that want to go public. These financial vehicles raise money from private investors to ultimately buy an unlisted company in the US Stock Exchange.

How a SPAC Works?

A SPAC agent raises capital from several investors and starts researching companies of a particular line of business to buy. The value assigned to the SPAC responds to investor’s expectations about the acquisition. Typically, the acquisition is made using funds raised from investors, placed in a fund that generates special interests until the purchase is completed and the payment is made to the previous business owners.

SPAC promoters have at least two years to successfully complete the acquisition. Meanwhile, the amount of capital raised is stored in treasury bonds and deposited in a custodian bank. Only a small amount is retained for working capital needs. But not only agents will have to return the money to shareholders if the acquisition fails – if investors are displeased and disagree with the transaction, the remaining money is returned as well. It’s essential that SPAC promoters gather all the information they need to make an accurate acquisition, and ultimately succeed.

As stated, if the special purpose acquisition company fails to list the company in the stock market, all the money is returned to investors. The rise of SPACs has generated a lot of commission income for underwriters and led to several investment banks to reorganize their stock teams to join the trend.

In essence, the underlying objective is pursuing contracts that can benefit shareholders as well as the company, through an agent that gathers private capital from several investors. SPACs are called “blank check companies” because they usually avoid spreading extensive information during the initial public offering. SPAC agents do this by avoiding identifying the targeted acquisition at first.

This approach typically requires the SPAC’s promoter to work with an investment bank to structure the fund and provide interested investors with the opportunity to participate in the project.

Examples of a SPAC (Special Purpose Acquisition Company)

A group of investors gathers to form a SPAC to buy a company that makes products using a particular type of artificial sweetener. By the time the SPAC is formed, they don’t know which company they want to buy but they do see considerable potential profits if they enter the market and make the purchase.

They team up with an investment banker, and the core group of investors functions as the managers of the new corporate entity, setting the task of seeking the participation of other investors, usually with the promise that they will become shareholders of the acquired company.

In the event that a suitable company cannot be purchased, the SPAC returns the funds raised to each of the participants. If the acquisition goes well, all participants will benefit from the deal, with the managers who organized the special purpose acquisition company receiving a portion of the proceeds, and the investors who contributed to the blind trust receiving shares in the newly acquired company.

Pros/Cons of a SPAC

SPACs have their pros and cons as well. If you are the owner of a small company, usually private stock funds, then SPAC can be an attractive route for your business. Going for a SPAC can increase the sale price of your company up to 20% compared to classical private equity deals. Typically, agents will gather an experimented panel that will guide them through the IPO process. Usually, a partner will be assigned to you, so you don’t have to worry if the market gets volatile, depending on investors’ sentiment.

But SPACs have their cons as well:

  • There’s a considerable dilution for the acquired company as founders can only keep 20% of the equity.
  • If the contract is consummated In the two year period, the SPAC promoter only keeps 20% of the investment, or returns the capital to investors.
  • The number of SPACs have increased exponentially during 2020, especially in November —a month where SPAC IPOs raised more than $62.5B. Thus, the current amount of SPACs in the market is overwhelming to an extent that popular private companies have their own SPAC suitors. At first, this sounds good for the targeted company, but it’s harmful for SPAC investors: if the acquisition gets higher, investors will receive a lower return at the end.

High-Profile SPAC Deals

In earlier, 2020, a high-profile acquisition that involved a SPAC occurred with Virgin Galactic Holdings Inc (NYSE: SPCE), a spaceflight company, and Chamath Palihapitiya, founder of Social Capital. Palihapitiya, a famous venture capitalist, invested $800M in Virgin Galactic, owned by Richard Branson.

Another popular IPO ran with a SPAC was Nikola Corporation (NASDAQ: NKLA), typically referred to as “Tesla’s competitor”. VectoIQ Acquisition targeted the company in mid 2020, listing Nikola shares in the Nasdaq as: NKLA.

How to Invest in SPACs?

If you decide to invest in a SPAC, you can choose between personal securities or investing in SPAC Exchange-traded Funds. Currently, the only SPAC ETF is SPXC (NASDAQ: SPXC). It’s the only SPAC ETF active in the Stock Market that offers direct exposure to these capital markets.

One good way of going into SPAC IPOs is investing when the agent has fully acquired the company and published at least two quarters of audited financials. It’s not recommendable to invest in SPACs until the hype for a new company is over. This can overwhelm potential investors due to the extensive amount of information there is.

With personal SPAC shares, you’re exposed to a wide range of opportunities in this type of market while still having downside protection thanks to its structure. Usually, when a SPAC announces its target, investors will sell their holdings within a week, making considerable returns.

Conclusion

SPAC IPOs have their detractors and supporters. There’s a number of growing critics who fear that companies listed through SPAC do not receive the same scrutiny as traditional IPOs, creating risks for investors.

But, typically, SPAC offers several advantages through time, like faster and a cheaper process than classic IPOs.

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FAQ

How does a SPAC work?

A SPAC agent raises capital from several investors and starts researching companies of a particular line of business to buy. The value assigned to the SPAC responds to investor’s expectations about the acquisition. Typically, the acquisition is made using funds raised from investors, placed in a fund that generates special interests until the purchase is completed and the payment is made to the previous business owners.

SPAC promoters have at least two years to successfully complete the acquisition. Meanwhile, the amount of capital raised is stored in treasury bonds and deposited in a custodian bank. Only a small amount is retained for working capital needs. But not only agents will have to return the money to shareholders if the acquisition fails, if investors are displeased and disagree with the transaction, the remaining money is returned as well. It’s essential that SPAC promoters gather all the information they need to make an accurate acquisition, and ultimately succeed.

This approach typically requires the SPAC’s promoter to work with an investment bank to structure the fund and provide interested investors with the opportunity to participate in the project.

What is a SPAC investment?

A SPAC investment usually involves a personal SPAC or SPAC ETFs (Exchange-traded funds). In the case of SPAC ETFs, investors gain exposure to these capital markets without directly having to trade them in the stock market. 

Naturally, SPAC ETFs also involves risk, as the fund could be traded at a premium or discount to Net Asset Value (NAV). Besides, European capital markets can differ from US markets, as there are several factors that can add risk to SPAC ETF, such as currency fluctuation and major political events.

With personal SPACs, you’re owning the shares of a capital market. The advantages of personal SPACs is that you can liquidate your holdings at any time.

What are SPAC warrants?

When you buy a unit or share of a SPAC you also acquire a warrant. This warrant gives you the right to acquire another unit or share, and even trading it on the market. It is essential to note that, unlike other instruments, the company can be listed without an operation history. Hence, its value will begin to fluctuate in the market once they have completed the acquisition of the company.

Why are SPAC so popular?

Typically, IPO pops occur thanks to investment banks underpricing the offering price of companies that want to go public. Thanks to this, several investors argue that the IPO process is not effective anymore, giving rise to SPACs and becoming popular routes to private companies to go public. Companies that want to go public choose SPACs as they have a cheaper process than IPOS with a shorter time frame.

What is a blank check company?

SPACs are called “blank check companies” because SPAC agents usually avoid spreading extensive information during the initial public offering. Thus, a “blank check company” is a publicly-traded company under development without an established business plan. Like SPACs, they are used to raise funds as a start-up / Initial Public Offering, or to merge a business entity.

What is an initial public offering (IPO)?

Initial Public Offerings are operations where one or more shareholders or even the company itself put financial assets up for sale. For the company, it has no effect on the share capital as there is only a change in ownership, not in the number of outstanding shares. IPOs are usually aimed at the general public or have restricted access.

Mainly, there are two types of IPOs:

  • Pre-IPO shares: These are companies that are not traded on the stock market, but are looking to place their shares there for the first time, which requires an application for admission to trading.
  • Listed IPO shares: Refers to companies already listed, where one or more shareholders sell their shares.
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