you may have seen the term “SPAC” emerge in financial news reports.
This new form of investment has caught on in recent years, with investors funding nearly $80 billion in SPAC acquisitions in 2020.
With the sudden rise in interest and the multitude of media written about SPACs, it can be tempting to think you’re missing out on a hot investment option. So today, let’s talk about what a SPAC is and some key details you’ll need to know before putting your investment dollars into one.
What is a SPAC?
For starters, let’s define this term. A SPAC is a “special purchase acquisition company,” or as it’s commonly referred to, a “blank check” shell company.
The reason it’s called a blank check shell company because the investors who back SPACs often have little idea what they are putting their money into.
Instead, SPACs are used as investment vehicles to purchase privately traded companies, often with the goal of taking them public. As such, the SPAC will typically only own the company it purchases and the funds from the leverage that company’s equity in an IPO (initial public offering).
There are several reasons a privately traded company might sell to a SPAC. First, for many private companies, the options for liquidations events are limited. The only time a founder or investor can cash out of their ownership share is when the company goes public through an IPO or gets acquired by another company.
Going public is expensive, time-consuming, and requires significant market interest. Some founders and venture capital investors are happy to skip the hassle of an IPO and cash out through a SPAC acquisition. This is the approach WeWork used when their IPO plans stalled.
With the recent increases in market volatility, it’s no surprise more companies are avoiding the uncertainty of an IPO and opting for a SPAC instead.
Key Investment Considerations
With all the buzz around SPACs, it may be tempting to add your investment money to the mix. But before you head down that road, here are a few elements of a SPAC to keep in mind.
Due diligence is lower. When investing in private companies, one of the most important steps is the due diligence process. During due diligence, an investor takes a close look at the company’s financials, as well as significant risk factors. However, when it comes to SPACs, the due diligence requirements are lower than that of a traditional IPO. This could leave a SPAC investor putting money into a company they don’t fully understand.
SPAC managers have a lot of power. When investing in SPACs, another key consideration is the manager making the purchase decisions. Since a SPAC is typically only investing in one company, the choice of that company is everything for the investor. However, given the lower due diligence requirements, investors may not have much say in company selection.
Incentives can be off. The last consideration has to do with incentives. With a hedge fund, the incentive is tied directly to performance. However, with a SPAC there are some signs that manager incentives may not be aligned with getting the best purchase price for the company. This could leave SPAC investors overpaying for an asset.
The investment world is often driven by what’s new and trendy. But just because a new investment vehicle is getting a lot of attention doesn’t mean its fundamentals are sound.
When it comes to SPACs, it’s worth considering who’s making the purchase decisions and why they choose to liquidate at this time. Weigh your options carefully. And remember, investing is a marathon, not a sprint.
Please note: this article is for informational purposes and does not constitute investment advice. Speak with a licensed investment professional before making a purchase decision.