James McGlynn CFA, RICP
What are SPAC's-Blank check companies?
SPECIAL PURPOSE acquisition companies are hot. But will investors get burned?
Also known as “blank check” companies, special purpose acquisition companies (SPACs) are shell companies with no current business operations that raise investor funds through an initial public offering (IPO). The companies then seek a merger with a private company, allowing its new partner to go public without the delays and demands of a traditional IPO.
An additional advantage: The acquired companies are allowed to make projections about their business prospects, something not permitted with a traditional IPO. SPACs have existed for years. But they became wildly popular in 2020, raising $82 billion in the U.S., six times more than any previous year.
There are some characteristics common to most SPACs. They’re sold in $10 units, which consist of one common share plus an “out of the money” warrant or fractional warrant. The warrants typically have an exercise price of $11.50, meaning they give you the right to buy the underlying stock at that price and hence the warrants are only worth converting to the common stock if the share price rises above that level. Investors have five years to exercise their warrants after the merger. When SPAC units begin trading, they contain both the stock and the warrant, and have a “U” designation at the end of their ticker symbol to denote units.
SPACs can be traded through a brokerage firm, just like any other stock. While a SPAC will initially trade only as a single unit, investors later have the chance not only to buy and sell the units, but also to trade the underlying stock and warrants as separate securities. Result: There can be three securities associated with any one SPAC.
Because investors in the shell company’s units are effectively giving management a blank check, the warrants are one way to compensate them for the uncertainty involved. SPAC warrants often have a forced redemption price of $18 that can limit the upside. If you don’t exercise your warrants at the forced redemption price, they would expire worthless.
The proceeds raised in the IPO are held in trust. SPACs usually have a two-year window to either make an acquisition or liquidate the trust and return the proceeds to shareholders. The trust’s assets are held in Treasury securities, which many SPAC investors find appealing. Why? If no acquisition is made, the return of the units should be similar to a money market fund, but with the possibility of stock-like returns if the SPAC makes a favorable merger. One possible strategy: You could invest in a SPAC IPO and potentially redeem your shares for $10 plus interest before any merger happens, while hanging onto the warrants and the upside they may offer.
Indeed, when voting on any business combination, each stockholder has the right to redeem his or her stock for cash. Those stockholders who vote to redeem their shares receive cash equal to the IPO price plus accrued interest, but they still get to keep their warrants. Alternatively, shareholders may be offered the chance to vote to extend the search period for a suitable acquisition beyond two years.
After an acquisition, the management team of a SPAC—the founders—typically receive 20% of the new company. This generous slice dilutes the other shareholders and can lead to poor performance overall.
In addition to the investing public, the SPAC’s management team and the acquired private company, there can be other participants in each deal. Extra cash for the acquisition is often, though not always, raised from a group of large private investors, who are known as the PIPE investors. PIPE stands for private investment in public equity.
A SPAC’s share price often rises on announcement of a deal, especially if the target company is in a “hot” sector. Online gaming, electric vehicles and space exploration are popular with this crowd. Four high profile SPACs are DraftKings, Virgin Galactic, QuantumScape and Nikola. After the merger of a SPAC with a private company, the shares begin trading under the target company’s name and with a new stock symbol.
Are SPACs the sort of thing that the typical investor should buy? I spent my entire career managing money, so I’m comfortable dabbling in them. But my advice for most investors is to view SPACs as highly speculative investments. Skeptics suggest that, even though there’s a trust involved that holds Treasury securities, it’s possible that there’s less than $10 per share in the trust. On top of that, I’d be leery of assuming investors will continue to enjoy the sort of gains clocked by the early winners. Today, record amounts of SPAC money are chasing private companies, so there’s a real risk SPACs will end up overpaying for these private companies.