A SPAC is a high-risk but potentially profitable way to get in on the ground floor of a new stock

richard branson virgin galactic ipo spac — Sir Richard Branson on the floor of the New York Stock Exchange as their SPAC-sponsored Virgin Galactic begins public trading in October 2019.
Brendan McDermid/Reuters

A Special Purpose Acquisition Company (SPAC) is a company created solely to merge or acquire another business and take it public — a cheaper, faster alternative to an initial public offering (IPO).
Investors essentially write blank checks to SPACs, which can take up to two years to target and buy another firm.
SPACs offer individual investors the chance to get in on the ground floor of a potentially big stock, but are also highly risky.
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A lot of individuals would love to get in early on an initial public offering (IPO) — a company’s launch on the stock exchange — before the shares start jumping on fever-pitch demand. But pension funds and professionals usually get there first, leaving “retail investors,” as Wall Street calls them, typically picking up the post-offering breadcrumbs — and often paying a higher price.

But a back-door, formerly out-of-favor IPO approach known as a SPAC has recently roared back in popularity among entrepreneurs and venture capitalists. It may offer a new opportunity for small investors to get in on the action at the beginning.

What is a SPAC?

SPAC is an acronym for a Special Purpose Acquisition Company, basically a publicly traded firm that has no operations, no assets — other than a war chest of cash — and just one stated business plan: to eventually buy another company.

A SPAC is generally formed by a group of investors, called sponsors, with a strong background in a particular industry or business sector. They raise funds from other investors, and use the money to acquire an existing, privately held company — and then take it public in an IPO.

When they launch the SPAC, the sponsors generally either don’t have a specific target in mind, or they’re not ready to name it in order to avoid the extensive paperwork and disclosures required by the Securities and Exchange Commission (SEC).

The early-bird underwriters and institutional investors, and the individual investors who generally come in later, typically have no idea exactly how the sponsors will spend the money. So early investors are basically relying on the sponsors' reputation in the hope of snagging a good investment.

But they've got to be prepared to wait. Even after a SPAC goes public, it can take up to two years to pick and announce the target company it wants to acquire, or technically speaking, merge with (the corporate charter specifies the exact time frame, per SEC regulations). If it doesn't, the SPAC is liquidated, and funds it's raised are supposed to be returned to investors.

All this uncertainty is one reason why most SPACs trade at only $10 a share. Of course, the assumption is that when, and if, they acquire a company and take it public, the share prices will soar. At this point, investors can cash out, or hold on for longer-term gains.

How SPACs work

If the SPAC set-up sounds like a situation ripe for abuse — it once was. Back in the 1980s, a lot of fraud surrounded these blank check companies, as they were then known. Many were purely shell companies, offering thinly traded penny stocks or "pink sheets." Often these firms either absconded with investors' cash or engaged in overvalued insider deals that left many investors with a bagful of nothing.

Since then, however, the metamorphosis from blank check company to SPAC has involved more than just a name change. The SEC has tightened regulations and procedures for these ventures.

Now, for example, a SPAC generally has to place the investor money in a trust or escrow account to keep it secure until the target company is publicly announced. At that point, if investors don't like the looks of the deal, they should be able to recover their funds.

SPACs also have to register with the SEC, even if they're relatively small (which in the IPO universe means assets under $1 million).

SPAC Pros and Cons

Like any investment, SPACs have advantages and disadvantages.

Advantages of SPACs

They're cheap. Many SPACs are priced at $10 a share, well within reach of retail investors. And they stay low for a while. "SPAC IPOs on average don't jump on the first day of trading," notes Jay R. Ritter, the Joseph B. Cordell Eminent Scholar Chair at the University of Florida's Warrington College of Business, who researches IPOs. "The average increase this year on the first day of trading has been 1.7%, so buying in the market might mean paying $10.17 or so."
They invest in hot areas. The new breed of SPACs focuses on sexy sectors in the tech or consumer fields. Promising startups like Opendoor, Clover Health, and electric automaker Nikola are among the firms that have gone public via SPACs.
They're open to individual investors. Even though institutional investors usually go to the front of the line for SPAC offerings, the high number of shares sold makes it easier for smaller investors to get a piece of the action.

Disadvantages of SPACs

Blind investment. SPAC investors usually don't know how their money will be used — what the SPAC's target company is (often the sponsors don't know either). So the deal's impossible to evaluate.
Lag time. There can be a long lag between the time investors pump money into a SPAC and when it actually buys up a company and starts operations. Your money may sit for up to two years in an escrow account. If no acquisition happens, your funds are returned, but idling capital for that long may be painful.
Mixed track record. In a July 2020 report, Goldman Sachs analyzed the performance of 56 SPACs — primarily in the technology, industrials, energy, and financial segments, — that "merged" with their target companies beginning in January 2018. "During the one-month and three-month periods following the acquisition announcement, the average SPAC outperformed the S&P 500 by 1 percentage point (pp) and 11 pp, respectively, and beat the Russell 2000 by 6 pp and 15 pp, respectively," the report notes. "However, the average SPAC underperformed both indexes during the 3, 6, and 12-months after the merger completion."

Of course, some SPACs do better than that. For example, Virgin Galactic Holdings (SPCE) — a particularly high-profile offering — has appreciated 146% in the year since it went public via a SPAC in October 2019.

Why SPACS are becoming popular

SPACs embarked on their newly respectable road in the mid-2010s. Big-name entrepreneurs, hedge-fund managers, and celebrities like Richard Branson, Bill Ackerman, and Michael Jordan became involved in them, as did mutual fund companies like Fidelity and T. Rowe Price, and investment banks like Morgan Stanley, Credit Suisse, and Goldman Sachs.

Their numbers swelled in 2020. As of early October 2020, SPACs have launched 128 IPOs, raising a total of $49.1 billion, according to SPAC Research, which gathers data on SPACs. That's up from 2019 when just 59 SPACs raised a total of $13.6 billion.

Certainly, the COVID-19 pandemic has been a factor. SPACs tend to fare better in periods of stock market decline because of the way they work.

Also, compared to a traditional IPO, SPACs offer certain advantages to sponsor-organizers and to the companies who want to go public. One is the streamlined disclosure requirements that save time, money, and trees.

SPAC IPOs are further turbocharged because there are fewer people involved. A traditional IPO involves "multiple investors negotiating with issuers and underwriters simultaneously, about specific terms like the offering price, executive compensation, underwriter rights, and multiple other issues," says Tyler Gellasch, executive director of Healthy Markets Association, a nonprofit, investor educational coalition. "But in a SPAC, it's often just the sponsor and the target company at the table."

So deals can move faster.

How to invest in SPACS

Getting into a SPAC is not as simple as buying regular equities: Hedge funds, mutual funds, and other deep-pocketed institutional investors typically find out about a new SPAC first. "It helps if a would-be investor has an existing relationship with a SPAC sponsor," says Tyler Gellasch.

But if Michael Jordan isn't among your contacts, there are other ways to break into the world of SPACs:

Your friendly stockbroker or wealth manager. Ask them to keep an eye out for offerings
The websites of IPO-oriented investment banks. One SPAC specialist, Early Bird Capital, lists companies that are actively seeking targets.
The NASDAQ website also lists upcoming IPOs, including SPACs, which can be identified by a ticker symbol that generally ends with a "U."
Industry associations like SPAC Research sometimes highlight S-1 filings, which give formal notice of a SPAC's intention to go public.

The financial takeaway

A SPAC is definitely not "a 'widows and orphans' investment," according to Gellasch. "For one thing, you may be tying up your money for a year or more without knowing what the ultimate investment will be. The sponsor and institutional investors may know — at least generally — what they're looking to do with the funds, but the small investor will likely be in the dark."

"Until a deal is announced, the investor is just hoping that a good merger will happen," Ritter adds. And of course, there are no guarantees as to returns after it does. SPACs are speculative animals. They tend to acquire growth companies — start-ups and fledgling firms — which, by their nature, are higher-risk than, say, established blue-chip companies.

Still, SPACs offer smaller investors a way to get into the IPO game — if not up in front with the big players, at least not too far behind them.

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