SPACs Create Unique Risks for Investors

by Marc Fitapelli | December 9, 2021 3:24 pm

SPACs Create Unique Risks for Investors

A special purpose acquisition company or SPAC is a publicly-traded company created specifically to merge with or be acquired by another company. These companies are also sometimes called “blank check companies” and are often promoted as a simpler way to take a company public than to go through the more traditional Initial Public Offering or IPO.

Investors must be aware of the two major phases for a SPAC:

  1. When the SPAC is in its shell company stage.
  2. During and after the merger or acquisition. (When the SPAC joins or is bought by an operating company, it is called an initial business combination).

SPACs are Shell Companies

It is important to know that SPACs are shell companies when they become public. SPACs have no underlying operating business and their business plan is simply to be merged with or to be bought by another operating company. They usually have a low market cap (no more than $300 million[1]).

The people that formed the SPAC are called the sponsor(s). When these sponsors identify a potential initial business combination, the SPAC shareholders vote on the merger/acquisition if the sponsors do not have the majority vote. The resultant combination is usually structured as a reverse merger although there are other structures for the initial business combination.

What are the risks of investing in a SPAC?

Unfortunately, several risks exist when investing in a SPAC at its IPO phase, before the Initial Business Combination. Primary among these risks is that the SPAC has no operating background, unlike companies that go through a traditional IPO.

Let’s take Facebook, for example. By the time it offered shares to the public in its IPO in 2012, it had already been operating for eight years[2]. Investors knew its business history and its product. SPACS have no such history.

Investors must therefore study the SPAC’s prospectus and various SEC filings thoroughly to gain an idea of the company’s financials and background before investing in it.

Celebrity Hype

Using celebrities to hype up a SPAC has become a common practice to attract investors. Investing in a SPAC simply because some famous personality is involved in it is a poor reason for doing so. Celebs can be swindled just like any other investor.

Regardless of whether the celebrity is a sponsor of, or investor in, the SPAC, ignore their hype when making your decision.

Celebrities are also often able to swallow up much higher risk than the average retail investor.

Trust accounts

SPAC IPO proceeds are often held in trust accounts until the SPAC is liquidated or the initial business combination is complete. It’s important to review the terms of the offering to know what the proceeds are being invested in.

During a business combination, investors can either redeem their shares or buy shares in the new company, thereby becoming shareholders. But if the SPAC does not complete a business combination, then shareholders are usually paid a pro-rata amount of what is in the trust account. This can sometimes be less than the investor initially paid into the account.

Trading price fluctuations

Unlike the complicated procedure to price shares during a traditional IPO, SPACs are usually priced at a nominal $10 per unit. During a traditional IPO, the price can fluctuate according to the business’s potential in the eyes of investors. But SPAC IPO price fluctuations have nothing to do with the underlying business, as there is no underlying operating business until the merger occurs. In essence, it’s a blind investment at the IPO phase.

Scarcity

The market is glutted by SPACs looking for businesses to combine with. This can reduce the availability of attractive mergers/acquisitions.

Remaining a shareholder or redeeming

Once the SPAC merges with an operating company, it essentially changes from being a trust account to becoming an operating entity. Investors must do whatever due diligence they can to determine if they wish to remain on as shareholders of the new company, or if they wish to redeem their shares for a pro-rata share of the aggregate amount currently deposited in the trust account.

Redeeming for a pro-rata share could mean obtaining less than the shareholder initially paid. But remaining in the company as a shareholder could mean other losses as it is not always possible to know the acquiring company’s merits if it is very new.

Sponsor conflict of interest

Generally speaking, sponsors obtain shares in the SPAC at more favorable rates than investors in the IPO, or later investors on the open market.

The majority of the capital for a SPAC will have been provided by investors. But sponsors and initial investors often stand to benefit more than later investors from a business combination. This might incentivize sponsors to complete initial business combinations on terms that are less favorable than the investor would expect.

To learn more about the sponsors’ interests in the SPAC, investors should study the following sections in the SPAC’s IPO prospectus:

What is the SEC’s view of SPACs?

The SEC considers SPACs—or “Blank Check Companies”—as penny stocks. By definition, penny stocks are highly speculative due to their low liquidity which can make it difficult for investors to find a price that matches the market price.

As such, SPACs are subject to additional restrictions and regulations from the SEC. One such restriction is that SPACs are often required to deposit any raised funds in an escrow account until an acquisition has been agreed to and approved by a shareholder vote.

Whereas there are indeed SPAC success stories, such as the recent ride-hailing Grab Holdings Inc[3] which completed an acquisition with as little as 0.02% investor pull-out, or the promising BASF-backed Essentium merger[4] that is now on the cards, such success stories relate to companies who already have a track record and a product to sell. And the risks at the IPO phase still exist.

When considering a SPAC investment, particularly at the IPO phase, investors are advised to exercise extreme caution.

Did You Lose Money Investing in a SPAC?

Endnotes:
  1. $300 million: https://www.investor.gov/introduction-investing/investing-basics/glossary/microcap-stock
  2. operating for eight years: https://www.history.com/this-day-in-history/facebook-raises-16-billion-in-largest-tech-ipo-in-u-s-history
  3. ride-hailing Grab Holdings Inc: https://www.bloomberg.com/news/articles/2021-11-30/grab-heads-for-public-market-after-investors-approve-spac-merger
  4. Essentium merger: https://www.bloomberg.com/news/articles/2021-12-01/basf-backed-3d-printer-essentium-to-go-public-via-spac-merger

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