Six questions about SPACs, answered.
Forget the pandemic. Forget the recession. Investors are tripping over themselves to put their money into soon-to-be-public companies, and those companies are more than happy to try and list on the public markets. And to do so, most are not going the traditional route of an initial public offering, or IPO. They’re looking for something faster: a SPAC.
The term SPAC stands for special purpose acquisition company, which is essentially a publicly listed pile of cash meant to buy a private company. SPACs have become the main maneuver through which companies list on the stock market. Some see these vehicles as a smart way to invest in newly public companies, while others say unchecked enthusiasm for these financial products bears similarities to the dot-com boom and bust two decades ago. Indeed, the word “bubble” keeps bubbling up around SPACs. And new SPACs are coming out every day.
In just the first two months of this year, 189 SPACs listed on major stock exchanges, according to data from University of Florida professor and IPO expert Jay Ritter. At an annualized rate, that would mean more than 1,000 SPACs in 2021 — more listings than any year in history for SPACs and traditional IPOs combined. As of the beginning of March, SPACs have raised $64 billion, according to financial markets platform Dealogic, $20 billion shy of their record 2020 total. That means huge piles of cash to invest in mergers with private companies.
Once an obscure investment vehicle, SPACs are seeing interest from retail investors: normal people who don’t invest for a living, like those trading on Robinhood. They’ve been spurred by pandemic boredom and stimulus checks, as well as a number of recent, high-profile SPACs that have performed uncharacteristically well, like DraftKings.
There are a number of pros and cons to SPACS, and a variety of ways the SPAC boom could play out, especially now that there’s increased interest from retail investors. So here’s what you need to know about the hottest stock type on Wall Street.
What is a SPAC?
A SPAC is a shell company that goes public with the express purpose of raising money to buy an actual company (or companies). This effectively brings the operating company public more quickly than through an IPO. A SPAC has two years either to find a private company to merge with or return investors’ money.
People can invest in SPACs much like they would any other stock, but until it merges with another company, there’s no way to know how viable it is. And when those mergers are announced, the companies involved are frequently not only unprofitable, they often don’t even have revenue. Unlike regular stocks, however, people can get out of the deal and redeem a guaranteed $10 per share before the merger is finalized, so if they paid close to $10 a share, they have little to lose if they don’t like the merger.
This year, a number of high-profile SPACs have gone public, including Churchill Capital IV, which recently announced it was merging with Lucid Motors, an electric vehicle company that hasn’t yet manufactured a vehicle. The stock traded as high as $64 before the anticipated announcement and is now around $24, suggesting investors were either disappointed with Lucid’s production schedule or with the terms of the deal.
Who makes/loses money off SPACs?
SPACs are created by a sponsor, often an industry executive, who puts in about $5 million to $10 million of his or her own money in exchange for about 20 percent of shares in the SPAC, which will typically owns a minority stake in the merged company. If the SPAC finds a company to merge with for a good price, the sponsor stands to make tens or even hundreds of millions of dollars. If the SPAC doesn’t complete an attractive merger, the sponsor could lose their initial investment.
Still, even if investors lose money, the sponsor can still make lots of it. Michael Ohlrogge, a law professor at New York University who researches SPACs, calculated that the sponsor of Clover Health, which was trading earlier this week under its initial offering price, still made approximately $150 million.
In addition to getting the opportunities to buy SPAC shares at $10 each — and sell them back at that price if they don’t like the company — early investors also get to keep a stock warrant, which entitles them to buy stock at a set price for the next few years. Ohlrogge likens it to timeshares offering free flights in order to give people their sales pitch, with the hope that those people will decide to buy the timeshare (if they don’t, they still got free flights).
“It’s wonderful for the people who do it,” he told Recode. “It’s free money.”
The situation isn’t so rosy for regular retail investors, who can only buy SPACs when they hit the public markets, when the price is usually higher than $10. The further the price is from $10, the more retail investors stand to lose even before the merger is closed. For example, if you buy a SPAC at $15 but then don’t like the merger, you’ll lose $5 if you try to redeem it instead of holding onto the stock. After mergers, SPACs have historically underperformed.
What’s the difference between a SPAC and a regular IPO?
Both IPOs and SPACs are ways for a company to raise money. SPACs are a faster, but not necessarily cheaper, way to go public.
When you invest in a SPAC before it’s merged with a private company, you’re essentially investing in the SPAC’s sponsor, with the belief that their SPAC will make a good merger. With an IPO, you know what company you’re investing in. And in the case of Churchill Capital IV, people were investing in its sponsor company and its history of well-performing SPACs, as well as in Lucid, which many had speculated would be the target.
SPACs also receive less regulatory scrutiny than IPOs.
A core difference between SPACs and IPOs is how the companies involved can sell the deal to potential investors. Due to an unintentional legal loophole, SPAC sponsors — wealthy, often high-profile, charismatic individuals — can make promises about their companies without as much legal liability should those promises not come true. In turn, those rosy projections can help the company gain larger valuations. Companies doing an IPO, however, are constrained by Securities and Exchange Commission (SEC) rules from making claims about the future growth of their companies, making them “legally vulnerable to lawsuits in a way SPACs are not,” according to Tulane business law professor Ann Lipton. It’s a lot easier to sell people on the idea that a company is a good buy when you aren’t on the hook if those promises don’t come true.
Why are they so popular right now?
A lot has been written about SPACs recently, and their popularity has begotten more popularity. Last year, there were four times as many SPACs as the year before, according to Ritter’s data. This year, we’re on track for four times as many as last year.
High-profile SPACs, like the electric truck maker Nikola and DraftKings, have captured interest from institutional and retail investors alike. Popular SPAC sponsors, including early Facebook executive and so-called king of SPACs Chamath Palihapitiya as well as a spate of celebrity endorsements, including those of Jay-Z and Steph Curry, have made SPAC investment even more compelling.
“There’s a really strong appeal among people that there’s a smart person making investment decisions on their behalf who’s going to make them a lot of money,” NYU’s Ohlrogge said.
Additionally, many SPACs are looking for mergers in popular sectors like electric vehicles, where investors are hoping to replicate gains like Tesla, whose stock price is up more than 1,000 percent in the last two years.
“I think it’s partly a case of investors chasing past returns,” Ritter told Recode. “The last few months have been very good for SPAC investors, and money tends to follow past returns.”
The stock market is also doing well right now and, and as Bloomberg’s Matt Levine noted, SPACs are viewed as a way to capitalize on current market conditions in order to take a company public in the future, when the conditions may not be as good.
What’s the catch?
If investors put their money in SPACs and hold onto those stocks after the merger, they’re likely to lose more money, on average, than if they invested in regular IPOs.
While SPACs might be a sure thing for those institutional investors who are able to buy shares at $10 and redeem their money if they don’t like the eventual merger, the value proposition is less clear for those who get in later on. In a study of nearly 50 SPAC mergers in 2019 and 2020, Ohlrogge found that a year after mergers, returns on SPACs were nearly 50 percent lower than for a basket of IPOs. Ohlrogge also found that some 97 percent of those who bought SPACs at the IPO either redeemed or sold their stock by the time the merger closed.
What happens next?
SPACs could be a victim of their own popularity.
“There’s now so much money chasing deals, it’s going to be harder and harder to pull off attractive mergers,” Ritter said.
That could mean SPAC sponsors having to eat their investments if they don’t find a good merger. If historical SPAC performance is any indication, investors in companies that do complete mergers and go public aren’t necessarily safe either. Even people benefiting from the SPAC boom are wary. David Solomon, CEO of big SPAC underwriter Goldman Sachs, said earlier this year that the trend is not “sustainable in the medium term.”
For now, SPACs are in a very buzzy space, but when the buzz stops, they’re liable to sting.