What is a SPAC? | How do they work and how to invest in them?

What are SPACs and why have they revolutionized the Wall Street market? At a time when it seemed that IPOs were going to suffer a sharp decline (due to the coronavirus crisis), this (we can't say it's new) business model burst onto the scene with strength and provided opportunities for both startups and investors with a formula to jump onto the stock market.

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However, since the first half of 2022, it seems that the SPAC model has been called into question. What happened? In this post, we explain it to you

What is a SPAC?

special purpose acquisition company

The name SPAC is identified with the acronym for “Special Purpose Acquisition Company” (company for special acquisition). They are also called “Blank Check Companies.”

Basically, a SPAC is a company without a specific business model: it has no commercial activity. Its only purpose is to raise funds to carry out mergers and acquisitions.

Its mission is to raise funds through an IPO. That is, through an Initial Public Offering (IPO), the company offers shares in exchange for raising capital.

The money is deposited in a trust account (an escrow account) that earns interest and the goal is to buy one or more companies to create a new resulting company that is listed on the stock market.

How does a SPAC work?

Sometimes, it can be a bit complicated to understand how the strings are pulled within these types of organizations that are far from what we use to know until now.

However, I will divide this section into some sections to clarify, as much as possible, the actions carried out by a SPAC.

The SPAC goes public

This is fundamental to understand and that is the SPAC is born with the sole purpose of going public. It does so without having started or developed any type of business activity, as its task is to raise money.

The sum they can obtain after this IPO is invested in possible mergers they can make with other companies that can provide them with greater growth, one of the options already mentioned.

Shareholders invest blindly

Whenever we talk about investing, we do it with great care, as you need to have very solid knowledge to avoid losing money that may be needed in the near future.

This contrasts a bit with the operation of a SPAC, as after going public shareholders invest without knowing what mergers are being considered or what companies have been targeted for acquisition.

Because of this, one might think, how can I invest money in something I do not know or know what result it will have? Well, the answer is that these shareholders review the resume of those who are behind this type of companies.

As we said, they are usually recognized investors or finance professionals with extensive experience. This offers a security that encourages investment.

The money is held in custody

The money that the SPAC receives from it shareholders are deposited in a trusted domain in this type of investment and it is held in escrow.

That is, the SPAC cannot use it unless it is going to buy a company or carry out a merger. This happens because investors must give the green light for what has been promised to be fulfilled, something that increases their confidence.

Shareholders can recover their money

It is not uncommon for a SPAC to fail to close any merger or purchase agreement of a company that may have promised the shareholders who have put their money for it. Therefore, one might think that, even if this does not happen, the money should be considered lost.

However, this is not the case for the peace of mind of those who have invested part of their capital. If the money from the shares is not invested, it must be returned.

This is a way to guarantee shareholders that they will always receive a guarantee for trusting and depositing a certain amount in the shares of the SPAC.

Thus, they will not lose out in any of the circumstances, something that reassures from the first moment. Perhaps this is what is increasing interest in this type of companies. Because, security in investments does not always have guarantees.

How to invest in a SPAC?

The most suitable way to invest in a SPAC is to buy its shares in the secondary market of these types of companies through a stock broker (it is not advisable to go to the IPO due to the risk of these stock operations and because, in the first instance, institutional investors and insurers participate in this process).

This is an alternative that provides diversification, since the investor has the opportunity to participate in a model similar to a venture capital fund.

Normally, blank check companies represent a speculative model that is not without risks. Financial regulators try to protect the rights of investors and maintain confidence in the system.

Therefore, a product of these characteristics is not without controversy and the Securities and Exchange Commission of the Finance Division of the SEC has spoken on the matter.

With respect to the Financial Conduct Authority (FCA), this model is accommodated according to it regulations. No type of modification would be necessary to make room for SPACs.

Investing in SPACs through ETFs

There is no better way to mitigate risks than building a diversified portfolio. For this reason there are SPAC ETFs and it is possible to invest in them by simply buying their shares, just as if they were company shares (with the services of a broker).

An example of this is the ETF SPAC and New Issue (SPCX), the first actively managed product on these types of companies. With the ability to manage a SPAC portfolio in an agile way.

This ETF was launched on the market on December 12, 2020. Therefore, it does not have historical data in terms of profitability. However, we show a list of some of the SPACs that make up its portfolio.

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Rise and fall of SPACs

what is a spac ipo

Rise of SPACs

When we talk about SPACs we must know that it is not a new model, in fact, it has been on the market for decades. However, due to the continuous changes that the economy faces, the emergence of new startups and the new investment needs marked by the coronavirus pandemic have put this formula on everyone's lips and, in 2020, it burst onto Wall Street with force.

According to the SPAC market report published by Duff & Phelps, from January 1, 2017 to September 30, 2020, 90 transactions were completed, for a value that exceeded 90 billion dollars. In 2019, 20% of Initial Public Offerings were SPACs

However, in 2021 a particular bubble was experienced, as only during that year, it is estimated that more than 600 SPACs were closed for a total amount of 140,000 million dollars, of which a seventh part, 19,000 million, were closed only in January 2021.

However, since then its value and investment have fallen considerably, so, was it a new bubble on Wall Street?, What happened?

Fall of SPACs or return to their normal condition?

Indeed 2022 is not a favorable year, and of course, the fact that there are macro conditions that do not help (rate hike, bear market, reduction of the population's savings levels, high inflation), punishes them, however, all these are enveloping causes, there is a more nuclear cause.

And it is that behind the falls of the SPACs hides the constant loss of value for the shareholders.

According to a report from Renaissance Capital, a research and advisory platform for IPOs , recently pointed out that of the almost 600 companies that went public in 2021 through a SPAC, a year later, only 11% are more valuable. And on average, the whole set of them, lost an average of 43% in value.

And in the same vein, another article from Pitchbook concludes that companies that merge with SPACs traditionally have poor track records and, in many cases, set IPOs at very high prices with the idea of going public at a high quote, and raising money at the initial moment of the sale. Moreover, some of the companies that merged, many of them newly created, not only did not reach the goals they set, but they were light years away from them.

For example, Virgin Galactic, Richard Branson's space tourism company, went public through a SPAC in 2019. It expected 210 million in 2021, but barely reached 4 million dollars.

Undoubtedly, this widespread behavior, a product of stock market euphoria times, where more than adding value, the aim is to make money by any means, has punished these IPO figures, reducing the first half of 2022 to 78 such companies, which raised about 15,000 million dollars.

Why are these companies called Blank Check Companies?

The reason they are called Blank Check Companies is none other than these types of companies do not disclose the acquisitions they are going to make (in some cases the sector is revealed). In this way, it is as if a blank check or a blank check is given to the executives, trusting in their ability to reach agreements.

Generally, the companies so named are those that are dedicated to raising funds without a clearly expressed business model. SPACs are simply a type of blank check companies.

This consideration is relevant because the Securities Exchange Commission (SEC) considers them as “penny stock” or penny shares (microcap shares). So this regulatory body imposes a series of additional requirements on them (such as depositing the money in an escrow account until the acquisitions are carried out and the combination of the companies is made).

Advantages and disadvantages of investing in SPACs

Advantages of investing in SPAC

The SPAC usually find opportunities in disruptive sectors, which usually present a special appeal in the medium and long term. Finding an emerging technology company and launching it on the market can generate great benefits.

Furthermore, the price of SPAC shares does not usually skyrocket after their IPO. They may experience strong fluctuations in their price when the commercial operation being carried out is announced, however, before this the market remains expectant and does not suffer the typical ups and downs of mass greed and fear.

In any case, the investor who buys shares in a SPAC must be patient. The agreements may take time to arrive and the shares meanwhile may remain stagnant (since the money is in an escrow account and no operation is carried out).

Risks of investing in SPACs

In principle, information is provided about possible cases where there may be a conflict of interest when the SPAC sponsors do not work exclusively for it. This conflict of interest is nothing more or less than the recovery value for the SPAC directors is linked to the price paid. The interests of the sponsors differ from those of the shareholders.

There may also be the situation where the directors of the SPAC carry out other commercial activities and this can affect the search and selection of the acquired company.

On the other hand, as there is a predetermined period to complete the acquisition process, if, as it approaches, the SPAC has not found a purchase opportunity, its options are reduced and may end up forcing agreements. In this case, the SPACs should disclose what the administrators' incentives are when completing a transaction.

It is also true that many companies without sufficient “quality” may start their journey in the stock market and this would pose a risk to investors. It would be necessary to carefully assess to what extent it is worth having shares in the acquired company.

Similarly, the opportunity found may not be so good. Does the investor have the means to know if the operation is really beneficial? Purchases are made on unlisted companies, therefore, without sufficient transparency. In addition, in many cases, these are technology companies or startups that are difficult to value.

We could also find ourselves in the situation where the SPAC requires additional financing to complete the acquisition and increases the capital with a new issue, which would dilute the value of the existing shares.

The pros and cons of investing in SPACs are summarized in the following table

Pros of investing in SPACsCons of investing in SPACs
Opportunities in disruptive sectors
(high technology)
❌ Conflict of interest shareholder / sponsors.
Lower volatility at the beginning❌ Hasty search for partners.
Money secured until the SPAC is carried out❌ Risk of lower quality companies.
 ❌ Less transparency in information.
 ❌ Risk of capital increases.

In summary, SPACs represent a new way of investing with multiple benefits (especially for the acquired companies). However, the risk it poses for the investor should not be overlooked.

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FAQs about SPACs

What happens if a SPAC does not merge?

SPACs have a time frame usually between 18 – 24 months in which they need to merge with another company and close a deal. If a SPAC cannot merge during the allotted time, then it liquidates and all funds are returned to investors.

How is SPAC different from IPO?

In an IPO, a private company issues new shares and, with the help of an underwriter, sells them on a public exchange. In a SPAC transaction, the private company becomes publicly traded by merging with a listed company—the special-purpose acquisition company (SPAC).

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