Initial public offerings are hot right now, with many high-profile companies choosing to go public by making their shares available to ordinary investors. The IPO process, however, can be long and difficult to navigate, with potential traps for companies that aren't as successful as others in handling things like road shows and drumming up investor interest.

But there's an interesting alternative that some companies use to get their shares traded on public exchanges. Rather than filing all the paperwork associated with the required registration statement with the U.S. Securities and Exchange Commission, a company can instead merge with another company that's already public. To take advantage of that rule, some investors turn to special purpose acquisition companies, also known as SPACs, whose sole purpose is to raise capital from investors and then look to acquire an operating business -- often one that's privately held.

After a long hiatus, SPACs are once again becoming more popular. Most recently, the announcement that the parent company of Chuck E. Cheese will merge with SPAC Leo Holdings (NYSE: LHC) and return to the public markets has turned attention back to these investment vehicles. Before you invest in one, it's important to know what SPACs are and why you're seeing more of them.

Purple cards marked Play Pass with Chuck E Cheese character on them.

Image source: Chuck E. Cheese.

The basics of SPACs

A SPAC is essentially a shell company that doesn't have any operations of its own. The stated purpose of the company is to identify and purchase a business that's consistent with the investment objectives of the SPAC. Some special purpose acquisition companies limit themselves to particular industries, while others have free rein to make acquisitions in whatever type of company they wish.

SPACs begin by going through the IPO process, offering shares to investors. Typically, the proceeds from the IPO are held in trust while the SPAC seeks a takeover candidate. The terms of the SPAC specify a given time frame in which a merger must be completed. If that time period expires without an acquisition, then SPACs will typically return their capital to their investors.

If the SPAC finds a suitable company, then the two will merge. The combined entity then typically takes the name of the operating business, often changing its ticker symbol to reflect the new name.

The most important benefit of a SPAC is that the IPO process for a special purpose acquisition company is almost always a lot simpler than it would be for an operating business. Because the business purpose is so straightforward, the SEC rarely has extensive issues or questions up front. Moreover, once the SPAC is in place, the process for doing the subsequent merger is simpler than it would be to file a full set of registration paperwork with the SEC.

Why SPACs are making a comeback

We've seen periods before when SPACs were popular, especially before the financial crisis. But use of SPACs declined precipitously following the market meltdown. Greater regulatory attention played a role in that downturn, but there were also fewer privately held businesses seeking to go public at the time, and so the list of takeover candidates for SPACs was short. Many SPACs ended up failing to find companies to take over before their specified time limits ran out.

Recently, though, an excess of capital has led investors to seek out merger and acquisition opportunities more aggressively, and that's led to the return of SPACs. More SPACs went public in 2018 than in any year since 2007, raising more than $10 billion in capital for use in searching for investment opportunities. In particular, private equity funds have become key users of SPACs, as in the Chuck E. Cheese transaction.

Far from a sure thing

Individual investors should understand that investing in a SPAC isn't a guarantee of success. When The Wall Street Journal looked at SPACs from three or four years ago, it found that more than half of them traded below their initial offering price. Given the huge bull market that investors have enjoyed, that track record is worrisome.

As long as the IPO market produces victories for companies going public, then you'll see many businesses opting to go through that process to generate buzz. But SPACs will also remain a way for investors to bet on a leadership team's ability to find a smart acquisition. And despite the potential pitfalls, SPACs will generate interest from those who hope to find the right acquisition at the right price.