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Special Purpose Acquisition Companies: Why SPACs Are Hotter Than Ever

By Dan Caplinger - Jun 27, 2020 at 7:14AM

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Believe it or not, investors used to avoid these investment vehicles.

Going public has long been a key milestone for successful companies to achieve. In the past, having your stock go public through an IPO showed the world that your business had proven itself and was ready to play in the big leagues. Even as the benefits of staying privately held for longer periods of time have become more evident recently, it's still a mark of distinction to have your stock traded on major stock exchanges.

However, the IPO process itself has gotten in the way of some companies coming public. Substantial expense and effort to comply with the regulations governing initial public offerings has deterred many businesses from doing IPOs, and some have sought alternative methods for making their shares available to ordinary investors. One such method involves special purpose acquisition companies (SPACs), and because of some big success stories lately, SPACs are now hotter than ever.

White mosaic squares spelling IPO against a yellow mosaic background.

Image source: Getty Images.

What's a SPAC?

A special purpose acquisition company is an entity that's set up specifically as a shell company with no immediate business purpose of its own. Rather than going into business for itself, each SPAC seeks to make an acquisition of an existing business.

If the SPAC is successful in finding a suitable business, then it does a merger with that company. From then on, the SPAC takes on the identity of the business that it's acquired.

Different SPACs are set up with different goals in mind. Some give their management teams complete discretion to purchase any type of business they want. Others target more specific sets of companies in certain sectors, industries, or geographical locations.

Why do companies like to go public through SPACs?

The benefit that SPACs offer their potential acquisition candidates is a simplified process for making their shares available to public investors. The SPAC itself goes through the U.S. Securities and Exchange Commission's IPO registration process when it first offers its own shares to public investors. Although the merger of the SPAC with the operating company triggers its own SEC disclosure requirements, those are generally less onerous than filing a full S-1 registration statement to do an IPO.

Recently, there've been many successful companies that have used SPACs to go public:

In addition, there are several companies in the process of looking to come public through SPAC mergers. One of the more popular is rival electric-vehicle specialist Hyliion, which recently announced it would merge with Tortoise Acquisition.

A big boom for SPACs

Investors are excited about SPACs because when they're successful, their share prices can soar. But would-be SPAC managers are jumping on that demand. Well-known private equity manager Pershing Square Management recently announced plans to do a $3 billion SPAC offering. That follows dozens of smaller SPAC IPOs to try to capture investment capital.

Not all SPACs turn out well. A typical SPAC will offer stock at $10 per share and give the management team two years to find a suitable target. If the SPAC doesn’t find a good merger candidate, then its terms call for it to liquidate. Unless the SPAC finds a candidate, the money raised in the IPO is held in trust, and so IPO investors typically get most or all of their $10 initial investment back.

However, excitement over SPACs has sent many of their share prices well above their initial offering price. If those SPACs don't find acquisition candidates, then anyone who paid a premium to buy SPAC shares will face a substantial loss.

Will the SPAC boom last?

If companies that want to come public see more value in using a SPAC than in pursuing a traditional IPO process, then the latest rise in the use of special purpose acquisition companies could turn into a permanent transformation in the way businesses raise capital. If too many SPACs start chasing too few targets, however, it could create substantial problems that could lead to big losses among newer SPAC investors.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Virgin Galactic Holdings Inc. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Virgin Galactic Holdings, Inc. Stock Quote
Virgin Galactic Holdings, Inc.
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DraftKings Inc. Stock Quote
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$19.35 (8.16%) $1.46
Nikola Corporation Stock Quote
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Tortoise Acquisition Corp. Stock Quote
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