Investors have never been more excited about privately held companies coming to market. Many companies have gone public in recent months, and promising privately held businesses are increasingly foregoing the traditional IPO process in favor of merging with a special purpose acquisition company (SPAC).
There have been many high-profile success stories among SPACs, and the IPO alternative does allow investors to obtain shares of privately held companies a lot earlier than would otherwise be possible. However, there's a hidden danger that many SPAC investors aren't aware of. As the popularity of SPACs grows, this trap could keep getting costlier for unwitting investors.
How a SPAC works (when everything goes right)
The lifecycle of a SPAC has four main phases. The first is when the SPAC announces its own initial public offering to raise capital from investors. With most SPACs, IPO investors pay $10 in exchange for a unit consisting of two things: a share of common stock, and a fraction of a warrant to buy additional common stock at a higher price, often $11.50 per share. At a later date, those units get broken up into their constituent parts, allowing investors to buy or sell stock and warrants separately.
The second phase involves the SPAC looking for a company with which to merge. Some SPACs seek specific types of companies as merger candidates; others have very loose criteria.
If the SPAC finds a promising privately held company and enters into a merger agreement with it, the third phase begins. During this period, shares of the SPAC don't yet technically represent shares of the privately held company, but many investors buy SPAC shares in hopes that the merger will get shareholder approval and go through.
The fourth and final phase comes after the merger closes. At that point, the SPAC shares represent ownership of the underlying business of the formerly privately held company. The SPAC's name gives way to the privately held company's name. The ticker symbol usually changes to reflect the new name or what the newly public company does.
What can go wrong
Merger candidates get lots of media attention, so many investors think every SPAC is successful in its mission. However, that's not the case, and not every SPAC gets to go through all four of those phases described above.
SPACs typically only have 24 months to find merger candidates and consummate deals. SPACs can ask shareholders for extensions, but investors don't have to grant them.
Each SPAC has provisions for what happens if the time limit lapses before it finds a suitable target company. Typically, the cash that the SPAC held in trust to go toward a potential future deal gets distributed back to shareholders, less any expenses along the way. For a SPAC that did its IPO at $10, that usually means shareholders will be entitled to somewhere around $10, after taking into account interest earned during those two years and costs of operating the SPAC.
How a minor headache can turn into a big loss
For investors who participated in the SPAC IPO, such a liquidation can be disappointing, but not devastating. If you were able to purchase SPAC shares at $10 and then get roughly $10 back, all you've lost is the opportunity to have put that investing capital to work more productively elsewhere.
Most investors, though, don't get in on the SPAC IPO. They instead buy shares on the open market. Lately, it's not uncommon to see SPAC shares trade 50% to 75% above their IPO prices even before they name an acquisition candidate.
If you pay $15 per share for a SPAC and it never makes a deal, you won't get your $15 back in liquidation. You'll get $10 -- a 33% loss.
Some SPACs have seen even bigger premiums once deal rumors circulate. For instance, Churchill Capital IV (CCIV) traded above $50 per share on reports of a deal with Lucid Motors. Shareholders were willing to pay that much without a signed agreement stating the terms of any possible merger and what role Churchill Capital IV would play in it. Everyone expects Lucid and Churchill to hammer out a favorable deal -- but if they don't, there's $40 per share or more at risk for investors buying at these levels.
Rolling the dice
SPACs aren't bad investment vehicles. They're great for ordinary investors wanting to participate in a process they're usually locked out of until much later in the going-public process.
To be successful, though, investors have to understand the risks involved with SPACs. Only by recognizing the hidden danger of paying premium prices for SPAC shares can you accurately assess the risks and rewards and make the right move in your portfolio.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.