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3 Things to Know About SPACs

By Nicholas Rossolillo - Feb 22, 2021 at 12:00PM

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SPAC fever has swept the market. Before you buy, there are a few things you need to know.

Technological innovations were on the rise well before the COVID-19 pandemic created an even greater need for them. Efforts to address the pandemic accelerated what was already shaping up to be a digital revolution. A digital-first economy focused on tech development and efficiency has emerged and been a driving force this past year.

In tandem with this digital-first economy, the interest in special purpose acquisition companies, or SPACs, has also surged. These unique business startups were purpose-built for this new era.

But before you go piling into every SPAC you can find, there are a few things any potential investor needs to know. Here are three things to consider when looking into a SPAC.

Woman with thought bubble and bag of cash illustrated over her head

Image source: Getty Images.

1. Investing before the merger is a bet on the management team

There are two key milestones for a SPAC. The first is the IPO when the SPAC itself becomes a publicly traded company and raises cash. A SPAC is effectively a shell corporation -- a cash-holding company tasked with bringing an actual operating business (or businesses) to the public market through a merger or acquisition. The success of this pre-IPO stage is driven by the SPAC sponsor and management team's ability to raise capital from investors.  

All sorts of people and groups are starting SPACs these days. Even retired baseball star Alex Rodriguez is getting in on the frenzy. Some SPACs, like venture capitalist Bill Ackman's Pershing Square Tontine Holdings (PSTH 0.05%), have already IPO'd and their shares are available to purchase like any other stock. Investors who purchase the stock are really speculating on the management team and its ability to target a worthy takeover and convince that company to be acquired (since there's no actual operating business yet). 

The second key milestone is when the SPAC announces its takeover target. For example, former Facebook executive Chamath Palihapitiya's SPAC Social Capital Hedosophia Holdings V (IPOE) has announced it will be bringing Social Finance (SoFi) public. Once announced, investors buying into the SPAC aren't just betting on the management team anymore, but rather on the business itself that is to be taken public via the SPAC.

2. The SPAC has a prospectus, but the acquisition doesn't

In a traditional IPO, the company that is going public releases a detailed prospectus (called an S-1 form, filed with data about the company's operations and available to read via the Securities and Exchange Commission (SEC) website). When a SPAC goes public, it too releases an S-1 in which it provides some details on what it will be looking for in an acquisition candidate.

However, once a private company has been targeted for a merger with the SPAC, a prospectus on that business is not filed with the SEC. Instead, an S-4 form is filed providing the details on the merger. The SPAC and/or company targeted for a takeover will provide information on the business, its operations, and some basic financials. However, a traditional prospectus (with lots of potentially important financial disclosures) is not available.  

Put simply, when investing in a SPAC stock after it has announced its acquisition target, investors are still betting on the management team -- specifically, on the team's due diligence regarding the private company that is being acquired.

3. The acquired business may have limited to no operating history

The digital economy is developing fast and disrupting players in the old economy. SPACs and their unique status as shell companies can help accelerate a fast-growing private company's expansion by infusing it with a sizable sum of cash. As explained by Palihapitiya, SPACs are ideal for targeting companies with huge future potential

A traditional IPO (and accompanying prospectus) describes past results for a company at length. But a company being taken public via SPAC can instead talk about the future and how it expects the industry it participates in to change over time, and make a long-term forecast on financials. In a fast-changing world, this can give average investors an opportunity to get in early on future leaders of the economy. 

But there's a drawback too. Many SPAC acquisitions have a limited operating history to examine. Some of them generate no revenue at all. These "story stocks" are a bet that an emerging technology (like a new electric vehicle or battery company) can be developed and commercialized quickly. There could be added risk in investing in a company like this if it fails to find paying customers -- and lots of stock price volatility along the way.

Know what you are getting into

The SPAC movement is an exciting development that's accelerating change in the economy. But unique risks exist that investors should be aware of, and there are unique opportunities as well. As is always the case, know what you're getting into before hitting the buy button.

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Stocks Mentioned

Pershing Square Tontine Holdings, Ltd. Stock Quote
Pershing Square Tontine Holdings, Ltd.
PSTH
$19.87 (0.05%) $0.01
Social Capital Hedosophia Holdings Corp. V Stock Quote
Social Capital Hedosophia Holdings Corp. V
IPOE

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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