TL;DR
- A Special Purpose Acquisition Company (SPAC) is a shell company that raises public funds to acquire a private company
- SPACs are blank-check companies, meaning, investors are contributing funds to a company that has no concrete business plan
- Investors contribute to SPACs because the shell company is often formed by an experienced executive with industry knowledge who is trusted to make a smart acquisition on the shareholders behalf
- Given a SPAC units low price, and high potential upside, investors may consider contributing funds if they believe in the leadership team and industry that the SPAC represents
What is a Special Purpose Acquisition Company (SPAC)?
A SPAC, also known as a blank-check company, is a shell company that uses public funds to acquire, and as a result, bring to market, a private company. Since it is just a shell corporation, with no financial history, early investors are taking a bet on the person who formed the SPAC. This person is often an experienced executive who has proven knowledge in a specific industry and is therefore seen as more likely to acquire a successful company. A successful acquisition could mean high returns for early investors.
Read more: What is a SPAC?
What is a blank-check company?
A blank-check company refers to a company whose business plan is either non-existent or contingent on a merger or acquisition. Because of the uncertainty associated with blank-check companies, all publicly raised funds are required by the Securities and Exchange Commission (SEC) to be placed in a trust account. The same applies to a SPAC; investor funds are placed in a trust, and therefore cannot be touched until an acquisition occurs.
How do SPACs work?
SPACs allow private companies to go public through acquisition, rather than through a formal IPO (Initial Public Offering). This is attractive for private companies that may want to enter the public market faster and under the guidance of more experienced industry leaders. When a SPAC enters the public market, investors can buy a unit for as low as $10.00. A unit consists of a common share and a warrant. A common share is a normal share of the company and is relatively stable. A warrant is more volatile but will provide the investor the option to buy a share at a discounted price post-acquisition. Both the common share and warrant are worthless if the SPAC never acquires a company. That being said, there are certain rules a SPAC must follow to successfully acquire a company.
Here are some SPAC rules worth noting:
- Most acquisitions must occur within two years of the SPACs creation
- It is often required that 80% of investor funds are used to complete the acquisition
If a SPAC fails to follow SPAC rules, funds are typically liquidated and returned to investors.
Once a SPAC decides on a company to acquire, shareholders are often asked to vote and approve of the company being considered before the actual combination of companies occurs. This is called the De-SPAC process. If a shareholder disagrees with the proposed acquisition, she reserves the right to withdraw her funds. If enough people withdraw their funds, the acquisition may not go through. This creates a lot of risk for SPAC founders. For this reason, you will often see a SPAC partner with a large investment bank or private equity firm upon formation. This provides more secure funding for the SPACs future acquisition.
What is a warrant?
As mentioned, a warrant provides an investor with the option to buy a share at a discounted price post-acquisition. Often SPACs offer units that are comprised of common stock and either partial or full warrants. If partial warrants are offered they can usually be combined to create full warrants. That being said, it is important to look into the SPACs warrant conversion rate before buying, as it can greatly influence the future value of the warrant.
If you are still confused by what possibilities a warrant presents, you are not alone; warrants are complicated. Here is an example that shows the potential of SPAC warrants:
Lets say you decide to buy $1000 worth of warrants at $2 (500 warrants) with a strike price of $11.50. The SPAC has a successful merger, takes off, and the companys common stock rises to $20. Since you bought warrants at a strike price of $11.50, each warrant will be worth $8.50 when the common share price is $20 ($20 – $11.50 = $8.50). Therefore, your $1,000 investment is now worth $4,250 ($8.50 multiplied by 500 warrants).
That being said, high-reward is often associated with high-risk and warrants are no exception. If the SPAC merger falls through and an investor exclusively bought warrants, she will be left with nothing. Investors should note, that most warrants can be exercised at any point within a five-year time frame post-merger.
SPAC investment opportunities
The upside potential of a SPAC investment is attractive because the downside risk is relatively low. As mentioned, investors hold the right to remove their funds if they disapprove of the acquisition candidate. Also, if the SPAC fails to acquire a company, funds are returned to investors. Both these contingencies coupled with the fact that SPAC units are relatively inexpensive make for a conservative bet.
As with other investments, the upside potential becomes great if the post-acquisition company turns out to be a success and the share price sky-rockets. In this case, the early investor will benefit from having bought the low-priced SPAC units.
But investing is rarely black and white, and often investors look to hedge their bets when the future is uncertain. If the company is not doing well right now but has the potential to turn up, the investor can sell her purchased shares while maintaining her warrants. Selling her shares in the short term may help mitigate losses. The warrants will allow her the right to buy a common share at a discounted price in the future. The warrant becomes valuable if the post-acquisition shares experience an uptick in price. Some may consider this strategy as a way to hedge their original bet.
SPAC investment risks
Since it can take up to two years for a SPAC to find a target company, money that is invested in SPAC units can be sitting idle for some time. Due to this window of time, some investors may find that their money could be generating greater returns through other investments.
Additionally, if the market is saturated with SPACs, finding a target company may become more difficult and may increase the likelihood of a failed acquisition. As mentioned, if a SPAC does not find a target company over the two years it will be forced to liquidate and return funds to investors. That being said, investors who buy SPAC units at a premium, or above market price, will not receive all their funds in the case of a liquidation. Therefore, while the downside risk is minimized, the potential for loss still exists.
SPACs in the market
Here is a list of some SPACs that exist in the market right now:
- Pershing Square Tontine Holdings (PSTH)
- Apex Technology Acquisition Corporation (APXT)
- Big Rock Partners (BRPA)
- Dragoneer Growth Opportunities Corp (DGNR)
See more: The SPAC pack investment theme.
Bottom line
Special Purpose Acquisition Companies dont promise much, but if they are led by seasoned executives in a specified industry they may attract high-quality investors, which could lead to a more successful acquisition. Given the low price of SPAC units and rules that a SPAC must follow, there is a relatively low downside risk for investors. And getting in early on well-respected SPACs could lead to a large upside somewhere down the line. Also, the ability to buy units that consist of common shares and warrants has a certain allure, because of the future opportunities it presents investors. At the end of the day, if you believe in the leadership team of the SPAC and the industry they represent, it may be worth considering for your portfolio.