Investors have never been more excited about private companies coming to market. Many companies have been announced over the past few months and promising privately owned companies are increasingly abandoning the traditional IPO process of merging with a special acquisition company (SPAC).
There have been many notable success stories among SPACs, and the IPO alternative enables investors to acquire shares of private companies much sooner than would otherwise be possible. However, there is a hidden danger that many SPAC investors are unaware of. As the popularity of SPACs increases, this trap can become more expensive for unconscious investors.
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How a SPAC works (if all goes well)
The life cycle of a SPAC has four main phases. The first is when the SPAC announces its own initial public offering to raise capital from investors. At most SPACs, IPO investors pay $ 10 in exchange for a two-item unit: 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, the units are split into their constituents, allowing investors to buy or sell shares and warrants separately.
The second phase involves the SPAC looking for a company to merge with. Some SPACs are looking for specific types of companies as merger candidates; others have very loose criteria.
If the SPAC finds a promising privately owned company and enters into a merger agreement with it, the third phase begins. During this period, shares of the SPAC do not yet technically represent the shares of the private company, but many investors buy SPAC shares in the hope that the merger will get the shareholders’ approval and it will go through.
The fourth and final phase comes after the merger has closed. At that time, the SPAC shares represented the ownership of the underlying business of the formerly private company. The name of the SPAC makes way for the name of the private enterprise. The text symbol usually changes to indicate the new name or what the new public company is doing.
What could go wrong
Fusion candidates are getting a lot of media attention, and so many investors think that every SPAC is successful in its mission. However, this is not the case and not every SPAC can go through all four of the above phases.
SPACs typically have only 24 months to find merger candidates and completed transactions. SPACs can ask shareholders for an extension, but investors do not have to grant it.
Each SPAC has provisions for what happens if the time limit expires before it finds a suitable target company. Usually, the cash that the SPAC held in trust to give a potential future deal is distributed to shareholders, minus any expenses en route. For a SPAC that has done its stock trading at $ 10, this usually means that shareholders will be entitled to about $ 10, taking into account the interest earned during the two years and the cost of operating the SPAC.
How a minor headache can be a big loss
For investors who participated in the SPAC IPO, such liquidation may be disappointing, but not destructive. If you could buy SPAC shares at $ 10 and then get back about $ 10, all you lost was the opportunity to make that investment capital work more productively elsewhere.
However, most investors do not enter the SPAC exchange. They rather buy shares on the open market. Lately, it is not uncommon for SPAC shares to trade 50 to 75% above their IPO prices even before naming a candidate for an acquisition.
If you pay $ 15 per share for a SPAC and it never makes a transaction, you will not get $ 15 back in liquidation. You get $ 10 – a 33% loss.
Some SPACs saw even greater premiums once the rumors spread. For example, Churchill Capital IV (NYSE: CCIV) traded more than $ 50 per share based on reports of a deal with Lucid Motors. Shareholders were willing to pay so much without a signed agreement setting out the terms of any possible merger and what role Churchill Capital IV would play in it. Everyone expects Lucid and Churchill to make a favorable deal, but if they do not, there is a risk of $ 40 per share or more for investors buying at these levels.
Roll the dice
SPACs are not bad investment vehicles. It is ideal for ordinary investors who want to participate in a process from which they are usually excluded until much later in the ongoing public process.
To be successful, however, investors need to understand the risks associated with SPACs. Only by recognizing the hidden danger of paying premium prices for SPAC shares can you accurately assess the risks and benefits and make the right move in your portfolio.
This article represents the opinion of the author, who may not be in agreement with the ‘official’ recommendation position of a Motley Fool premium advisory service. We are furry! When we question an investment thesis – even one of our own – it helps us all to think critically about investing and to make decisions that help us become smarter, happier and richer.