Forget the pandemic. Forget about the recession. Investors are stumbling over themselves to put their money in public companies soon, and the companies are more than happy to list on the public markets. And to do so, most do not go the traditional route of an initial public offering or IPO. They are looking for something faster: a SPAC.
The term SPAC stands for the acquisition of special purposes, which is essentially a listed stack of cash intended for the purchase of a private company. SPACs have become the most important maneuver in which companies list on the stock market. Some see these vehicles as a smart way to invest in newly public companies, while others say that uncontrolled enthusiasm for these financial products is similar to the dot-com boom and bust two decades ago. Indeed, the word “bubble” keeps bubbling up around SPACs. And every day new SPACs appear.
In the first two months of this year, 189 SPACs were listed on major stock exchanges, according to data from the University of Florida professor and Jay Ritter. At an annual rate, that would mean more than 1,000 SPACs in 2021 – more deals than any year in history for SPACs and traditional IPOs combined. As of early March, SPACs have raised $ 64 billion, according to financial market platform Dealogic, which sheds $ 20 billion off its 2020 record total. This means large amounts of cash to invest in mergers with private companies.
Once an obscure investment tool, SPACs see interest from retail investors: normal people who do not invest money, such as those who trade on Robinhood. They have been spurred on by pandemic boredom and stimulus studies, as well as a number of recent, high-profile SPACs that have performed exceptionally well, such as DraftKings.
There are a number of pros and cons to SPACS, and a variety of ways the SPAC boom can play out, especially now that the interest of retail investors is greater. So this is what you need to know about the hottest stock type on Wall Street.
What is a SPAC?
A SPAC is a shell company that is disclosed for the purpose of raising money to buy a real company (or companies). It effectively brings the operating business faster than through an IPO. A SPAC has two years to find a private company to merge or to return investors’ money.
People can invest in SPACs, just like any other stock, but until it merges with another company, there is no way to know how viable it is. And when these mergers are announced, the companies involved are often not only unprofitable, they often do not even have an income. Unlike ordinary shares, however, people can get out of the deal and redeem a guaranteed $ 10 per share before the merger is finalized. So if they pay nearly $ 10 a share, they have little to lose if they do not like the merger.
This year, a number of high-profile SPACs were announced, including Churchill Capital IV, which recently announced it would merge with Lucid Motors, an electric vehicle company that has not yet manufactured a vehicle. The stock traded up to $ 64 before the expected announcement and is now around $ 24, indicating that investors were either disappointed with Lucid’s production schedule or with the terms of the deal.
Who earns / loses money with SPACs?
SPACs are created by a sponsor, often a CEO, who puts in about $ 5 to $ 10 million of his or her own money in exchange for about 20 percent of the shares in the SPAC, which is usually a minority stake in the merged company. possess. . If the SPAC finds a company to merge with at a good price, the sponsor will earn tens or even hundreds of millions of dollars. If the SPAC does not complete an attractive merger, the sponsor may lose their initial investment.
Even if investors lose money, the guarantor can still earn a lot of it. Michael Ohlrogge, a law professor at New York University who researches SPACs, calculated that the sponsor of Clover Health, which traded below the initial offer price earlier this week, still earned about $ 150 million.
In addition to having the opportunity to buy SPAC shares at $ 10 each and resell them at that price if they do not like the company, early investors can also hold a warrant enabling them to buy shares at a fixed price for sale. for the next few years. Ohlrogge compares it to time shares offering free flights to give people their selling price, hoping people will decide to buy the time share (if they don’t, they still got free flights).
“It’s great for the people who do it,” he told Recode. “It’s free money.”
The situation is not so rosy for ordinary retail investors, who can only buy SPACs if they reach public markets, while the price is usually higher than $ 10. The further the price is from $ 10, the more retail investors will lose before the merger be closed. For example, if you buy a SPAC for $ 15 but do not like the merger, you will lose $ 5 if you try to redeem it instead of holding the shares. After mergers, SPACs have historically underperformed.
What is the difference between a SPAC and a regular IPO?
Both IPOs and SPACs are ways in which a business can raise money. SPACs are a faster, but not necessarily cheaper, way to go public.
If you invest in a SPAC before it is merged with a private company, you are essentially investing in the SPAC’s sponsor, with the belief that their SPAC will make a good merger. With an IPO, you know in which company you are investing. And in the case of Churchill Capital IV, people have invested in its sponsorship business and its history of well-performing SPACs, as well as in Lucid, which has been speculated by many to be the target.
SPACs also receive less regulatory scrutiny than IPOs.
An important difference between SPACs and IPOs is how the companies involved can sell the transaction to potential investors. Due to an unintended legal loophole, SPAC sponsors – affluent, often sensational, charismatic individuals – can make promises about their companies without so much legal liability if those promises do not come true. Those rosy projections can help the company get bigger valuations. However, companies that do an IPO are restricted by the Securities and Exchange Commission’s (SEC) rules to make claims about the future growth of their companies, making them “legally vulnerable to lawsuits in a way that SPACs are not. “, according to Professor of Tulane in Business Law. Ann Lipton. It’s much easier to sell people on the idea that a business is a good buy if you are not hooked, if the promises do not come true.
Why are they so popular now?
Much has been written recently about SPACs, and their popularity has become increasingly popular. Last year, according to Ritter’s data, there were four times as many SPACs as the previous year. This year we are four times as much on track as last year.
Well-known SPACs, such as the manufacturer of electric trucks, Nikola and DraftKings, have caught the interest of institutional and retail investors. Popular SPAC sponsors, including the early Facebook CEO and the so-called king of the SPACs Chamath Palihapitiya, as well as a spate of celebrity investigations, including those of Jay-Z and Steph Curry, further fueled the SPAC investment.
“There’s a strong appeal among people that there’s a smart person who’s going to make a lot of money making investment decisions on their behalf,” Ohlrogge, NYU, said.
In addition, many SPACs are looking for mergers in popular sectors such as electric vehicles, where investors are hoping to repeat gains like Tesla, whose share price has risen more than 1,000 percent over the past two years.
“I think it’s partly a case of investors chasing past returns,” Ritter told Recode. “The last few months have been very good for SPAC investors, and money tends to follow the returns of the past.”
The stock market is also doing well at the moment, and as Bloomberg’s Matt Levine noted, SPACs are seen as a way to capitalize on current market conditions to make a company known in the future, when conditions may not be so good. not.
What is the catch?
If investors put their money in SPACs and hold the shares after the merger, they are likely to lose more money on average than when investing in ordinary IPOs.
While SPACs may be a sure thing for institutional investors who can buy stocks at $ 10 and redeem their money if they do not like the eventual merger, the value proposition is less clear to those who come in later. In a study of nearly 50 SPAC mergers in 2019 and 2020, Ohlrogge found that returns on SPACs a year after merger were nearly 50 percent lower than for a basket of IPOs. Ohlrogge also found that about 97 percent of those who bought SPACs at the IPO either redeemed or sold their stock when the merger closed.
What happens next?
SPACs can be a victim of their own popularity.
“There’s so much money chasing transactions right now, it’s going to be harder and harder to make attractive mergers,” Ritter said.
This can mean that SPAC sponsors have to eat up their investments if they do not find a good merger. If a historic SPAC performance is an indication, investors in companies doing mergers and a stock market are also not necessarily safe. Even people who benefit from the SPAC boom are wary. David Solomon, chief executive of major SPAC underwriter Goldman Sachs, said earlier this year that the trend was not “sustainable in the medium term.”
SPACs may also come under more regulatory scrutiny, as the SEC takes a closer look at their performance and how well it is understood by retail investors.
For now, spaces are in a very buzzing space, but when the buzz stops, it can sting.