What's a SPAC?

Nov 2, 2020

Year-to-date, SPACs (Special-purpose acquisition companies) have raised over $48b, more than the last ten years combined. It seems like every day a new one gets announced, often with a recognizable name attached (e.g., Paul Ryan, Billy Beane, Shaq). But what exactly are they, and how do they work?

A Blank Check

SPACs are also known as "blank check" companies. When one is created, it has no operations and no existing business of its own. A SPAC is formed and funded with the intent of using the cash raised to acquire another company in the future. Management might have an industry in mind. For example, they may state that they intend to acquire a tech or healthcare company. They might even have a specific target company in mind, though they are under no obligation to disclose the target.

A SPAC goes through an initial public offering (IPO) process like a more traditional company and post-IPO, it trades on an exchange. Since there are no operations to look at, the IPO process is more straightforward than a traditional company. The cash raised through the IPO is typically placed in a trust while a suitable takeover candidate is sought. A SPAC has a stated time frame, typically two years, in which to complete an acquisition. If no suitable target is found, money is returned to shareholders, and the SPAC is liquidated.

Why Bother?

It may seem like a lot of work to IPO a SPAC for the sole purpose of buying another company, but there is a method to the madness. As stated, since the SPAC has no operations, an IPO is a simple, straightforward process. But for a SPAC's target, being purchased offers a much faster process to becoming publicly traded. Rather than shoulder the time and costs of an IPO, the target company bypasses that process and becomes publicly traded upon the deal's close.

Some Recent Examples

Two of the better-known recent SPAC acquisitions were DraftKings (DKNG) and Nikola (NKLA). DraftKings, the online sports betting operator, went public via SPAC acquisition in late April. Including the run-up in the SPAC pre-merger, the company is up a tidy 310%+ year-to-date.

Electric vehicle maker Nikola's ascent was even more dramatic. At its peak, the stock was up nearly 700% on the year. However, doubts about some of the company's technological claims (including as-yet unfounded allegations of outright fraud) have led to a steep drop in the share price. While it is still up nearly 100% on the year, that's a significant drop from +700%.

It's too early to say if the questions about Nikola's technology are valid. However, if they are, it highlights one of the dangers to investors of buying a company that goes public via a SPAC acquisition. One would hope that a more-robust traditional IPO process would have uncovered any such shenanigans (again, if they turn out to be true).

The Investor's Conundrum

The Nikola situation really highlights the conundrum that investors face. Typical advice for anyone planning to invest is to perform due diligence on the prospective investment. However, that may be impossible in a situation like this. The company had virtually no operating history and no proof of concept. It is a company built around an idea. Granted, it is potentially a huge idea, but should it be publicly traded yet? Can you analyze a company like that, or is buying it more like placing a bet on the DraftKings app? Interesting questions, and ones with no simple answers.

Summary

SPACs are getting a lot of headlines, but investors should tread carefully. Some of the returns can be eye-popping, but these investments are not without risk. The huge amounts raised should also give investors pause. The last peak occurred in 2007 – does anyone remember how the market did in 2008?

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Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.

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