Getting in early on the next Tesla (TSLA) or Netflix (NFLX) is a major selling point of SPACs, or special purpose acquisition companies.
SPACs offer an alternative to traditional initial public offerings (IPOs) and have surged in popularity. But picking a winner is far from a sure thing.
Because of the way SPACs are structured – think of them as "blank check companies" whose sole goal is to acquire early-stage businesses and take them public – it's hard for SPAC investors to assess the merits of what they're buying.
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SPAC mania has been driven by cheap money, a soaring market and investors' search for new opportunities. SPACs had a breakout year in 2020, with a record 248 SPAC IPOs, a fourfold rise from 2019, according to data provider Dealogic.
High-profile SPAC IPOs that now trade as regular stocks include sports-betting firm DraftKings (DKNG) and space-tourism company Virgin Galactic (SPCE). (For more on Virgin Galactic, see How to Cash In on the Final Frontier.)
SPACs got off to a hot start this year, with 315 SPACs listed and $100.4 billion raised through May 7, topping full-year records for 2020. So far this year, SPACs account for 41% of all IPOs.
How SPACs Work
When you invest in a SPAC, you're not investing in a company such as Tesla with real products and sales. You're giving your money to a "sponsor," or investment team, who will identify and invest in the next potential Tesla for you. The sponsor has two years to acquire a yet-to-be-identified company. Until a business combination is completed, the money raised from investors is held in a trust account.
SPAC shares trade on an exchange while the sponsor searches for a company to take public, and it’s not uncommon for SPACs to trade sharply higher as investors react to rumors about merger candidates.
If an acquisition target isn't found in the allotted time, the SPAC will liquidate. IPO investors will get back their initial investment, and buyers in the secondary market can redeem their shares at the initial offer price, typically $10 a share, dubbed the pro rata share.
Once a target company is announced, you must decide whether to stay invested in the new, post-merger company, which will trade with its own symbol, or redeem your shares at the pro rata price. You can get burned if you jump into a SPAC at or near a top.
How Have SPACs Performed?
SPAC fever cooled in mid-February, as SPACs sold off with tech stocks and other speculative issues.
"SPACs were exhibiting bubble-like characteristics, and growing pains were likely," says Jason Draho, head of asset allocation Americas at UBS Financial Services. The wipeout has been swift, with some of the worst-performing SPACs and post-merger stocks down 50% to 70% from mid-February through mid-April, according to Bespoke Investment Group.
Regulatory scrutiny hurt, too. The Securities and Exchange Commission recently warned SPACs about issuing misleading sales projections and noted that SPAC sponsors may pursue deals that aren’t in the best interests of investors.
Overall, post-merger performance hasn't been great. Of the SPACs that brought companies public in 2020, the median post-acquisition return trailed the S&P 500 Index by 13 percentage points after one month and by 27 points after six months, according to investment bank Goldman Sachs. SPACs have also underperformed traditional IPOs by a wide margin. A sizable SPAC pipeline may signal a saturated market. In April, there were nearly 400 SPACs seeking acquisitions, Goldman Sachs says.
David Sekera, chief market strategist at Morningstar, thinks most retail investors should steer clear of SPACs. "I don't think this is an appropriate product," he says.
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