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SPACS or special acquisition companies are becoming a popular way to raise money. It is a unique and innovative concept that, on the surface, doesn't seem to make sense.
This article will answer the question, what is a SPAC, and offer the pros and cons of the method as we see them. Read on to get the knowledge you need to answer the questions when someone asks.
Let's get started.
What Is a Spac?
A SPAC is a company that raises money from investors to acquire another company. They are typically listed on an exchange and have a board of directors and management team. Once they raise enough money, they will find a company to buy.
SPACs have been around for quite some time, but in 2020 there was a sizable SPAC boom. 248 SPACs went public in 2021 and raised a total of $83 billion. For comparison, there were only 59 that went public in 2019 and raised $13 billion.
However, Guy Davis, Portfolio Manager at GCI Investors, cautions, “The current SPAC craze is likely to be self-correcting, and potentially the correction has already begun. As SPACs become less profitable, they will become less popular, and the boom will fade. As more and more SPACs compete for deals, the quality of deals they take has to fall, and the prices they have to pay rise, so more SPACs will end up creating losses for investors.”
The first Special Purpose Acquisition Company was created in 1993 by Bill Ackman, Pershing Square Capital Management founder. Since then, they have acquired companies such as Hertz Global Holdings Inc., Burger King, and Red Roof Inn.
SPACs exist in pretty much every industry. They have been used to acquire banking, oil, gas, real estate, retail, and technology industries.
SPACs have gained momentum because it can be difficult for a company to go public and raise money when they don't have any revenue or profits. A SPAC allows companies to raise money upfront and then use that money to acquire another company.
How Do They Work?
SPACs have two years to find a target company or return the money to investors (including retail and institutional investors). SPAC investors are betting that management can identify target companies with stock prices undervalued by the market and buy them at a discount (or on the cheap) within this time frame. Once this happens, shareholders from both companies would receive SPAC shares in a new entity created with their combined assets – which means more value for everyone involved if things go according to plan. Because companies have considerable flexibility on their acquisition targets, SPACs are often called “blank check” companies.
That is different from traditional Initial Public Offerings because there isn't a roadshow where management meets with potential investors to make their pitch or set an offering price ahead of time. Instead, the company will issue units consisting of common stock and warrants at $11 per unit – which means they can raise as much cash as possible while still having some skin in the game.
Pros of Investing in Spacs
There are many pros to investing in SPACs:
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- They are easy to access for many investors since you do not need special qualifications like passing through accredited investor status.
- There are not any lockup periods where you can't sell your shares of SPAC stocks right away, unlike with traditional IPOs
- You could get some upside potential if management finds an undervalued business that's worth buying on a discount (and becomes profitable once acquired)
Cons of Investing in Spacs
There are also some cons to investing in SPACs:
- They are highly speculative investments since there isn't much known about their assets after finding another company or business to buy out. That means the market value is unknown, making it harder to determine whether or not they are overpriced and therefore at risk of losing money on the investment. If things go south, investors would probably lose everything invested in it later.
- The management teams of these companies tend to be former CEOs who have retired from running large corporations with lots of experience and expertise. Still, now they're trying something new by buying out smaller businesses that need help in some way. These could involve more risk since their track record isn't as strong or established yet – especially if an acquisition doesn't go well because then investors would get burned too.
- Investing in the stock market is always a risky business no matter what you do, so make sure your portfolio has enough diversification. It would help if you also understand your risk tolerance before putting any money into these investments.
Examples of Some Well-Known Spacs
There are a few well-known SPACs that you might have heard of:
Albertsons Companies, Inc. (ABS) is an American supermarket chain formed in 2006 by the merger of Albertsons and Safeway. It became a publicly-traded company on July 26, 2006. In 2019, private equity firm Cerberus Capital Management acquired ABS for $68 billion
The Carlyle Group is an American multinational private equity, alternative asset management, and financial services corporation headquartered in Washington, D.C. It has over $200 billion of assets under management across six continents.
KKR & Co. L.P. is an American global investment firm with headquarters in New York City that manages investments across multiple asset classes, including private equity, energy, real estate, and hedge funds.
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Why Would a Company Choose to Invest in a Spac?
There are a few reasons why a company might choose to invest in a SPAC:
- They may feel like their business is no longer growing, and they want to explore other opportunities outside of their current industry.
- The company's management team might feel like they're running out of ideas or opportunities for growth within their organization.
- The company might be looking to acquire another business but doesn't have the time or resources to go through an IPO process, so a SPAC would be a quicker way to do this.
What Is the Process of a Spac Merger?
There are four steps to the process of a SPAC merger:
The SPAC raises money from investors by selling shares in an initial public offering (IPO). The company then uses the fresh capital; to acquire another business, which becomes its operating subsidiary. The acquired company will then get listed on a major stock exchange after going through regulatory approval processes with the exchange and having their financial statements audited by an independent accounting firm.
SPACs use this as leverage against other companies because they can offer more money for acquisitions than private equity firms would typically be able to pay out in cash due to restrictions imposed by regulators about how much debt can go into deal financing structures like leveraged buyouts (LBOs)
The company that gets acquired will have its management team, which will be responsible for running the business and reporting to the board of directors at the SPAC.
Investors in a SPAC need to do their due diligence before investing to ensure that the subsidiary's management team is experienced and has a good track record. Investors may also benefit by hiring a financial advisor who knows the ins and outs of SPAC investing to help them make a more informed decision.
The Typical Spac Timeline
Here's a typical timeline for a SPAC:
The company raises money from investors by selling shares in an initial public offering (IPO). The company then uses the capital to acquire another business, which becomes its operating subsidiary. Then the subsidiary is listed on a stock exchange.
At this point, the SPAC is a public company and can start making acquisitions using the cash it raised from its IPO.
The company usually has three years from its IPO to make an acquisition. If no acquisitions are completed within that time frame, it dissolves, and the money raised goes back to the investors.
Spac Management Structure
One of the critical things for investors to look at when investing in a SPAC is the management structure. That is because the acquired company will have its management team, which will be responsible for running the business and reporting to the board of directors at the SPAC.
It's crucial for investors in a SPAC to do their due diligence before investing. Ensure the subsidiary's management team is experienced and has a good track record.
Spacs and Reverse Mergers
One of the significant advantages that SPACs have over private equity firms is using their public status to do a reverse merger. The acquired company goes public by merging with the SPAC, which already has a listing on a major stock exchange.
That is a quick and easy way for the subsidiary to go public without going through an IPO process, which can be time-consuming and expensive. The downside of this structure is that it gives the management team of the SPAC more control over the subsidiary. The SPAC management essentially becomes the majority shareholders in the business, which could be good.
How competent the management team of the SPAC is of utmost importance before investing.
The Bottom Line
SPACs are an excellent way for investors to get exposure to the private equity market and a relatively easy way for companies to go public without going through an IPO process.
The key thing for investors is to do their due diligence before investing and make sure that the subsidiary's (and SPAC's) management team is experienced and has proven prior success.
This article originally appeared on Wealth of Geeks.
As a certified credit counselor and syndicated writer at MaxMyMoney, Max has coached over 250 Millennials to help take the stress out of money. When Max is not coaching, you'll find him reading financial books, indoor cycling, or visiting local pawn shops looking for swiss-made watches.