There's a trendy way to invest in new public companies, but be sure to understand the risks

The stock market began to surge about a year ago, as government stimulus money and other assistance poured in. Over that time, an interesting investing subplot has emerged – the rise of "SPACs" as a way to get new companies, especially glitzy technology startups, to market faster.

Special purchase acquisition companies have been around for decades, but their recent ascent has been spectacular, even raising eyebrows in two recent investor alerts from the Securities and Exchange Commission.

The list includes last year's biggest SPAC, Pershing Square Tontine, and both new Arizona-based electric vehicle manufacturers – Lucid Motors and Nikola Corp. Even Rapper Jay-Z and Colin Kaepernick, the pro-football quarterback turned social activist, have gotten involved in SPACs, focusing on a cannabis business and a social-activist consumer company, respectively.

The traditional way that private companies raise money in the stock market is through an initial public offering or IPO. SPACs offer a faster and potentially more controllable means of doing that, which partly explains their heady rise.

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In 2020, 248 SPACs raised $83.3 billion, according to SPACInsider, up from $3.9 billion in 20 deals just five years earlier, in 2015. From October through December of last year, special purchase acquisition companies surpassed traditional IPOs on a quarterly basis for the first time in both measures, and the pace is running even faster so far in 2021.

The SPAC surge "certainly has the look and feel of a ... bubble," wrote Dave Sekera, chief U.S. market strategist at Morningstar in a recent report. "The last time SPACs proliferated was in 2007, just before the market imploded."

What, exactly, are SPACs?

SPACs are blank-check or shell companies, flush with cash, that search for attractive private corporations with which to merge.

The process starts when a SPAC raises money from investors in its own IPO. "Blank check" means the sponsoring firm doesn't have any business operations of its own and few assets other than the cash raised in the IPO.

"If you invest in a SPAC at the IPO stage, you are relying on the management team that formed the SPAC," said the SEC's Office of Investor Education and Advocacy in a December alert to investors.

The management team might identify a specific industry to target, but it's not obligated to go there. By contrast, more traditional IPOs happen when a company with operations and assets – and sometimes decades of history – raises money by selling shares directly in the stock market.

For target companies lured by SPACs, three main benefits cited by Sekera include a greater certainty of knowing how much money they will bring in, a process that's often faster than for IPOs and the ability to disclose certain financial projections and other information that typically isn't allowed with a traditional IPO. 

Help from the sponsors is important, too. "They're really relying on that management team and expertise," said Adam Olsen, national quality leader at accounting and financial consultant Embark in Phoenix.

In some cases, SPAC officials share in management duties at the combined company. They also often receive at least some board seats.

Aren't blank-check companies risky?

A SPAC might identify a specific industry that it intends to pursue and often is headed by executives with experience in the field, but these aren't requirements. So yes, the blank-check nature adds an extra element of uncertainty or risk.   

After the SPAC team targets a private company, the two sides start negotiating. If a deal is approved, a business combination results. Deals often are designed as reverse mergers in which the operating company folds into the SPAC.

Before then, proceeds raised in the SPAC's IPO are parked in a trust or escrow-type account, held in low-risk financial instruments. "They're basically holding onto cash until they find a target," said Olsen.

If a deal is consummated, "the SPAC changes from essentially a trust account into an operating company," the SEC said. SPAC shareholders who don't like the combination can redeem their shares before they become investors in the new, combined company.

Similarly, if the SPAC management team can't complete a deal within an allotted period – typically two years – investors are entitled to a refund of their share of the money held in the trust account.

What should investors look for?

Like other public companies, a SPAC will issue a prospectus or general disclosure document along with periodic reports filed with the SEC. These can be viewed in the agency's EDGAR database at sec.gov.

Potential investors should examine the business objective, intended strategy, background of the management team and financial incentives accruing to them, which are often highly favorable. "There's often a ton of upside for the founders, who are buying in for next to nothing," Olsen said.

The SEC warned in a second alert this month that it's "never a good idea to invest in a SPAC just because someone famous sponsors or invests in it."

If the sponsoring team must raise additional capital to complete a merger, it might do so through a PIPE or private investment in public equity – a type of transaction that can further dilute or worsen the deal for existing shareholders, Sekera noted.

With more SPACs chasing a finite number of viable targets, "It is important to consider whether attractive initial business combinations will become scarcer," the SEC warned.

Because the sponsors paid less for their shares than other investors, they have an incentive to ink a deal "before the two-year clock runs out," Sekera added. "They may end up in bidding wars."

How are SPAC shares priced?

Investors who buy SPAC securities should understand what they're getting. They typically receive a "unit" that initially includes both common shares and warrants.

"A warrant is a contract that gives the holder the right to purchase from the company a certain number of additional shares of common stock in the future," often at a price slightly above where the shares were trading when the warrant was issued, the SEC said.

After the IPO, the SPAC shares and warrants may split and trade separately.

Terms will specify the number of shares that can be purchased with warrants, the applicable price and the expiration date. Warrants typically can be converted into common shares after the latter appreciate a bit.

Are SPACs right for me?

Whether to invest in SPACs depends largely on your sophistication, willingness to research deals, access to attractive offers and ability to sustain losses. "Investing in SPACs has a much higher degree of risk than investing in traditional public equities," Sekera wrote.

You might not get many opportunities to invest in SPACs on the ground floor, through the IPO process, though you can certainly buy in later on the open market.

SPAC IPO units often are allocated to big-dollar hedge funds, Sekera noted. "While the vast proliferation of new-issue SPACs has increased the distribution to a wider audience, the IPO allocations will likely remain limited to institutional investors."

Still, it's important to know what SPACs are, especially if more of them show up as holdings of mutual funds and other mainstream investments you own.

Reach Wiles at russ.wiles@arizonarepublic.com.