The Broad View
With SPACs, corporate debuts reach for both the spotlight and the veil

A trendy path to public ownership underscores the risks in certain corners of the market.

It’s been an interesting year for unusual investments.

Bitcoin and other cryptocurrencies have ridden a wave of volatility, bobbing up and down due to factors as small as a passing tweet. So-called meme stocks — companies with questionable fundamentals and rocky outlooks that are nonetheless beloved by vocal groups of retail investors — have swung wildly in both directions.

And then there are special-purpose acquisition companies. Better known as SPACs, these once-obscure vehicles take companies public with lower regulatory hurdles and faster turnarounds than traditional initial public offerings. Proponents frame them as an investor entrée to up-and-coming companies before they are mature enough for conventional — and consequently more expensive — IPOs.

“More than half of the SPACs since the early 2000s were in 2020 and 2021,” explains Dane Mott, a Capital Group global accounting analyst. “Private investment firms have seen this as a golden opportunity to get companies into the public market.”

A constellation of athletes and celebrities — including Shaquille O’Neal, Serena Williams and Jay-Z — have been linked to SPACs, sometimes as advisors to the investment firms creating them. Among the companies that have gone the SPAC route: space-tourism company Virgin Galactic Holdings and sports-betting firm DraftKings. Office-space provider WeWork, which flopped in its attempt at a conventional IPO in 2019, also plans a SPAC.

But as with the other momentum-fueled investments, SPACs have raised eyebrows. They’ve been criticized for issuing overly rosy financial projections and producing disappointing returns for investors despite rewarding their creators handsomely. Investors’ ardor has cooled recently as a number of SPAC stocks have faltered and federal regulators have stepped up scrutiny.

SPAC funds raised in select sectors in the U.S. in 2020 (billions US$)

This chart shows cash raised for select sectors for special-purpose acquisition companies (SPACs) in 2020. Technology enjoyed the most funds raised, at $19.28 billion, while health care, ESG (environmental, social and governance) and financials each raised less than $5 billion each. Diversified targets raised $10.71 billion, while SPACs with no specified sector target raised $11.29 billion. Souce: Statista. As of Dec. 31, 2020.
Source: Statista. As of December 31, 2020.

“This process is not going through all the normal vetting of an IPO,” says Elizabeth Mooney, a Capital Group global accounting analyst. “SPACs have their own pitfalls and risks. But as long as they are permitted and investors buy them with decent valuations, then they are apt to continue coming to market.”

SPACs and IPOs both take companies public, but they differ in key ways.

In a traditional IPO, a company must release detailed financial information and pass regulatory muster before transitioning to public ownership. It’s an expensive and onerous process, but the disclosure is intended to protect investors.

SPACs, by contrast, “are ‘blank-check’ companies. They’re formed specifically to find and purchase a company by a sponsor who has industry experience,” says Samira Somany, a Capital Group research associate.

A SPAC has no operations; its singular goal is to find a private entity and merge with it. The newly acquired private business takes the SPAC’s place in the public market, effectively circumventing the laborious IPO process. However, sponsors cannot announce acquisition targets before seeking capital, forcing investors to consider the sponsor’s judgment and reputation rather than a private firm’s fundamentals or outlook.

Share of traditional IPOs and SPACs in the U.S.

This chart shows what percentage of new public offerings were initial public offerings (IPOs) versus special-purpose acquisition companies (SPACs). From 2016 through 2019, IPOs were the dominant form of public offerings, but lost share each year. In 2016, IPOs made up 90% of the market, while they made up 74% in 2019. In 2020, SPACs became the most common form of public offering, making up 53% of the market versus 47% being IPOs. In the first quarter of 2021, 75% of public offerings were SPACs, with 25% being IPOs. Souce: Statista. As of April 2021.
Source: Statista. As of April 2021.

Investors who purchase shares in a SPAC during this first phase typically also receive warrants that allow them to later purchase more shares at a set price. Sponsors eschew salaries but take a portion of the combined companies’ equity, typically a hefty 20%.

After announcing an acquisition target, sponsors often sell additional shares in subsequent fundraising rounds. At that time, shareholders who want out can redeem shares at their original cost.

SPACs have advantages but come with unique risks.

The lower regulatory hurdles, faster time to market and potential to gain a significant stake in a promising company are powerful draws for sponsors, Somany says.

Investors enjoy some benefits, though they’re not as robust. “Investors have some downside protection because they can redeem their shares,” Somany notes. “And warrants provide additional upside if the share price rises.”

However, SPAC investors also face significant risks.

Looser reporting requirements can make it difficult to appraise a company. For example, SPACs don’t have to list the material risks that they would in a traditional IPO. Similarly, SPACs are much more comfortable making forward-looking projections than are traditional IPOs, which are constrained by stricter regulations.

“There is a lot more room for speculation in a SPAC,” Mooney says. “That makes sense for some businesses, but it also means some projections are riskier or based on hidden assumptions.”

Then there’s the unusual ownership structure of a SPAC, which dilutes investors’ stake. Sponsors do not pay for their shares — rather, they’re given those shares as compensation. That reduces the value of everyone else’s ownership, as the company is divided into more pieces. Investor actions can exacerbate this issue: Redemptions pull capital out of the company, reducing its value (and thus the value of the remaining shares). Exercising warrants adds shares, further diluting ownership stakes while injecting less capital than the market value of those shares.

These costs can escape an investor’s notice because they’re primarily reflected in the share count. “Dilution can be hugely negative for shareholders, and it’s kind of hidden,” Mooney says.

SPAC investments require extensive due diligence.

Capital Group does not consider SPAC investments until an acquisition is announced — in part because analysts and portfolio managers can’t assess an entity’s prospects until it has operations, management and revenue to examine. And in the fast-paced world of SPACs, many deals close too quickly for analysts to vet.

“The SPAC market has become so much frothier, and that’s compressed our research time,” Somany says. “There have been some extreme cases where we’ve only had a couple of days to do our homework. In those situations, when we’re unable to appropriately do the due diligence, we back away.”

Mott adds: “There’s definitely a risk-reward tradeoff. All investments have inherent risk, but we still have to work through our fundamental process. We have to be comfortable with the risk we’re taking, and it’s harder to evaluate some SPACs.”

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