Investors have never been more enthusiastic about the arrival of private companies on the market. Many companies have gone public in recent months, and promising private businesses are increasingly abandoning the traditional IPO process in favor of merging with a special purpose acquisition company (SPAC).
There have been many outstanding success stories among SPACs, and the IPO alternative allows investors to obtain shares in private companies much earlier than would be possible. However, there is a hidden danger that many SPAC investors are unaware of. As the popularity of SPACs grows, this trap may become more and more expensive for involuntary investors.
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How a SPAC works (when everything goes well)
The life cycle of a SPAC has four main phases. The first is when SPAC announces its own initial public offering to raise capital from investors. With most SPACs, IPO investors pay $ 10 in exchange for a unit consisting of two things: one common share and a fraction of a guarantee to purchase additional common shares at a higher price, usually $ 11.50 per share. action. Subsequently, these units are divided into their constituent parts, allowing investors to buy or sell shares and guarantees separately.
The second phase involves SPAC looking for a company to merge with. Some SPACs look for specific types of companies as candidates for the merger; others have very vague criteria.
If SPAC finds a promising private company and signs a merger agreement with it, the third phase begins. During this period, SPAC shares do not yet technically represent the shares of the private company, but many investors buy SPAC shares in the hope that the merger will obtain shareholder approval and be approved.
The fourth and final phase occurs after the merger is closed. At that point, SPAC’s shares represent ownership of the underlying business of the previously private company. The name of SPAC gives rise to the name of a private company. The stock symbol usually changes to reflect the new name or what the new public company does.
What can go wrong
Merger candidates receive a lot of media attention, so many investors think every SPAC is successful in its mission. However, this is not the case, and not every SPAC is able to go through all four phases described above.
SPACs typically have only 24 months to find candidates for mergers and close deals. SPACs can request extensions from shareholders, but investors do not need to grant them.
Each SPAC has provisions on what happens if the deadline expires before finding a suitable target company. Typically, the money that SPAC has kept in confidence to go into a possible future business is distributed back to shareholders, less any expenses along the way. For a SPAC that made its IPO at $ 10, this usually means that shareholders will be entitled to something around $ 10, after taking into account the interest earned during those two years and the costs of operating the SPAC.
How a small headache can turn into a big loss
For investors who participated in the SPAC IPO, such a settlement can be disappointing, but not devastating. If you could buy SPAC shares for $ 10 and then get around $ 10 back, all you missed was the opportunity to put that investment capital to work more productively elsewhere.
Most investors, however, do not enter the SPAC IPO. Instead, they buy shares on the open market. Lately, it is not uncommon to see SPAC’s shares being traded 50% to 75% above its IPO prices, even before nominating a takeover candidate.
If you pay $ 15 per share for a SPAC and never close a deal, you will not receive your $ 15 back on sale. You will receive $ 10 – a 33% loss.
Some SPACs have seen even bigger prizes as soon as business rumors circulate. For example, Churchill Capital IV (NYSE: CCIV) traded above $ 50 per share in reports of an agreement with Lucid Motors. The shareholders were willing to pay that amount without a signed agreement setting out the terms of any possible merger and what role Churchill Capital IV would play in it. Everyone expects Lucid and Churchill to make a favorable deal – but if they don’t, there will be $ 40 per share or more at risk for investors who buy at these levels.
Rolling the dice
SPACs are not bad investment vehicles. They are great for ordinary investors who want to participate in a process from which they are usually blocked until much later in the IPO process.
To be successful, however, investors need to understand the risks involved in SPACs. Only by recognizing the hidden danger of paying premium prices for SPAC shares can you accurately assess the risks and rewards and make the right move in your portfolio.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even our own – helps all of us to think critically about investing and making decisions that help us become smarter, happier and richer.