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Understanding the risks of investing in SPACs: What investors need to know

Special Purpose Acquisition Companies (SPACs) are non-operating publicly listed companies created with the sole purpose of merging with or acquiring an existing private company. They raise funds through an initial public offering (IPO) and then seek out suitable targets for acquisition.

SPACs offer an alternative route for private companies to go public without following the traditional IPO process. Once a target is identified, the SPAC merges with the target company, enabling it to become publicly traded through the SPAC's existing listing.

SPACs are also referred to as blank check companies or shell companies.

One notable SPAC deal was Richard Branson's Virgin Galactic. Venture capitalist Chamath Palihapitiya's SPAC, Social Capital Hedosophia Holdings, purchased a 49% stake in Virgin Galactic for $800 million before listing the company in 2019.

Understanding the Risks of Investing in SPACs: What Investors Need to Know | The Globetrotting Investor | Stock Analysis

Although SPACs have been present in the market for decades, they have recently gained popularity in the United States. In 2019, a total of 59 SPACs were established, attracting $13 billion in investments. The following year, 247 SPACs were created, raising a substantial $80 billion. Surprisingly, in just the first quarter of 2021, an impressive 295 SPACs emerged, drawing in a massive $96 billion in investment. Furthermore, an astounding statistic reveals that in 2020, SPACs represented over half of all newly listed companies in the United States [Source].

Despite the excitement, not all SPACs will find high-performing targets, and some will fail.

For instance, Bill Ackman wound up his SPAC after failing to find a suitable target company to take public through a merger.

Hence, I want to share the risks associated with investing in SPACs that investors should be aware of.

Understanding the Risks of Investing in SPACs: What Investors Need to Know | The Globetrotting Investor | Stock Analysis

1. Uncertainty about the target company

Investors do not know which company the SPAC will eventually merge with, and this uncertainty poses a risk.

2. Inadequate information

Investors lack fundamental information about the target company until the merger is completed. Private companies may not publicly share such information before a merger.

3. Insufficient management due diligence

Thorough due diligence is commonly conducted on a company intending to go public during a regular IPO process. However, SPACs face a strict two-year deadline to secure an acquisition, which often leads to this crucial step being overlooked. As a result, investors may end up with executives or board members who do not meet the stringent criteria of a traditional IPO. Additionally, as the deadline approaches, founders of these blank check companies may rush into purchasing firms that are ill-suited for the demands of public markets.

4. Unreliable forward-looking statements

SPACs often make projections on growth and earnings, unlike companies in IPOs. However, many private companies going public through SPAC mergers are unprofitable but emphasize their growth prospects by projecting anticipated revenue figures.

5. Inaccurate financial reporting

Due to time limitations, SPAC managers often prioritize finding companies willing to engage in swift transactions rather than thoroughly assessing their suitability for the public market. As the acquired companies in SPAC transactions are typically private, their historical financial statements are not subjected to the same level of requirements as those of public companies.

6. Lack of regulations

Unlike companies choosing the conventional IPO method, SPACs are not subjected to the same level of regulatory and investor scrutiny regarding audited financial statements. This is because SPACs follow a different structure and do not go through the traditional IPO process. Therefore, the success of SPACs heavily relies on the expertise and capabilities of the management team.

7. Price fluctuations

Investors must exercise extra caution when dealing with SPACs due to rapid and significant price fluctuations. SPACs primarily aggregate cash and lack the necessary information to connect price movements with fundamental factors like earnings streams until a merger occurs.

8. Insider trading

The risk of insider trading increases as various parties involved in the transaction, such as sponsors and target companies, have access to non-public information.

9. Dilution of SPAC share value due to compensation

SPAC sponsors may receive 20% of IPO shares as "compensation," and first-stage investors may redeem their shares when the SPAC finds a target. However, this may lead to share dilution for non-redeeming and later-stage investors.

What is the alternative to investing in SPACs?

While SPACs offer a guaranteed return on investment if they fail to acquire or merge with a company within two years, investors incur lost opportunity costs. Moreover, investing in SPACs involves more speculation than actual investment, as several studies have shown that SPAC sponsors and founders of acquired companies often gain the greatest advantages, while investors receive lower returns. Despite the perceived simplicity, investing in SPACs is more complex than merely providing funds and expecting higher returns.

If investors are determined to invest in SPACs, they may consider a SPAC-focused ETF, such as the $SPCX. An ETF offers investors a diversified portfolio of SPACs instead of relying on a single deal.

Understanding the Risks of Investing in SPACs: What Investors Need to Know | The Globetrotting Investor | Stock Analysis

Bottom line

In conclusion, investing in SPACs entails various risks that investors should consider. It is advisable to exercise caution or avoid investing in SPACs altogether due to their speculative nature. However, if investors are determined to invest in SPACs, they may minimize risks by considering a SPAC-focused ETF rather than individual SPACs.


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