What are SPACs, the IPO alternative used by DraftKings, Lucid, and Nikola?

Forget the pandemic. Forget the recession. Investors are stumbling to invest their money in companies that will soon go public, and those companies are more than happy to try to go public. And to do so, most do not follow the traditional route of an initial public offering or IPO. They are looking for something faster: a SPAC.

The term SPAC stands for Special Purpose Acquisition Company, which is essentially a publicly traded pile of cash intended to buy a private company. SPACs have become the main maneuver through which companies go public. Some see these vehicles as a smart way to invest in publicly traded companies, while others say the unbridled enthusiasm for these financial products has similarities to the dot-com boom and bust of two decades ago. In fact, the word “bubble” keeps bubbling around SPACs. And new SPACs come out every day.

In the first two months of this year alone, 189 SPACs were listed on major stock exchanges, according to data from University of Florida professor and IPO expert Jay Ritter. At an annualized rate, that would mean more than 1,000 SPACs in 2021, more listings than any year in the history of traditional SPACs and IPOs combined. As of early March, SPACs have raised $ 64 billion, according to financial markets platform Dealogic, $ 20 billion less than their record 2020 total. That means huge piles of cash to invest in mergers with private companies.

Once an obscure investment vehicle, SPACs are seeing the interest of retail investors – normal folks who don’t invest for a living, like those who trade on Robinhood. They have been spurred on by pandemic boredom and stimulus controls, as well as several recent high-profile SPACs that have performed unusually well, such as DraftKings.

There are a number of SPACS pros and cons, and a variety of ways the SPAC boom could play out, especially now that there is increased interest from retail investors. So here’s what you need to know about the hottest type of action on Wall Street.

What is a SPAC?

A SPAC is a publicly traded shell company for the express purpose of raising money to buy a real company (or companies). This effectively causes the operating company to go public more quickly than through an initial public offering. A SPAC has two years to find a private company to merge with or return investors’ money.

People can invest in SPAC as they would any other stock, but until it merges with another company, there is no way of knowing how viable it is. And when such mergers are announced, the companies involved are often not only unprofitable, they often don’t even have income. However, unlike normal stocks, people can exit the deal and redeem a guaranteed $ 10 per share before the merger is finalized, so if they paid close to $ 10 a share, they have little to lose if they don’t. like fusion.

This year, several high-profile SPACs have gone public, including Churchill Capital IV, which recently announced that it would be merging with Lucid Motors, an electric vehicle company that has yet to build a vehicle. The stock was trading as high as $ 64 before the early announcement and is now hovering around $ 24, suggesting investors were disappointed in Lucid’s production schedule or terms of the deal.

Who makes or loses money with SPACs?

SPACs are created by a sponsor, often an industry executive, who puts in between $ 5 million and $ 10 million of his own money in exchange for approximately 20 percent of the shares of the SPAC, which typically owns a minority stake. in the merged company. . If SPAC finds a company to merge with for a good price, the sponsor can earn tens or even hundreds of millions of dollars. If SPAC does not complete an attractive merger, the sponsor could lose its initial investment.

Still, even if investors lose money, the sponsor can still earn a lot. Michael Ohlrogge, a New York University law professor who researches SPAC, estimated that the Clover Health backer, which was trading earlier this week below its initial offering price, was still making roughly $ 150 million.

In addition to having the opportunity to buy shares of SPAC at $ 10 each, and sell them again at that price if they don’t like the company, early investors can also hold a share guarantee, which entitles them to buy shares at a fixed price. over the next few years. Ohlrogge likens it to timeshares offering free flights to give people their sales pitch, hoping those people will decide to buy the timeshare (if they don’t, they still have free flights).

“It’s wonderful for the people who do it,” he told Recode. “It’s free money.”

The situation is not so optimistic for regular retail investors, who can only buy SPAC when they hit the public markets, when the price is usually above $ 10. The further the price is from $ 10, the more retail investors will lose even before the merger closes. For example, if you buy a SPAC at $ 15 but then don’t like the merger, you will lose $ 5 if you try to trade it instead of keeping the shares. After mergers, SPACs have historically underperformed.

What is the difference between a SPAC and a regular IPO?

Both IPOs and SPACs are ways for a business to raise money. SPACs are a faster, but not necessarily cheaper, way to go public.

When you invest in a SPAC before it merges with a private company, you are essentially investing in the SPAC’s sponsor, in the belief that your SPAC will make a good merger. With an IPO, you know which company you are investing in. And in the case of Churchill Capital IV, people were investing in their sponsoring company and its SPAC track record of good performance, as well as Lucid, which many had speculated to be the target.

SPACs also receive less regulatory scrutiny than IPOs.

A fundamental difference between SPACs and IPOs is how the companies involved can sell the deal to potential investors. Due to an inadvertent loophole, SPAC backers – wealthy, often high-profile, and charismatic people – can make promises about their companies without as much legal liability in case those promises don’t come true. In turn, these optimistic projections can help the company obtain higher valuations. However, companies that do IPO are restricted by Securities and Exchange Commission (SEC) rules from making claims about the future growth of their companies, making them “legally vulnerable to lawsuits in a way that SPACs are not, “according to the Tulane business law professor. Ann Lipton. It’s so much easier to convince people that a business is a good buy when you’re not hooked if those promises don’t come true.

Why are they so popular right now?

Much has been written about SPACs recently, and their popularity has spawned more popularity. Last year, there were four times as many SPACs as the year before, according to Ritter data. This year, we are on track four times more than last year.

High-profile SPACs, such as electric truck maker Nikola and DraftKings, have captured the interest of institutional and retail investors alike. Popular SPAC backers, including Facebook CEO and so-called SPAC king Chamath Palihapitiya, as well as a number of celebrity endorsements, including those of Jay-Z and Steph Curry, have made investing in SPAC even more compelling.

“There is a great appeal among people that there is a smart person making investment decisions on their behalf and who will make them big money,” said Ohlrogge of NYU.

Additionally, many SPACs are seeking mergers in popular sectors like electric vehicles, where investors hope to replicate gains like Tesla, whose share price has risen more than 1,000 percent in the past two years.

“I think it’s partly a case of investors chasing past returns,” Ritter told Recode. “The last few months have been very good for SPAC investors, and the money tends to follow past returns.”

The stock market is also doing well right now, and as Bloomberg’s Matt Levine noted, SPACs are seen as a way to capitalize on current market conditions to take a company public in the future, when conditions may not be as good. .

What’s the trick?

If investors put their money in SPAC and keep those shares after the merger, they are likely to lose more money, on average, than if they invested in regular IPOs.

While SPACs can be a sure thing for those institutional investors who can buy $ 10 stock and trade their money if they don’t like the eventual merger, the value proposition is less clear for those who enter later. In a study of nearly 50 SPAC mergers in 2019 and 2020, Ohlrogge found that one year after the mergers, SPAC returns were nearly 50 percent lower than for a basket of IPOs. Ohlrogge also found that about 97 percent of those who bought SPAC in the IPO redeemed or sold their shares at the time the merger closed.

What happens next?

SPACs could be victims of their own popularity.

“Now there is so much money chasing deals, it will be increasingly difficult to achieve attractive mergers,” Ritter said.

That could mean SPAC sponsors have to eat your investments if they don’t find a good merger. If SPAC’s historical performance is any indication, investors in companies that complete mergers and go public are also not necessarily safe. Even the people who benefit from the SPAC boom are cautious. David Solomon, CEO of Goldman Sachs, SPAC’s big underwriter, said earlier this year that the trend is not “sustainable in the medium term.”

SPACs may also come under increased regulatory scrutiny as the SEC takes a closer look at how they operate and how well they are understood by retail investors.

For now, the SPACs are in a very lively space, but when the buzz stops, it’s likely to sting.

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