Special purpose acquisition companies (SPAC) have become a buzzword on Wall Street over the past few years, as they’re offering investors a unique way to bet on initial public offerings (IPOs). Unlike the traditional IPO process, SPAC IPOs give firms a faster way to access share-markets. It also gives retail investors a chance to invest in a budding company that they otherwise may not have access to.
It sounds like the perfect solution — the firm gets a direct path to the market, and investors get access. In recent months, it has drawn a lot of attention from individual investors looking for a way to grow their wealth in a bloated market.
But as with every good opportunity, there are some serious risks to consider before jumping in the SPAC IPO pool.
Are these investments right for you? Here are seven things to consider:
SPAC IPOs Offer Little Control
A big part of whether or not SPAC IPOs are right for you depends on the type of investor you are. Buying shares in a SPAC firm does give investors a potential inroad to being part of an IPO they otherwise would miss out on — typically only Wall Street’s bigwigs have access to shares when a company goes public.
But buying a SPAC in hopes of participating in a hot new IPO means putting your money in someone else’s hands — investors don’t have a say in what company the SPAC decides to take public.
For investors comfortable putting their money in someone else’s hands, that might be a risk worth taking. But if you’re the sort of person who pours over a firm’s financials before buying their stock, that could be a problem.
A Different Kind of Research
If you’re comfortable letting a venture capitalist take the reins, the next step is figuring out who you want to trust. When buying traditional shares, it’s important to know who’s in the driver’s seat, and whether or not you want to trust them.
Companies with polarizing CEOs like Ryanair (NYSE:RYAAY) or Tesla (NASDAQ:TSLA) can scare investors away because their erratic behavior can impact the share price. While the CEO should be a factor in your research, most investors aren’t buying a company based solely on whether they like its leader.
With SPACs it’s a bit different. Understanding the venture capitalist team at the helm is a huge part of whether or not the stock is worth buying. That’s because ultimately they’ll be responsible for whether or not an IPO materializes, and whether the firm they take public is a good one.
Needle in a Haystack
That brings me to my next point — when you buy shares in a SPAC, it doesn’t guarantee access to an IPO. The firms have up to two years to make an acquisition, during which time investors’ money is simply held in a pool waiting. If no acquisition is made within that timeframe, the SPAC returns investors’ money.
That means that theoretically, investors could be waiting around for years only to be disappointed. According to an analysis by the Financial Times, that happens just under half the time. Those aren’t great odds, which makes it especially important that you’re investing in a VC team that you believe in.
Although SPACs have only gained mainstream popularity recently, they’ve been around for a long time. But 20 years ago, they were considered a junk investment that only the riskiest investors would consider. Fast forward to today, and they’ve drawn interest from a host of ordinary traders looking to make money on Wall Street.
There are a few things that the dicey history of SPACs tells us — first, they’re risky. That’s clear from their subpar performance in the past. Of course, the famed venture capitalists at the helm today will tell you that times have changed, and investing in a SPAC is no longer the gamble it was in 2015.
Some data backs that up — the most successful SPAC IPOs have happened in the past two years. But when it comes to identifying trends in data, two years isn’t much.
Working for Investors or Sponsors
Perhaps the most controversial aspect of investing in SPAC IPOs is the fact that oftentimes, the “sponsors”’ behind the investment vehicle will profit whether they orchestrate a successful IPO or not. SPAC founders are usually entitled to a “promote” fee, equal to about a fifth of the value of the company. This fee is collected whether the founders perform or not, so it begs the question of whether or not founders are motivated to find a quality company to take public.
In today’s market, not all SPACs are set up this way. Diamond Eagle, for example, the SPAC that took DraftKings (NASDAQ:DKNG) public, did not allow sponsors to collect their promote fee until shares reached $16 — a 60% increase from their IPO price.
That kind of setup offers investors a layer of security and is worth keeping in mind when researching potential SPACs to buy.
Sector Makes a Difference
If you’re keen to add SPACs to your portfolio, it’s important to consider the industry it’s likely to find the company it plans to take public. From this perspective, you want to choose an industry that’s ripe for growth and especially vulnerable to disruption. We saw that within the electric vehicle industry in recent months, as SPACs like Nikola (NASDAQ:NKLA) and Hyliion Holdings (NYSE:HYLN).
But investors should be thinking ahead to spaces that have room for innovation where a startup might be able to step in. One potential place to look is healthcare, where telemedicine and remote technology has become a huge focus. Investors should have a good idea of the kind of industry their SPAC will buy into by reading the firm’s SEC registration documents.
Don’t Bet the House on a SPAC
Like any other stock on the market, you shouldn’t pour all of your money into one. Nor should you be solely invested in SPACs. For investors who can wait out some sideways trading, they make for a good investment because of their potential to deliver big profits upon orchestrating an IPO.
However, that doesn’t mean they’re the only way to make money on the stock market. Investors should not only diversify with more than one SPAC, but they should also hold some traditional investment vehicles as well — an appropriate mix of stocks, bonds and funds.
While SPACs may not be quite as risky as they once were, it pays to do your research and pick up SPACs run by venture capitalists you trust to spend your money wisely.
On the date of publication, Laura Hoy held a LONG position in RYAAY.
Laura Hoy has a finance degree from Duquesne University and has been writing about financial markets for the past eight years. Her work can be seen in a variety of publications including InvestorPlace, Benzinga, Yahoo Finance and CCN.