SPACs present some very promising opportunities for financial services industries, but companies must be careful to avoid risky bets on this trendy financial instrument.
Special purpose acquisition companies, also known as SPACs, have experienced a rapid boom in popularity, starting in late 2020 and continuing into 2021. These financial instruments have become an increasingly trendy way for companies to go public, while providing significant opportunities for a variety of financial service industries.
What are SPACs?
A SPAC is a shell company, which is listed on a stock exchange for the purpose of acquiring a private company. This enables companies to go public without going through the traditional initial public offering (IPO) process. SPACs are registered with the US Securities and Exchange Commission (SEC) and are listed as a publicly traded company, enabling the general public to buy shares before the acquisition takes place, and thus, before the company goes public.
SPACs vs. IPOs
SPACs are typically faster than a traditional IPO, although not necessarily any less expensive for the company going public. Additionally, SPACs are backed by a sponsor, making a SPAC essentially an investment in the SPACs sponsor and their record of successful SPAC deals. SPACs also receive less regulatory scrutiny from the SEC compared to IPOs, with more latitude on how SPAC sponsors can promote future growth of their companies. Increasingly, many large companies within the Investment Banking and Securities Dealing industry, which have a long history of underwriting IPOs, have generated high returns from underwriting high-profile SPAC trades.
Retail investors love SPACs…
The recent boom in SPACs is partially fueled by a broader trend of speculation among retail traders, rocking financial markets over the past year. Retail investors, many of which are using popular online brokerages created by companies in the e-Trading Software Developers industry, accounted for 46.0% of trading volume in SPACs in January 2021. This has provided further assistance to companies in this industry, which have benefited from a sharp rise in retail investment during the COVID-19 (coronavirus) pandemic.
But SPACs love institutional investors more
However, since many of these retail investors are only able to buy common shares on the open market rather than before the initial offering, they typically miss the first day “pop” in price. Institutional investors, such as Private Equity firms and Hedge Funds, are able to gain much higher returns due to being able to buy in at much lower prices before the SPACs are on the public market. Additionally, these large institutional investors tend to sell shares once the merger is completed, which typically brings down prices. As a result, individual investors who put their money in SPACs and hold onto them after the merger are more likely to lose money on average than if they invested in standard IPOs.
SPACs: High reward, but high risk
While SPACs are currently performing quite well, financial services companies seeking to benefit from the boom in this investment vehicle must also keep a close eye on it. As SPACs boom, the market may become flooded by public offerings for companies with increasingly dubious prospects for future growth. Even large institutional investors, which are well positioned to generate returns from SPACs, may find themselves in trouble if they invest in public offerings through SPACs that do not live up to their promise.
