I got a call from a client the other day. Our quarterly client letter listed several speculative investments we would avoid, among them SPACs. He wanted to know what a SPAC was. SPACs have been around for a while but have become increasingly popular in the past year. Now everyone talks about them like you should already know what they are.

A SPAC (Special Purpose Acquisition Company) is a creative way for a private company to publicly list its stock. First someone creates the SPAC, which is a company formed for the sole purpose of publicly listing its shares and then looking to merge with an existing company. Let’s say I want to create a SPAC. O’Connor Acquisition Company is born. I tell all the major financial companies that I’m going to raise $2 billion and sometime in the next two years I’ll tell them what company I’m going to buy. People love gambling in the stock market today, so I raise my money and my stock starts trading.

Now I’d better find some company to merge with. If I don’t merge with a company within two years, I must give my investors their money back. Lucky for me, there are plenty of private companies looking to cash out while valuations are high. I find a widget manufacturer and announce the terms of the deal. The widget manufacturer is happy because they avoided the hassle of doing a traditional IPO (Initial Public Offering) and they can be a bit rosier about their prospects in public statements because they aren’t yet a publicly traded company.

My investors who trusted me with a blank check do get some say in the deal. They get to vote for whether the merger should happen. They also get a warrant to buy more shares at a specified price.

What do I get as the SPAC sponsor? I get a bunch of shares at a very steep discount. I hate to tell you that this will dilute the value of my investors’ shares. I also get a lot of nice fees paid to me by the investors in the SPAC.

It’s clear SPACs work out well for the sponsor. How have these deals worked out for the investors? SPAC stocks in aggregate have underperformed a small company index fund. On average you are giving up returns for the excitement and hype. If you’re here for entertainment, go ahead and invest in one. If you’re here to make money, skip them.

About the Author:

John has more than ten years experience as an Investment Advisor. He focuses on devising and maintaining portfolios that meet individuals’ needs, investment research, and investment strategy. John has been recognized as a “FIVE STAR wealth manager” by Twin Cities Business Magazine 2016-2020.

Legal Disclaimer: These posts do not constitute an offer or recommendation to buy or sell any securities or instruments or to participate in any particular investment or trading strategy. They are for informational purposes only. CTW gathers its data from sources it considers reliable. However, CTW makes no express or implied warranties regarding the accuracy of this information or any opinions expressed by the author and may update or change them without prior notification.