Too embarrassed to ask: what is a SPAC?

A financial instrument called a “special purpose acquisition company”, or SPAC for short, is growing increasingly popular in the US stockmarkets. But what exactly is a SPAC?

What is a Spac?

Spac stands for “special purpose acquisition company”. The key difference between a Spac and a normal company is that the Spac has no business of its own. Instead, its sole purpose is to raise money via an initial public offering (IPO – ie, joining the stockmarket) and then use that money to buy an existing private company or companies.

For this reason, Spacs are also known as “blank cheque companies” in the US. In the UK, they’d more commonly be described as “cash shells”.

Spacs have been around for some time, but they have erupted in popularity (and controversy) in recent years. For example, in 2009, only one Spac came to market, and even in 2019, the number was only 59 (according to data from Statista).

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

By contrast, nearly 250 Spacs were created in 2020, raising $83bn. And in 2021, that number surged to more than 600 Spacs, raising more than $160bn, according to industry website SpacInsider.

Big names that have gone public via the Spac route include Virgin Galactic and US sports and gaming group DraftKings.

So what is a Spac and how does it work?

A Spac is usually put together with the aim of buying a company (or companies) in a specific sector. The founders may be experts in the area, although as the popularity of such vehicles has rocketed, many are now associated with celebrities or other well-known figures, with everyone from US cook Martha Stewart to former president Donald Trump backing Spacs in recent years.

Once it has listed, the Spac generally has two years to find a deal or target to spend the money on. If it doesn’t then it has to return the cash to shareholders. Investors in Spacs can range from members of the public to big private equity firms and hedge funds.

What are the advantages?

Spacs have numerous benefits compared to traditional IPOs – at least, for the companies involved. The main advantage is time – Spacs allow private companies to go public much more quickly than via a normal IPO process. Another selling point is that being bought by a Spac saves on the hassle and paperwork of an IPO, and it’s also less costly.

As Martin Szydlowski, assistant finance professor at University of Minnesota Carlson School of Management, points out, Spacs “avoid the use of an underwriter, making it cheaper”. Spacs are also less tightly regulated, particularly in terms of the information they have to disclose to investors.

What are the biggest risks?

For an investor, Spacs come with plenty of risks. Perhaps the biggest is that investors do not know what their money is going to be spent on, so they are often taking a leap of faith when investing in a Spac.

Spacs also have a record of disappointing. According to one study by the European Governance Institute, “Spac share prices tend to fall by about a third of their value within a year of their mergers,” notes Rana Foroohar in the Financial Times.

This view is echoed by Szydlowski: “In the last decade, Spacs have been performing poorly in the stockmarket, leaving investors with substantial losses and alarming regulators… Some research suggests Spacs release excessively optimistic projections of future value, which influences retail investors who overvalue the shares.”

Partly as a result of this, Spacs have been coming under greater regulatory scrutiny. For example, the US Securities and Exchange Commission’s chair, Gary Gensler, warned in December 2021 that he wants to introduce tougher rules for the sector early next year.