What is a SPAC?

Introduction

As teenagers, most people phase through a variety of hobbies. When thinking of teenage hobbies, the first things that come to my mind are usually video games, baking, dancing, and reading, but when teenagers are given weeks of free time, it’s much easier for them to dive into unique hobbies. After a long, boring semester of virtual learning, I decided to find an activity to pass the upcoming winter break. With no school, little in-person contact with non-family members, and too much free time, I picked up a new hobby: day trading.

Although I was relatively uneducated in the stock market, I was confident that the $400 I set aside for day trading would be worth at least $1,000 in two weeks. Beating the masterminds behind the S&P 500 was going to be easier than buttering toast. The challenge was: how could I get a better return rate than top hedge fund managers in the country?

The first step was clear. Just as millions of other teenagers would, I turned to TikTok to learn how to compete with the best hedge funds in the country. As I was scrolling through my “For You Page,” I came across a video that announced, “Last month, my Discord notified hundreds of people to buy ticker NIO at $30.58, and one week later the same stock was trading at $41.63. A 36% increase in one week.” Although this increase didn’t fully align with my day trading aspirations, it was a good lead, but I couldn’t exactly be waiting one full week to turn my $400 into $545. After twenty seconds of consideration, I followed boatrading, the account that posted the video.

With less than a week before the start of winter break, I started to worry about my upcoming deadline and continued to search for ways to double my money in two weeks. After a deep Google search, it seemed that it wasn’t going to be easy to make money that quickly. Frustrated, I resorted back to the boatrading TikTok account I’d found. After browsing through the videos, it seemed that the Discord, advertised in the first video, notified people when to buy and sell stocks on the day trading level.

Being hesitant to spend $20 on Discord, I deliberated over the pros and cons of joining the Discord with my dad. Like most parents, he wasn’t thrilled that I wanted to day trade. My dad told me, “It’s too risky. You could lose all your money in seconds.” He wasn’t wrong, but I was more concerned about if this Discord was worth it. My dad’s advice was crystal clear. “You’re seriously going to let some random guy from TikTok tell you which stocks to trade?! That’s the dumbest thing I’ve heard all year.”

“But, I just want to try it for a month, so I can make some money.”

“It’s your money. Frankly, I don’t care what you do with it, but I won’t be happy if you lose it all.”

“Okay,” I responded, walking away from this conversation. Although I, too, was skeptical about trusting somebody from TikTok, my talk with my dad motivated me to prove him wrong. I pulled out my phone and opened TikTok. I clicked the link in boatrading’s bio, which prompted me to enter my credit card information. I was about to make my first investment. $20 for one month of investing advice. At the very least, I needed to make my $20 back by the end of the month.

The next morning, I woke up in my mom’s apartment at 5:30 AM. I took a quick shower to wake up and drove to my dad’s house, so I would have a more stable WiFi connection to execute my orders more quickly. With only five minutes before the market opened, I entered the house and opened my computer at my desk. I quickly closed everything on my computer beside Fidelity’s website and boatrading’s Discord server and waited for the market to open.

At the market open on December 17, 2020, I bought stock in two tech mutual funds and one retail store mutual fund for long term holding. I kept the Discord server running as I watched hundreds of trade alerts pop up on my screen. There were recommendations to buy long term stocks, short term stocks, stocks for daytrading, penny stocks, stock options, and SPACs. Although I planned to daytrade, I was still hesitant to invest my money in a stock for a short amount of time to only pray the price wouldn’t drop. So for the day, I kept my Discord open on the long term stock section and decided to buy a share of SunRun (RUN) and First Solar (FSLR). I wouldn’t consider my due diligence to be the best as I simply read a short paragraph explanation on Discord on why buying these stocks was a great idea.

?After the market closed at 1 PM, my curiosity had me browse through the two sections of the Discord server I knew nothing about. I started by clicking on “Penny Stocks.” After looking into some of the companies recommended under that section – ie. Sundial Growers (SDNL) and Farmmi (FAMI) – I quickly realized that a penny stock is self-explanatory. It’s simply a stock that’s worth a few pennies. The rule of thumb for penny stocks is that they don’t trade for more than $5.?

Since I immediately felt like I had a better understanding of penny stocks, I entered the “SPACs,” or special purpose acquisition companies, section. At the top of the section, there were two alerts for SPACs that I apparently needed to invest in tomorrow: Social Capital Hedosophia Holdings Corp. III Class A (IPOC) and Gores Holdings IV Inc Class A (GHIV). There was an upcoming vote within these companies. If this vote was successful, their stock prices were going to shoot up, and they’d soon be merging with Clover Health Investment Corp. and United Wholesale Mortgage, respectively. Due to Clover Health’s presence in the medical industry, this merger was supposed to be a great success, and since United Wholesale Mortgage was valued at $16 billion, it was going to be the largest SPAC deal to date. Not knowing what any of this meant or even what SPAC stood for, I closed my computer for the day with a new plan in mind. I was going to invest in IPOC and GHIV tomorrow morning.

The next morning I woke up before the market and prepared myself, mentally and physically, to make my first risky investments. I’d thought that I knew nothing when I bought shares in SunRun and First Solar, but buying these two SPACs was about to make me seem like a genius when investing in RUN and FSLR. At the market open, I quickly spent $46.46 on two shares of IPOC and spent $10.75 on one share of GHIV. At that point, I hadn’t exactly dumped my life’s savings into these SPACs, so I wasn’t freaking out that I was about to lose piles of money. However, I was still worried about losing $5 to $10, and I don’t blame myself because I didn’t know what I’d invested in.

Later that day, I sat down with my dad for lunch. As I bit into my tuna melt, my dad began to ask about how my investments had done. “What’s your investment portfolio looking like?” he asked.

“I haven’t bought much yet. Just a few Fidelity mutual funds and a few shares in SunRun and First Solar. Why’d you ask?”

“I’m just curious. Weren’t you going to try day trading?”

“I was planning on it, yes. But, I’m still a little scared to invest like that.”

“If you’re too scared, then, why’d you buy and sell shares in Social Capital something and Gores Holdings?”

I knew that my dad could see every investment I made since I had a Fidelity custodial account, but I didn’t think that he’d actually watch over it. “They’re two SPACs that Discord recommended me to buy. I tried to flip them for a profit today, but it didn’t work out too well.”

“What’s a SPAC?” my dad asked.

“It’s just some company that merges with another company,” I replied.

Throughout the rest of December, I began to day trade with more and more stocks and about 30% of my investments were into SPACs. Despite my limited knowledge, I had no problem investing in them by late December. Then, on January 6, something I found quite interesting happened. IPOC’s ticker switched to CLOV. At first, I was surprised by this because when I searched IPOC’s stock price, Yahoo Finance no longer showed any results. After a quick bit of research, I realized that the Social Capital Hedosophia Holdings Corp. had successfully acquired Clover Health Investment Corp, and because of that, the ticker changed.

Two days later, I received an email from my dad with the subject “Fwd: GHIV.” I opened the email to see an email correspondence between my dad and his older brother, Keith. This thread started with the question, “What is GHIV?”

Keith’s response read, “It’s for United Wholesale Mortgage.” Now, I could’ve figured that out on my own from Discord. Based on what had happened with CLOV, Gores Holdings and United Wholesale Mortgage were attempting to do the same.

Along with this forwarded email conversation, my dad wrote, “Do you understand what GHIV is?”

The answer was no. I had no idea what I’d been investing in over the past month. Forget about GHIV. I didn’t even know what a SPAC was. Where did they come from? How do they work? Who makes them? Why are they made? And the questions went on.

Now, one year later, I hope to answer the seemingly simple, yet complicated question: “What is a SPAC?”

The History of SPACs

SPACs have had a recent boom in popularity, but I did not know if this hype around SPACs was because they were a new invention or if something else caused people to become interested. After some quick research, I found that this method of taking a company public has been around since 1993. The founder of investment bank GKN Securities, David Nussbaum, and his friend who he had met at New York University Law School in the early 1970s, David Miller, created the first SPAC template. The goal behind his new idea was to get everyday investors access to investing in private companies that would not be able to become publicly traded through a traditional Initial Public Offering (IPO) in the near future. But more importantly, private companies now had a way to receive investments from the everyday person.

Even though private firms could now become publicly traded through a SPAC, they were far from a huge success. While there was a fair share of individuals who made the executive decision over their stock brokers to invest in SPACs and some stock brokers who recommended SPACs, the majority of investors were opposed to investing in SPACs because they were seen as a new variation of a blind pool.?

Due to my limited finance knowledge, I had never heard of a blind pool, so I had to figure out what they are and why they caused issues in the past. Blind pools have been around as long as the US stock market, gaining popularity in the booming market of the 1920s, and again in the 1980s. Like SPACs, blind pools begin with a blank check company, a company that raises money without stating where their money will be invested. As the name suggests, a blind pool is an investment in which investors do not know where their money will end up. The management team can use the money however they please as long as they have a goal to merge with another company in the future.?

The everyday investors who choose to invest in blind pools are trusting the blind pool’s management team to find shrewd investments. However, everyday investors were frequently attracted to the blind pool companies because they were almost always penny stocks. Back then and still today, it is common to find people investing in penny stocks without doing their due diligence because when shares are that cheap, people are not as worried about the downside risk as much as they are hoping that the stock price will increase. Everyday investors also had to stand firm against their convincing stock brokers’ wishes to invest in these stocks. Unfortunately, many people lost significant sums of money investing in blind pools during the 1980s due to minimal government regulations and fraud.

The Securities and Exchange Commission (SEC) did not consider blind pools to be any different than normal securities, so they created no additional regulations for blind pools. Without additional regulations, blind pools became a large source of fraud because management teams’ actions could not be monitored by blind pool investors. On the state level, however, some governments implemented legislation that protected everyday investors from being scammed by blind pools. For example, Utah, a state with many blind pools during the 1980s, introduced legislation that required management teams to keep 80% of investments in an escrow account before they announced the purpose of the blank check company, giving investors more insight into where their money would end up.?

With limited regulations, I can easily imagine why these stocks gained a bad reputation. Management teams would create their blank check company and begin raising capital, so the company could merge in the future. Since the market was so small, the few rules that had to be followed were not enforced by the SEC. So management teams would secretly sell stock shares to close friends and family. Then, the company would create excitement around the company increasing share prices up to three times the price sold to their inner circle. With the new enthusiasm surrounding the company, the over-inflated stock prices would make the company especially appealing to the public. Everyday investors would see the strong upward trend of the penny stocks and want to buy in with doing little to no due diligence. What these oblivious investors were actually buying were the shares that were previously owned by the management team’s close friends and family, so this inner circle would quickly and easily double to triple their investment. Once the inner circle sold their shares and stock brokers took their profits, they abandoned their recently created shell companies, leaving their share prices to plummet.

As the SEC’s former head of penny stock task force, Joseph Goldstein put it, “When you are dealing with penny stocks, you are dealing with the riskiest investments someone could make.” In the 1988 fiscal year, the SEC received 1,510 complaints about penny stocks, and in 1989, the SEC received 3,751 more complaints. Thousands of investors were upset that penny stocks had caused them significant losses. The stock brokers who spent hours on the phone persuading clients to buy penny stocks were exceptionally convincing and could rather easily get someone to buy these risky investments. Since the brokers were making large profits from these penny stocks, anywhere from $10,000 to $50,000 per month, they had quite the incentive to get investors to buy in. Although I knew that there were general complaints about penny stocks, I wanted to learn about specific issues people had with them, so I looked into lawsuits people filed around 1990 against penny stocks.

In one lawsuit in 1989, Milton Winstrom from Salem, OR, testified in front of a congressional subcommittee that he had saved $41,000 while working for the US Navy. Winstrom invested his money through Blinder, Robinson & Co., and his stock broker allegedly put all $41,000 into penny stocks without Winstrom’s permission or knowledge. Unfortunately, the $41,000 quickly turned into $8,000.

In another lawsuit, William and Lily Lynes from Powder Springs, GA sued their stock broker Charles Wilson at Stuart-James Co for scamming them out of their life savings of $13,000. Wilson had convinced the couple to invest into penny stocks, but like many penny stocks, the share value dropped to nearly nothing leaving the couple nearly broke. The whole time, Wilson had convinced them to trust him although they did not actually understand where their money was going. The Lyneses and five other Wilson clients tried to sue Wilson, but the judge refused to take the case since the investors had signed a form stating that they would take issues to arbitration. In 1988, they filed an arbitration claim with the? National Association of Securities Dealers (NASD) that ultimately, did not lead to anyone receiving their money back.

In 1988, the SEC filed 25 penny stock fraud cases, and in 1989, the agency filed 58 fraud cases. With the high number of complaints and lawsuits against stock brokers and firms encouraging investors to buy penny stocks, the SEC created new anti-fraud regulations for penny stock companies that went into effect on January 1, 1990. Additionally, the SEC posted two million fliers warning investors of the dangers of investing in penny stocks. These people were going exactly against what my dad had warned me: do not put your trust into someone you do not know. Like me, who was trusting a random person I found on TikTok, these people were blindly putting money into pools run by unfamiliar brokers. Blind pools ranked among the most dangerous of the penny stocks because nobody who invested in them knew where their money would end up. These investments were the closest investments you could get to legalized gambling.?

In the midst of this blind pool chaos, David Nussbaum realized there was an opportunity to make an investment vehicle similar to a blind pool, but with more security for investors. At the time, Nussbaum was working for his own brokerage and was part of a blind pool deal that inspired him to create the SPAC. In 1991, this deal took the video game company THQ Inc. public. After the company released the “Home Alone” video game, creating hype around THQ Inc, its share price soared.

In the meantime, Miller had been working with other attorneys to protect investors against fraud from blank check companies. After Nussbaum helped take THQ Inc. public, he reached out to his friend, Miller, to help him create a more protected blind pool. Examples of additional protection included allowing investors to get their money back before a merge is executed and making blank check companies become more transparent with their money usage and intentions. This added protection led to the first SPAC being created in 1993.

This SPAC was led by venture capitalist Arthur Spector and raised $12 million through a blank check company, Information Systems Acquisition Corp, that, in March 1995, merged with Human Designed Systems and became known as Neoware Systems. This was the first successful SPAC deal, but even with increased regulations on SPACs,? Miller and Nussbaum faced an uphill battle, having to overcome the stigma of blind pools created in the prior decade.

After the first successful SPAC, Miller and Nussbaum trademarked the term. This forced others to make similar blank check companies, but different acronyms were used, such as SPARC for special purpose acquisition rights company, to get past this barrier of taking companies public. With too many loopholes, Miller and Nussbaum changed their minds and got rid of the trademarked name, so anyone could use a SPAC to take a company public.

As the dot-com bubble in the late 1990s rolled around, the future of SPACs did not look promising. Internet companies were all the hype, and because of this hype, the companies could easily go public through traditional IPOs. From everyday investors’ standpoints, it did not make sense to put money into a SPAC or blind pool when they had the opportunity to invest in the booming internet stock market. The risk seemed to be much lower because they knew where their money would end up and not have to worry about being scammed by penny stocks. Even with uncertainty around SPACs in the 1990s, Nussbaum and his team were able to take fourteen companies public during the decade through SPACs.

Very few people realized how the dot-com bubble was potentially affecting the future of the SPAC market, and Miller and Nussbaum were two people concerned about the future of SPACs.? They worried that their first SPAC deal was going to be their only one as they had needed to focus on helping companies use a traditional IPO during the bullish market. But in March 2000, the market began its crash as doubt in internet stocks grew. Three months later, Nussbaum co-founded EarlyBird Capital with Steve Levine.

With Nussbaum and Levine in charge of EarlyBird Capital, the company executed the first SPAC deal of the new millennium. After the dot-com bubble popped, Spector, who had run the 1993 SPAC, worked with EarlyBird Capital to create another SPAC. By August 2003, Spector raised $24.2 million and was able to merge the SPAC, Millstream Acquisition Corp., with NationsHealth, Inc. in August 2004.

From one SPAC in 2003, their popularity grew to have 66 SPACs in 2007, but as the 2007 mortgage crisis took its toll on the economy, the crashing stock market caused there to be only one SPAC in 2009. It was not until 2019 that their popularity returned to what it was in 2007. In 2019, one of the most profitable SPAC deals occurred when the space-tour company, Virgin Galactic Holdings Inc. went public. Then in 2020, a record-setting, 248 SPACs entered the market, but that was nothing compared to the 613 SPACs in 2021.

As evident by the number of SPACs deals executed in 2021, this method for going public has recently become popular. Despite the blind pools and penny stocks' shaky pasts, many retail investors are still willing to invest in SPACs. Everyday investors have put billions of dollars into blank-check companies, hoping that the assetless company will find a great company to take public, so they can see fantastic returns on their investments.

The SPAC Structure

Like many things in life, every SPAC starts as an idea. A person or group of people who have financial experience and access to large sums of money decide to create their own SPAC. Once someone makes the decision to work on a SPAC, they are committing hours of their time hoping that they will turn a large profit in a relatively short amount of time.

After deciding to create a SPAC, a search for a management team and board of directors for the blank check company begins. Although there are no guidelines around who can join the management or board, it is best to choose people who are experienced in finance, and it is even better when they specialize in whichever sector the company is planning to focus on. For example, the president of the SPAC may determine that they want the company to merge with a sustainable energy company. If this is the goal, then it would be ideal for the board of directors to have worked for sustainable energy companies, such as SunRun or Enphase, and the management team to have experience investing in the energy sector because many retail investors will ultimately decide to invest based on the board and management’s experience.

Around the same time, someone is searching for a board and management team, there is a search for a SPAC sponsor or group of sponsors. Sponsors typically fall into one of the three following categories. There are private investors and public equity investment funds that choose to sponsor SPACs in hopes of receiving a high return on investment. There are also business executives who want more funding for a project that would cost somewhere between the tens and hundreds of millions of dollars, and since they do not have the necessary capital, a SPAC can raise the money more quickly and easily than a traditional IPO. Finally, there are companies that need more capital for projects. These companies are in a similar scenario to the business executives but at the corporate level.

The job of the sponsor is to take on the risk of the SPAC failing. To take on this risk, they cover the at-risk capital, the money that would be lost if the SPAC does not acquire its target. The at-risk capital must be 5.1% or more than the planned IPO capital that other investors will raise. If a company had a goal of creating a $200 million SPAC, then sponsors must pay at least $10.2 million, and often, sponsors will have to pay more than 5.1% to cover the costs to get the SPAC off the ground. These fees include paying auditors, attorneys, and underwriters.

In exchange for taking on the risk of a SPAC that fails, sponsors will typically receive 20% equity in the SPAC for free. The equity they receive is normally a combination of $10 shares and $11.50 warrants. Each SPAC has its own warrant regulations. The most common rules are that the warrant cannot be redeemed earlier than 30 days after the acquisition, or that they have to be redeemed within a year after the acquisition, and that if the share price reaches $18, the warrant must be redeemed. As long as the share price is above $11.50, the sponsors can make hefty profits from their warrants.

To top it all off, sponsors are usually on the SPAC’s board of directors, so they get to help with the decision-making process of which company they should acquire. This way they have some control over how their sponsor capital is going to be used.

So once all of the people behind the SPAC have been chosen, the SPAC forms their blank check company, usually a limited liability corporation (LLC), and prepares it to become publicly traded on a stock exchange under SEC Rule 419. At this point, the sponsors are able to deposit their funding into the SPAC’s escrow account, which is used to hire auditors and attorneys to help with the process. Then, the shell company prepares an S-1 form, which is the form used to take a company public. The SEC then takes around 4 weeks to review it. After that, the SPAC will need to respond to the SEC, and send it in for additional review. Generally, the SEC will look at the S-1 form four times before it becomes effective, which will take about 16 weeks.

In the final month of the S-1 filing process, the management files their preliminary prospectus and prepares for their roadshow. Information about the company’s plans, capital use, management team, and financial statements are in the preliminary prospectus. On the roadshow, this prospectus is available for prospective investors when the SPAC is testing the waters (TTW). The management team that goes on the road will prepare a TTW presentation for wealthy, private investors to see what their initial thoughts on the SPAC are. Do they think their business plan makes sense? Are they targeting the right companies? Will it be profitable?

The roadshow will last for about one month, and once it ends, the management team creates their final prospectus, which is similar to the preliminary prospectus but has more information like the price of the securities.

When the final prospectus has been printed, the company will be officially ready to be listed on a stock exchange, so the morning after the decision to go public is made the SPAC will have its IPO.?

At the IPO, the institutional investors who were met during the roadshow will buy their shares, and retail investors will also be able to buy stock. The share price will be held at $10 until there is a successful acquisition. The invested money will be held in an escrow account, so investors are given the opportunity to back out if they do not like the company that the SPAC later chooses to acquire.

From the IPO date, the SPAC has 24 months to merge with another company, so the management team needs to work quickly to find a company to acquire; otherwise, the time spent on SPACs will have gone to waste, the sponsors will have lost millions, all shares will be returned to their owners, and nobody will be impressed with the management team. Target companies must meet a few guidelines. They have to be private, which means they are not traded on a stock exchange. The company’s purpose must fall in line with the goal of the SPAC as outlined in the prospectus. Finally, the company should be valued at about two to three times the amount of capital raised by the SPAC, so there is less dilution during the transaction. It’s not always difficult to find a company that meets these criteria, but the SPAC management wants to find the best target company. However, the two-year merge deadline can put a block in finding the ideal company because a SPAC would rather merge than fall apart, so profits can be made. This deadline can lead to management teams rushing their decision-making process and not finding a low quality acquisition. Finally, once the SPAC acquires a company, the de-SPACing process begins, or the reverse merger. During this process, the formerly private assets of the target company are made public via the SPAC, and the SPAC ceases to exist.

Voila! A new company is publicly traded.

The Performance of SPACs

If you are smart about SPACs, they can be wonderful, low risk investments. But if you were like me when I bought GHIV shares, you can lose money and probably will if you are not paying attention. Because of the SPAC structure, anyone who invests pre-merger is in a temporary low risk investment. They can buy shares knowing that they can redeem the shares for $10 plus interest. These pre-merger shares could be trading as low as around $9.50 if the market is sour about the SPAC, or they could be trading at $30 if the market is optimistic. But if you invest in the SPAC before any merger is announced, the odds are that the share price will be around $10, give or take a dollar. So if you choose to invest in a SPAC at this point, you will not lose piles of money. You will only lose the time value of the money invested if it fails to acquire a company.

To most, this deal seems too good to be true, but the reality is from a money-making standpoint, it is not. Many smart investors buy SPAC shares before a merger is announced hoping that the hype around the news will jack up the share prices, so their shares can be sold for a profit. Anyone can do this, and there are three steps to giving yourself the best chance of success. First, research the management teams of each SPAC you are considering investing in. With a more experienced management team, there is a higher likelihood of the SPAC successfully merging. Second, find a SPAC that has a liquidation date that is relatively soon, so you do not have to wait two years to hear the announced acquisition. The one downside of waiting until the merger date is close is that the quality of the company the SPAC acquires is more likely to be low, or there may be no acquisition. In either of these cases, you still have your $10 safety net in case the share prices drop below $10 prior to the merger. If a SPAC acquires a low quality company, the odds of the share prices shooting up are not high, but it is still likely that they will rise above $11. But if you did not feel like researching a SPAC, you could get by without losing money if you follow the last, most important step: make sure you follow the news around the SPAC and stay up to date. You do not want to hold onto your shares through the acquisition date. As long as you do not lose your safety net, you will not lose your money.???

If you work to find a high quality SPAC investment, there is a good chance that the SPAC will successfully merge. Generally, you can do what I did and use a simple Google search to see if the SPAC will likely merge. Before 2015, around 20% of SPACs were liquidated, but since then, over 90% of SPACs have successfully merged. Historically, SPACs have been able to find companies to acquire relatively easily. Going forward, however, this may not be the case. Currently, there are about 4 times as many SPACs on the market as there are prospective companies to acquire, so the high rates of merging are likely to decrease in the near future.?

But, management teams will work hard to merge, so they do not lose their at-risk capital. One of the biggest causes of SPACs not merging is that too many investors sell their shares after the merger is announced. The management teams then become desperate to raise the lost capital, so they turn to private investors for help. For example, if there was a $200 million SPAC with $15 million of at-risk capital and investors pulled out $80 million before the merger, the management team would turn to a private investor who could invest $80 million in the SPAC, so it could merge. But when a private investor invests this much capital into a SPAC, they usually want to receive part of the sponsor’s share of the company post-merger. Although the sponsors never want to forfeit their shares of the company, when too many investors pull out, they need private investors’ investments, so the SPAC can merge. If there is no help from private investment, then the sponsors lose their at-risk capital, so it is much better for them to lose some shares of the company post-merger than to lose the at-risk capital. So investors, like me, need to be aware that management teams are not always going to find the best deal for their investors if there is a time limit approaching.?

Today, private investments are becoming more popular because there are many more SPACs than there are qualified target companies. Investors are pulling out before the merger more frequently since there is a high chance of merging with a low-quality company. With more investors withdrawing their funds, SPACs have to find private investors to save the SPAC. But even with the help of private investors, many SPACs will not find a merger because there are too many SPACs on the market for potential mergers.

Before the 2020 SPAC boom, data showed that pre-merger SPAC returns were approximately 46%, and post-merger returns were about -14%. These statistics surprised me at first, but after some research, the cause behind this becomes quite evident. Before a SPAC merges, the management team builds up hype around the deal, so more people buy the stock causing prices to shoot up.

After the merger successfully happens, the prices drop for two main reasons. First, generally, investors are likely to sell their shares before the merger because they are guaranteed to not lose money. Often, there are private investors with large sums of money who pull out just before the merger.?

But the more significant factor in the price drop is dilution, which is caused mainly by the sponsor’s promote, or 20% of the company they receive, and the warrants that the early investors receive. Let’s say that there is a SPAC that sells 1,000 shares at $10 per share. This SPAC successfully merges with its target company, so the sponsors receive 250 shares valued at $2,500 for free. Now, the amount of cash in the SPAC is still $10,000 since the sponsors paid nothing for the promote, but the value of the shares is $12,500 because there are 1,250 shares that are traded. To determine how much cash backs each share, you can divide $10,000 by 1,250 which tells us that each share is backed by $8 in cash. The stock market for some reason does not take this into account until after the merger, but once the market realizes this, it is very common for prices to drop to near $8 per share. The other form of dilution SPACs face comes from warrants. The original investors who receive warrants for $11.50 can execute their warrants almost whenever they want, and when they do, the company is creating new stock. Since a share is essentially being created out of thin air, the SPAC is being diluted in the same way the promote dilutes the SPAC. When shares are created from nothing, there is no cash to back them up, so the cash backing the remaining shares lowers. When the market takes that into account, stock prices can decrease even more.

One company that created a less dilutive SPAC structure is Pershing Square, a $4 billion SPAC consisting of 200 million $20 shares. Bill Ackman, the founder of this SPAC, took multiple steps to ensure each share was backed by more cash than the typical SPAC. Pershing Square does not have the 20% sponsor promote. Instead, there will be warrants that can only account for 5.95% of the company, and these warrants cannot be exercised until 3 years after the business combination and at a 20% premium. The prospectus explains this structure as being “better aligned with [their] stockholders and potential merger partners.” In the normal SPAC, a shareholder who redeems their shares right when the target company is announced gets to keep their warrants. But Pershing Square has non-detachable warrants. This means that shareholders must give up two-thirds of their warrants when they redeem their SPAC shares, giving them an incentive to hold on to their shares through the merger. Finally, this SPAC has tontine warrants. So, whenever a shareholder redeems their warrants, the company distributes the warrants among the remaining shareholders pro rata. This innovative SPAC structure does a great job at aligning the incentives of the people working on the SPAC with retail investors’ incentives. It will be interesting to see which company this SPAC acquires and its performance.

When investing in SPACs it is helpful to keep their historical performance in mind and to understand why they have performed so well before the merger and poorly after the merger. The more you understand SPACs the easier it is to make smart investments in them.

Conclusion

Now that I have a fundamental understanding of SPACs, I began to think about another simple question: are SPACs a good invention? To answer this question, I spoke with David Nussbaum, the SPAC inventor, and a few professors.

On my Zoom with Mr. Nussbaum, I asked him, “What were your intentions when you created the SPAC?”

? He replied, “I wanted to give investors the opportunity to invest alongside smart, savvy investors. Big investments, like college endowments, invest in managers, not stocks, and private equity and mutual funds can invest in people. But the average investor could not.” While SPACs do give everyday investors the ability to invest in people, the goal of a SPAC management team is not necessarily for the everyday investor to profit. Rather, they want themselves to profit, which may or may not help the retail investor. When wealthy investors invest in money managers, the managers generally have similar incentives as the investors because when there is a greater profit, the managers also make more money.

Now that I had a better understanding of why SPACs were created, I wanted to know if Mr. Nussbaum would recommend everyone to invest in SPACs, so I asked him, “What are the biggest pros and cons of investing in a SPAC?”

His response was straightforward. “Investing in SPACs has an overwhelming amount of pros. Because of the redemption right, there is zero downside risk. It is almost impossible for an investor to lose money if they sell their shares prior to the merger. Whenever my investors invest in SPACs, they almost always trade out before the deal goes through.” Had I known to get out before the merger, I could have had better returns on my SPAC investments two years ago.

At first, Mr. Nussbaum did not mention any cons of investing in SPACs, so I nudged him, and he told me, “The only real con about SPACs is that if there is a high quality company that can use a traditional IPO, they will, so there are not as many high quality companies that go public through SPACs.” This lack of high quality companies is another reason SPACs tend to not perform well after the merger besides having to face dilution, but again, had I known this two years ago, I could have put myself in a much better position to profit off of SPAC stocks.??

After my conversation with Mr. Nussbaum, my general feelings about SPACs improved. When I had invested in IPOC and GHIV, I felt completely ripped off. The stock prices tanked from when I bought them to when I sold them. I bought IPOC shares at just over $12 per share on December 18, 2020, less than one month before the merger. Just one week before the merger, the share prices reached an all time high of $16.77, but my ignorance of SPACs led me to believe that there was no reason for the prices to not remain that high. I waited until January 15, 2021, one week after the merger, watching the stock slowly fall, and fortunately, I sold my shares for $13.55. Indeed, I had profited, but I had failed to capitalize on the stock when the prices soared days before the merger. Since I was simultaneously trading GHIV stock, I had another feeling of disappointment within myself for not capitalizing on these stocks. I was buying GHIV stock throughout late December for prices of anywhere from $10.72 to $12.78? per share. Unlike IPOC, GHIV was not merging until January 22, 2021, and its price peaked three weeks before the merger at $13.13 per share. Again, I waited until a week after the merger to sell my shares, and by then, the stock price had dropped to $9.91.? In retrospect, I had not been ripped off. I bought shares of stocks that I did not understand. If I had known what I was getting myself into, I would have been able to take advantage of SPACs and capitalize on their pre-merger profits.?

After my Zoom with Mr. Nussbaum, I got on the phone with Professor Michael Klausner from Stanford and Professor Michael Ohlrogge from New York University. These professors worked together on a few research papers about SPACs that I had read, and it was easy to tell that they did not have the same positive view of SPACs that Mr. Nussbaum had.

I began my conversations with the two by asking them if SPACs were good investments. Both professors answered with a resounding yes. “If you’re looking for a low-risk investment, SPACs are great,” said Professor Klausner.?

So the skepticism the professors had with SPACs was around their structure and their ethicacy of them. As mentioned previously, SPAC stock is heavily diluted from the sponsor promote and warrants. This dilution causes many retail investors to lose their money after the merger. When people are in similar shoes as I was two years ago, they will not realize that even if the SPAC deal is great, the stock price is likely to drop since there is not enough cash backing up each share. Secondly, SPAC management teams almost never have the same incentives as the retail investors, so investors must pay close attention to their investment. The management team always looks for the best company to take public, but their choices are limited. And it is much better for a management team to merge with a horrible quality company than no company because they will still get 20% of the company. So, the people who run the SPACss are focused on making money for themselves, and their top priority is not to make money for everyday investors.

This difference in incentives can be problematic, but it is mostly the investor’s responsibility to understand their investments. If you invest in a SPAC, they need to know the basic structure, rules, and performances of these vehicles rather than blindly investing, like me. SPACs are great investments from a purely money-making standpoint, but when you invest in SPACs, you are also investing in the people who run them. These people are not usually there to help you, so it may be worth thinking about where you want your money.