If you’re a regular reader of business or investment news, you’ve probably noticed more and more articles about SPACs, or special purpose acquisition companies. What are they? And do they have any relevance for you and your investments?

Let’s take the second question first. SPACs are not used in any SMI strategies and we’re not recommending them for any investing you might do outside of SMI. That said, we want you to be an informed investor, so here’s what you need to know about SPACs.

SPAC basics

A SPAC is a publicly held company that doesn’t make or sell anything, other than shares in the company. It’s a shell company that exists for the sole purpose of raising money to buy or merge with another company (a “business combination”). They’re often referred to as “blank-check companies” because, while a SPAC might identify a specific business or industry it will target in its acquisition efforts, it is not obligated to stay within those parameters. As a result, investors are seen as writing the SPAC a blank check.

While SPACs are getting a lot of publicity lately, they’re nothing new. SPACs have been around for decades. They’ve become especially popular over the past couple of years because of the rough start a number of IPOs have had recently, increased volatility and economic uncertainty brought on by the pandemic, and an appetite among some investors for more high-potential investments.

To better understand SPACs, let’s look at them from three different angles.

1 – The SPAC sponsors

These are the people or organizations who create SPACs, often private equity firms or hedge funds. What’s in it for them? They don’t typically need to put much money into the SPAC. Their job is to raise money from investors and then find and close a deal with a company that wants to go public. In return, they often receive a 20% stake in the SPAC, which turns into 20% of the acquired company, assuming a deal is completed.

The money they raise is held in a trust, which earns interest that is used to pay taxes and operating expenses. The SPAC has a specified amount of time, usually 18-24 months, to complete a deal or it is dissolved and the money is returned to investors.

2 – The SPAC acquisition targets

Going public by combining with a SPAC is less rigorous, less expensive, and less time-consuming than going the IPO route, which can take 6 to 12 months to meet all of the SEC’s requirements. Plus, working with a SPAC gives the company more control over its valuation. Rather than seeing what the market will bear once its stock starts trading, valuation decisions are worked out in advance, with company founders receiving a predetermined amount. Also, because the rules regarding mergers are different than those governing IPOs, the company being acquired is able to provide forward-looking guidance, which is not allowed under the IPO process. This can help the business being acquired potentially get a fairer price if part of the company's appeal is based on its future potential.

Some high-profile companies, such as DraftKings and Nikola, have gone public recently through a SPAC business combination.

3 – The SPAC investors

Those who invest in a SPAC’s IPO gain upside potential and downside protection. Initially, “units” are sold to investors, each one typically priced at $10 and equating to one share of the SPAC plus a fraction of a warrant. Units become shares 52 days after a SPAC’s IPO. One warrant can be used to purchase an additional share of the SPAC or new company at a predetermined price, usually at the later of one year or 30 days after a business is acquired.

Once a SPAC goes public and before it acquires a company, the SPAC’s shares trade publicly. They can fluctuate in price on positive news (a potential acquisition) or negative news (a deal not coming together). Just this week, news that a SPAC called Churchill Capital Corp IV (CCIV) is getting closer to a merger with electronic vehicle maker Lucid Motors sent shares of CCIV up sharply.

When a SPAC identifies a company it wants to acquire, shareholders vote on whether to move forward. If the deal does go ahead, shareholders can choose to have their SPAC shares converted to shares of the new public company or they can cash out.

If a SPAC is dissolved because it can’t find a deal to complete within its specified time frame, the money being held in trust is distributed to investors on a pro-rata basis, which means investors usually get around $10 per share back. Their warrants become worthless.

Investor beware

As with all investments, there are risks involved in investing in a SPAC. For those who get in at the IPO price, there may be little downside risk since they will typically get their money back if the SPAC doesn’t complete a deal. Still, there is the opportunity cost of waiting for a deal to come together. Also, when an acquisition target is found, a majority of shareholders could vote it down, and even when a deal is struck, there’s no guarantee that the new entity will be successful. For those who buy SPAC shares after the IPO, if the shares are purchased at a premium over the IPO price, those shares could decline in value.

Numerous celebrities and other public figures have gotten on the SPAC bandwagon as sponsors — from former professional athletes such as Shaquille O’Neal to singers like Ciara to former politicians like Paul Ryan. This may pique the interest of companies looking to be acquired, but it has also drawn criticism, with some seeing it as a sure sign of investor “mania” and CNBC’s Jim Cramer saying they’ve made SPACs “feel like an inside joke for the super-rich.” Others have pointed out that the two-year deadline SPACs have to meet in finding a deal makes them prioritize getting a deal done over finding a good deal.

Will the SPAC boom replicate the IPO boom of the late 90s, which was fueled by enthusiasm for all things dot-com? It’s too early to tell, but that experience certainly looks like a relevant cautionary tale. Again, we’re not recommending any action here. We just want you to be informed.