From Alex Rodriguez to former President Donald Trump, it seems everyone has been getting in on one of Wall Street’s hottest fads: the SPAC. It stands for Special Purpose Acquisition Company, and while the concept has been around for decades, the market for SPACs exploded over the past two years.

Critics warned in early 2021 that the SPAC bubble was about to burst. Instead, the SPAC market did the opposite, notching more deals and public offerings than ever before seen.

But experts warn trouble may be ahead. There are more companies underperforming if they go public via a SPAC merger compared with those that go public through the traditional route. That may be one reason why an increasing number of companies pulled out of SPAC deals toward the end of 2021.

How does a SPAC work?

Definition

A SPAC, sometimes called a blank-check company, is a shell corporation set up by investors with the sole purpose of raising money through an initial public offering to eventually acquire a private company.

Still confused? Basically, it’s a fast-tracked way to make a private company public without going through the traditional IPO process.

How it works

First, a management group made up of sponsors decides to form a SPAC. They raise money through an IPO, selling units to investors. These early investors also commonly reserve the right to buy more shares at a set price down the road. That’s called a warrant.

Keep in mind, investors don’t know what they’re getting when they buy in. The SPAC at this point has not targeted a company and it doesn’t have a product, a track record or assets beyond the money raised in the IPO. So investors are really putting their money behind the management team, betting on them to find something great…a blank check, if you will.

Morningstar Editorial Manager Ruth Saldanha said recognizable sponsors are a big draw, from celebrities like Jay-Z to venture capitalists like Chamath Palihapitiya.

“There have been investors who have done successful SPACs in the past, and therefore the investor thinks that this is a good time for us to get into this at the ground floor and maybe make a lot of money,” Saldanha explained. “And so that’s why they’re perhaps flocking to it.”

All the money raised from investors goes into an interest-earning trust. Sponsors have up to two years to acquire a private company they think has tremendous upside to take it public.

If they don’t find a company in that time, the SPAC dissolves and investors basically get their money back. If they do find a company, the SPAC and the private company merge into a publicly traded company.

At this point, initial investors can decide if they like the merger and want to stay invested or pull out their money.

Not one-size-fits-all

Sometimes a SPAC merger booms and makes initial investors rich, like when the SPAC Digital World Acquisition Corp announced its merger with Trump’s media company.

Sometimes it busts, like when Southeast Asia’s ride-hailing giant Grab lost more than 20% of its value its first day of trading.

“It’s not a ‘one-size-fits-all,’ where every company decides that merging with a SPAC is the right way to go, but obviously hundreds of companies are deciding to do it, so it’s got some attractions,” University of Florida finance professor Jay Ritter said. He’s known as ‘Mr. IPO’ for his extensive work in the field.

The number of SPAC IPOs has exploded the past two years. According to SPACInsider, in 2019 there were 59 SPAC IPOs, the most in one year to date. But in 2020, that number more than quadrupled to 248 SPAC IPOs, and 2021 has seen more than 600.

SPAC vs. traditional IPO

One draw for private companies is that merging with a SPAC typically provides a much shorter runway to public.

“For a traditional IPO, it could take anywhere from six months to well over a year for a company to go from private to public, but in this case of SPACs that has been crunched down to just a few months,” Saldanha said.

But perhaps the difference that requires the most scrutiny comes from regulation. While a traditional IPO puts all the financials on the table, the SPAC process is more private, so investor risks might not be spelled out. That’s one reason the SEC is now taking a closer look at SPACs.

“The SEC doesn’t try and decide for investors: Is this a good deal or a bad deal,” Ritter said. “They just want to make sure that investors have enough information to be able to evaluate a deal.”

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