Last week I discussed an opportunistic trade involving Donald Trump’s social media platform Truth Social. In brief, Trump Media & Technology Group (NSDQ: DJT), the parent company of Donald Trump’s social media platform Truth Social, was listed on the Nasdaq stock exchange following a merger with Digital World Acquisition Corp., a publicly traded shell company. This type of transaction is often referred to as a SPAC (Special Purpose Acquisition Company) merger.

The merger allowed Trump Media (TM) to bypass the traditional initial public offering (IPO) process, which can be lengthy and complex. Instead, the shell company (Digital World Acquisition Corp.) that was already publicly traded on the Nasdaq acquired TM, and TM took its place on the stock exchange.

Trump Media & Technology Group shares surged following the listing. This led to a spike of interest in SPACs. So, today let’s talk about this niche type of investment.

What Is a SPAC?

A SPAC forms as a shell company to raise IPO funds for acquiring another company. A SPAC is a so-called “blank check company,” which is a development stage company that has no specific business plan or purpose except to engage in a merger or acquisition with an unidentified company or companies.

In most cases, a SPAC will conduct its IPO without revealing the company or companies it intends to acquire. Thus, investors are putting their trust in the management team to make good decisions on these acquisitions. But investors aren’t flying completely blind. Because a team of institutional investors or Wall Street professionals with solid track records typically creates a SPAC, investors can have some level of confidence in their financial acumen.

SPACs have been around for a long time, but they have risen rapidly in popularity over the past decade. From 2003 to 2022, there were 1,157 SPAC IPOs in the U.S. But that number increased significantly in 2020 and 2021, when there were 248 and 613 IPOs, respectively. However, there was a decrease in 2022, with 86 SPAC IPOs.

Increased market volatility has driven this surge of popularity. During periods of extreme volatility, a company has a lot of uncertainty about its IPO pricing. They may get far less than they had anticipated. So, a company may go public via a SPAC instead of simply executing its own IPO because the SPAC transaction gives the company more certainty over pricing compared to a traditional IPO.

Investing in a SPAC

The way a SPAC works for individual investors is the SPAC conducts its IPO, typically at $10 a share. Those proceeds will go into an interest-bearing account while the management team locates a private company seeking to go public via that route.

After completing the acquisition, shareholders of the SPAC can exchange their shares for shares in the new company. Alternatively, they can redeem their shares for their initial investment plus the accrued interest while the money was deposited. If the sponsors of the SPAC do not find a suitable deal within a certain timeframe, typically two years, the SPAC undergoes liquidation. Investors then receive back their original investment plus interest.

But Investor.gov, a website within the U.S. Securities and Exchange Commission, offers up this warning:

“One thing to keep in mind is that if you purchased your shares on the open market, you are only entitled to your pro rata share of the trust account and not the price at which you bought the SPAC shares on the market. For example, if a SPAC had an IPO at $10 per share, but you bought 100 SPAC shares on the open market at $12 per share, the shares you purchased are associated with a trust account balance of about $10 per share, so your share of the trust account would be worth about $1,000 (not the $1,200 you paid for your shares).”

High profile investors such as Bill Gates and Richard Branson have gotten behind SPACs. And well-known companies have gone public via merging with SPACs, including Draftkings (NSDQ: DKNG), Virgin Galactic (NYSE: SPCE), and Nikola Motors (NSDQ: NKLA).

Buyer Beware

Draftkings has been a big success, returning 363% since its IPO. However, that’s been the exception to the rule. Advisory firm Renaissance Capital has examined SPAC performance in detail, and found that SPACs in general have underperformed the market:

“Of the 313 SPACs IPOs since the start of 2015, 93 have completed mergers and taken a company public. Of these, the common shares have delivered an average loss of -9.6% and a median return of -29.1%. That compares to the average aftermarket return of 37.2% for traditional IPOs since 2015. Only 29 of the SPACS in this group (31.1%) had positive returns as of Wednesday’s close.”

Final Thoughts

Despite a few SPACs achieving hype and high-profile successes, data shows these blank check companies underperform traditional IPOs overall. The prospect of getting in on the ground floor of the next big thing entices individual investors. However, investors should approach SPACs with caution. The lack of transparency, combined with historically poor average SPAC returns, means SPACs carry more risk than meets the eye.

Unless investors have a very high-risk tolerance and faith in the SPAC sponsors’ ability to identify winning acquisition targets, sticking to conventional IPOs is generally advisable. For most retail investors, the speculative nature of SPACs makes them more suited for small, venture capital-type allocations.

Editor’s Note: Our colleague Robert Rapier just explained the risks and rewards of SPACs. You also need to get up to speed on cryptocurrency. If you ignore crypto, you’re leaving big money on the table.

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