If you spend any time watching CNBC these days, it won’t be long before you hear them mention special purpose acquisition companies, or SPACs. Today I want to dive into the world of SPACs so readers have a better understanding of this class of investment vehicle. Are they too risky for average individual investors?

What Is a SPAC?

A SPAC is a shell company formed for the purpose of raising money through an initial public offering (IPO) to acquire 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.

Read This Story: Beware of “Blank Check” Investing

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 SPAC is typically created by a team of institutional investors or Wall Street professionals with solid track records, 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. Of 961 SPAC IPOs that have been carried out since 2003, 60% have taken place in the past two years. This surge of popularity is being driven by increased market volatility. 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.

When the acquisition is complete, the SPAC’s shareholders can swap their shares for shares in the new company, or they can redeem their shares for their initial investment plus the interest that accrued while the money was deposited. If the SPAC’s sponsors haven’t found a suitable deal within a certain time frame, typically two years, the SPAC is liquidated and investors are paid 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 457% 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%, compared 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.”

Even though there are some nice triple-digit returns among SPACs, individual investors would probably be better off sticking with conventional IPOs.

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