New offerings of Special Purpose Acquisition Companies (SPACs) were red-hot in 2020, outpacing even traditional initial public offerings (IPOs) for the first time in history.

After a slow start to 2020, initial public offerings (IPOs) rebounded in strong fashion during the second half of the year. That wasn’t necessarily surprising because owners of private companies generally prefer to take their ventures public in bullish market environments. 

Within the 2020 IPO trend, however, there was a surprising development—a surge in Special Purpose Acquisition Company (SPAC) listings. And given their newfound relevance in the financial markets, it’s important that investors and traders understand what they are.

SPACs live up to their name—their “special purpose” involves a future merger or acquisition (M&A). That’s because SPACs are basically shell companies founded and funded with the intent of eventually merging with, or acquiring, another company.

SPACs, therefore, represent a non-traditional method of raising capital because the funding comes first and the business idea comes second. This runs counter to the traditional IPO approach, which involves growing a successful business and using that momentum to attract new investors—eventually through a public listing.

Seemingly putting the cart before the horse, originators of SPACs (referred to as sponsors) pull together a group of investors that, according to the U.S. Securities and Exchange Commission definition, agrees “to pool funds in order to finance a merger or acquisition opportunity within a set timeframe.” 

The ultimate success of a SPAC often resides in the reputation of the sponsors and their ability to generate interest in the entity. SPACs are frequently founded by subject matter experts (SMEs) who possess key experience in a business field that in all likelihood will be the focus in a future acquisition or merger. 

With SPACs, potential investors are banking on the ability of the sponsors to wisely deploy capital. Traditional IPOs, on the other hand, typically involve investment in a business idea—although the perceived capabilities of an IPO’s founders can also be an important consideration. 

So why should investors and traders care about such entities? For one, there are a lot more of them in the market these days. 

From 2019 to 2020, the total number of new SPACs listings in the U.S. financial markets increased by over 300%. 2020 set SPAC records for both the number of deals closed and the total capital raised—237 and over $80 billion, respectively. That means market participants are now a lot more likely to run across a SPAC or two when filtering for potential trade ideas.

SPACs have also risen in stature because some high profile global business leaders and investors have become associated with them in recent years.

Names such as Bill Ackman, Richard Branson and Michael Jordan tend to draw extra media attention. Notably, Ackman’s Pershing Square Capital Management hedge fund is the sponsor of the largest-ever SPAC, Pershing Square Tontine Holdings (PSTH.U). 

That, however, doesn’t mean that every SPAC is a guaranteed gold mine—far from it. Investors and traders need to analyze potential SPAC exposure as exhaustively as they would any other position in their portfolio. 

A good starting point is to investigate where a given SPAC is on the development timeline. Is it still a shell, or has it already acquired or merged with a target entity? After their initial listings, SPACs can trade for years before finding a suitable target or partner.

Some investors buy into a given SPAC because they believe in the ability of the sponsors to identify a promising young company or technology, and believe that the SPAC will grow significantly in valuation after a future acquisition or merger. Vetting the sponsors and management can therefore be a critical step in the SPAC investment process.

Other market participants only monitor SPACs to trade short-term movement in the underlying shares immediately following an acquisition or merger. This approach varies widely depending on a trader’s unique outlook and risk profile.

One of the most visible SPACs in the market these days is Nikola (NKLA), which has been plenty volatile since it merged with VectoIQ Acquisition in June. Some other newly minted SPACs (post-merger) from 2020 include DraftKings (DKNG), Fisker (FSR), Hyliion Holdings (HYLN) and Virgin Galactic Holdings (SPCE).

While these are some of the well-known SPACs, there are plenty of unknowns out there. And the fortunes of these companies are equally shrouded. 

Market participants should note that the U.S. Securities and Exchange Commission clearly outlines the speculative nature of pre-merger SPACs in their broader definition of such entities: “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person. These companies typically involve speculative investments and often fall within the SEC’s definition of penny stocks or are considered microcap stocks.”

The above is an important reminder that the fortunes of SPACs vary widely, just like traditional IPOs and the broader stock market. 

Since last March, the “everything rally” has floated all boats, and the SPAC corner of the initial offerings market has been no exception. One would think that an extension of the SPAC trend in 2021 would therefore depend heavily on the performance of the overall stock market. 

To follow all the newest SPACs and IPOs, readers may want to tune into TASTYTRADE LIVE, weekdays from 7 a.m. to 4 p.m. Central Time, at their convenience. 

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Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.