While that’s usually not enough to persuade seasoned investors to part with their money, it has worked like a charm in these times of booming markets and practically free money. SPACs have been raising money and doing deals at a never-before-seen rate in 2020. SPAC initial public offerings are outpacing traditional IPOs this year. And some of the hottest new stocks began life as SPACs: Nikola (ticker: NKLA), DraftKings (DKNG), and Virgin Galactic Holdings (SPCE).

SPACs—first conceived in the 1990s—have gone into overdrive, fueled by rock-bottom interest rates, a volatile stock market, and an insatiable appetite for new public growth companies.

How should retail investors who don’t ordinarily get IPO allocations or face time with sponsors approach this booming but once-obscure asset class? They shouldn’t approach it at all, unless they’re willing to do some real homework. SPACs demand caution, knowledge of complex details, and a willingness to dig through Securities and Exchange Commission filings.

Signs of froth—the flood of IPOs, the online frenzy on Reddit and Twitter, the celebrity participants—aren’t hard to find. Yet the chance to get in on the ground floor of what could be the next hot stock is tempting.

For retail investors, it may be the closest thing to being a venture-capital or private-equity investor—without knowing what the target company will be. SPACs go public as just cash shells, with the goal of later combining with operating businesses, which become publicly traded companies after the mergers close.

Individual investors need to be choosy, judging SPACs on how shareholder-friendly their terms are and how comfortable they are piggybacking on an experienced deal maker.

“This industry has morphed into something much more institutionalized,” says David Sultan, chief investment officer at Fir Tree Partners, a $2.7 billion hedge fund that began investing in SPACs in the mid-2000s. “Aside from better sponsors, you now see plenty of marquee hedge funds and long-only guys investing, and every major bank underwrites SPACs. That doesn’t mean there won’t be cycles—we’re definitely in a frothier period—but I think SPACs are here to stay.”

The biggest name to start a SPAC this year is silver-haired investor Bill Ackman. His hedge fund, Pershing Square Capital Management, is the sponsor of Pershing Square Tontine Holdings (PSTH.U), the largest-ever SPAC, having raised $4 billion in its offering on July 22.

Ackman made his name as an activist investor swinging for the fences. He took big stakes in companies and pushed for changes in strategy and management, at times with great success ( Canadian Pacific Railway and General Growth Properties ), and at times not ( J.C. Penney. )

Now, Ackman could have a SPAC war chest of as much as $7 billion when other commitments from Pershing Square funds are included. He plans to pursue a minority position in a “private, large-capitalization, high-quality growth company” that can then bypass the traditional IPO route.

Ackman sees “mature unicorns” as attractive targets, referring to often venture-capital-backed tech companies that have ballooned to large valuations and moved past the peak loss-making stage of their growth.

“We want one of the great businesses of the world that we’re happy to own for a decade,” Ackman tells Barron’s. “We’re a unicorn looking to marry another unicorn.”

A guessing game of what Ackman could buy has been making the rounds on Wall Street. Giant unicorns like home-sharing upstart Airbnb and data company Palantir Technologies are among the names most speculated about for a merger, as is financial information behemoth Bloomberg.

Whichever it is, Pershing Square Tontine’s terms will give the SPAC an edge in getting a merger done, Ackman contends. Its units have climbed 8% from their IPO price to $21.65. “We’ve always thought the SPAC structure was a great idea that was missing something in its ultimate execution,” he says. “The problems really lie around alignment of incentives.”

Other recent SPACs have emphasized attracting long-term investors, aligning sponsors with shareholders, and reducing dilution to strike better deals with target companies.

Fifty-five SPACs have already gone public this year, raising $22.5 billion in proceeds—with another 22 SPACs on file to IPO in the coming weeks, according to SPAC Insider. That compares with 59 IPOs and $13.6 billion in proceeds in 2019—both previous records. More than 100 SPACs are currently on the market, with close to $40 billion in their war chests.

Here’s how a typical SPAC works. It goes public by selling $10 units consisting of a common share and a fraction of a warrant—essentially a call option—which split and begin trading separately within a few months after the IPO. The cash raised goes into the SPAC’s trust, where it earns interest until the SPAC completes a merger with an operating business. (SPAC shareholders vote on the merger.)

Typically exercisable at $11.50 after the combination is completed, the warrants are a sweetener for IPO investors in exchange for locking up their cash as sponsors seek a target.

SPAC sponsors may invest alongside shareholders, but more often they tend to buy founder shares or warrants for close to nothing—known as their “promote”—which can give them as much as 20% of a SPAC’s common shares soon after a deal closes.

If a SPAC doesn’t complete a deal before its deadline—often two years after the IPO—the trust is liquidated and funds are returned to shareholders, while the warrants expire worthless and sponsors lose their at-risk capital. At the time of the merger, shareholders can also elect to redeem their stock for a proportionate share of the cash in the trust. That option means that downside for shareholders from an unattractive merger proposal is limited, but that SPACs can sometimes be left without cash to complete deals.

“The way I’ve always thought about SPACs is that it’s a downside-protected investment,” says Yoav Roth, managing partner and co-founder of Hudson Bay Capital, a longtime SPAC investor with over $5 billion in assets under management. “If I don’t like the proposed business combination, there’s a way for me to get my cash back. But if the deal is exciting, then there’s some upside.”

Not every SPAC merger is a success. Alta Mesa Resources, which merged with Silver Run Acquisition Corp II—at the time the largest U.S. SPAC by IPO proceeds and backed by former Anadarko Petroleum CEO Jim Hackett and Riverstone Holdings —filed for bankruptcy in September.

The most frequently cited criticism of SPACs is that sponsors are more interested in getting any deal done, rather than getting a good deal done. Even if postmerger shares drop significantly, sponsors can walk away with millions of dollars in profit, thanks to their close-to-free promote shares vesting soon after the deal closes.

And even for a well-received merger, the resulting dilution can still be significant, reducing the reward for other shareholders and presenting a sticking point in negotiations with target companies.

Pershing and other sponsors aim to be different. Its funds paid $65 million for warrants that can eventually be used to acquire about 6% of shares outstanding, but not until three years after the merger closes—and exercisable at a 20% premium to the IPO price. It is an incentive to get a deal done, but not a huge sum relative to Pershing Square’s $10 billion in assets under management.

“There’s no scenario in our structure where we do well but our investors do poorly,” Ackman says. “Because it’s out of the money, it’s only on 5.95% of the shares, and we pay for it, the friction is very small.”

GS Acquisition Holdings II (GSAH.U), the second effort from Goldman Sachs Group’s (GS) Permanent Capital Strategies SPAC unit, plans to tie its promote shares to a vesting schedule that means the postmerger stock price needs to rise to certain levels before sponsors benefit.

“We don’t think we should be paid if we can’t deliver an asset that will perform well for our investors,” says Tom Knott, GSAH II’s CEO. “We hope that every SPAC follows this model, but we’re cognizant of the fact that we’ll likely have to close a transaction with the structure in place before it takes hold across the market.”

GSAH II went public by selling units including a quarter of a warrant in June, raising $750 million. Like Goldman’s first SPAC, which merged with Vertiv Holdings (VRT) earlier this year, the new SPAC is targeting a mature business.

Such earn-out structures could help shake off the old reputation of SPACs as a vehicle designed to advantage sponsors at the expense of other stakeholders. Another trend that could help, by encouraging longer-term shareholders, is fewer warrants per unit at the time of the IPO.

Common stock-only SPAC IPOs are also becoming a reality. After first filing with a third of a warrant, biotech-focused RA Capital refiled its first SPAC with an increased offering composed of just common shares at $10 each. Therapeutics Acquisition (TXAC) went public on July 8, raising about $135 million.

“We wanted to have the cleanest, most company-friendly SPAC structure ever executed so that we would have a simple pitch that would help us to more easily attract a high-quality company to merge with us,” the SPAC’s chief financial officer, Matthew Hammond, wrote in an email.

The lack of warrants clearly hasn’t sapped demand: Therapeutics Acquisition stock recently traded near $14.

For Pershing Square Tontine Holdings, the warrant structure includes an extra twist. The IPO included 200 million $20 units sold with just a ninth of a warrant per common share, exercisable at $23. A tontine is a 17th century annuity in which income is shared by a pool of investors, with each individual’s share of the pot increasing as other investors die off.

For the SPAC, that means that only investors who choose to participate in the merger and do not redeem their shares get access to a second pool of warrants, fixed at 44,444,444, or two-ninths per each unit sold at the IPO. The more shareholders who redeem, the greater the reward for those who don’t. And because the additional warrants are tied to the common stock until after the merger closes, each premerger share should trade above the $20 redemption value.

Partnerships between financial backers and experienced executives have helped many SPACs. Moneyball’s Billy Beane has teamed up with RedBird Capital Partners, which filed for a sports SPAC IPO this past week.

Sponsors with strong track records—and expertise in hot sectors like technology or biotech—will be able to fill their IPOs without having to include the “free-gift-with-purchase” incentive of more warrants per unit. But first-time backers may have to offer more generous terms to fill their IPO books. “I think that eventually there will be the haves and have-nots,” says Roth of Hudson Bay Capital.

Retail investors usually do not get to participate in SPAC IPOs, leaving them to consider the value of SPAC units, shares, and warrants once they have begun trading publicly. That means weighing market price against the sponsors’ ability to attract a promising merger partner. “The question becomes how much are you willing to pay for the option of a good management team,” says Fir Tree’s Sultan.

That requires looking at previous deals that sponsors have done, reading up on their industry connections, and combing through prospectus filings for details on how sponsors are paid and what the potential dilution will be—fewer warrants and postmerger earn-outs are positive signs.

Once a SPAC has identified a merger, the decision falls to the same fundamental analysis that investors would do for any operating company. Merger announcements are usually accompanied by a detailed presentation of the target’s business, financial performance, and management projections—disclosure greater than that found in traditional IPOs.

Investors should also pick SPACs focused on attractive target sectors, or those with few competitors. Jeff Mortara, UBS ’ head of equity capital markets origination, sees the greatest shortages of SPACs in technology, biotech, and those over $1 billion.

Current SPACs on the market include target areas like industrials, ESG, cannabis, and Mexico.

Of late, anything related to electric vehicles and the future of transportation has been hot. SPACs have merged or announced deals with Nikola, Hyliion, and Fisker, focused on making EVs or alternative-fuel powertrains; MP Materials, which mines rare-earth elements needed for electric motors; and Velodyne Lidar, which makes sensors employed by self-driving EVs and plans to combine with Graf Industrial (GRAF).

There have also been several well-received deals with financial-technology companies and firms in online gambling and sports betting.

Fewer warrants and greater sponsor alignment can also expand the universe of potential SPAC targets to industries where companies tend to trade close to the value of their total assets. Accepting even moderate dilution can be a deal-breaker for sellers of those companies.

“It’s going to make SPACs applicable to a broader universe of asset types where a 20% sponsor promote is too dilutive,” says Mortara, pointing to real estate and insurance as potential industries to mine for deals.

SPACs are also expanding by targeting companies at earlier stages in their growth. Most companies that merged with SPACs have emerged from private-equity portfolios. That has meant mostly mature businesses.

But a new breed of more-speculative targets has emerged, with Virgin Galactic and Nikola as prime examples. “You’ve started to see concept stocks use SPACs as a vehicle to access the public markets,” says Vik Mittal, portfolio manager at Glazer Capital. “Those loss-leading but disruptive companies traditionally fit more in late-stage venture-capital portfolios, but there’s a lot of public-market interest in owning VC-like investments right now.”

Chamath Palihapitiya, an early executive at Facebook (FB) who left in 2011 to found the Social Capital venture-capital fund, is focused on that part of the SPAC market. His first SPAC combined with spaceflight-venture Virgin Galactic late last year, and he has since raised two more SPACs: Social Capital Hedosophia Holdings II (IPOB), with $414 million targeting technology investments in the U.S., and Social Capital Hedosophia Holdings III (IPOC), which raised $828 million and is focused on tech companies abroad

“You have a massive supply/demand imbalance now in the public markets,” says Palihapitiya. “What that creates is an enormous opportunity for younger technology companies to go public sooner, because it allows them to find higher valuations and investors who are willing to underwrite a very long-term growth model.”

The red-hot market for SPACs will cool. A high-profile merger could end up being a dud, or a large SPAC might not find a target by its deadline. Still, the industry will continue to mature, and SPACs aren’t likely to go away.