If a roaring stock market isn’t enough for you, be ready for a SPAC attack. Interest rates are low, money is free and retail investors are hungry for more deals.
Let’s start from the beginning
Capital is flowing freely in America today. Last I checked there was a trillion dollars on the sidelines. That’s why when the economy stalled in the middle of the pandemic, good businesses had access to capital. Even some bad businesses got some loot too.
So the government and billionaires decided to get together and create a new investment vehicle. Just kidding but let’s talk about what smart money really did. Let’s begin with a simple question.What is a SPAC and why does it exist?
A SPAC is a “blank check” company designed to raise capital from the public markets to acquire a private business. Also known as a Special Purpose Acquisition Company. The target company will then become public through the merger. The term “blank check” comes from the pool of investors who park their money in a trust before a deal takes place. If the SPAC doesn't close a deal within 24 months then the money is returned to the investors.
Stick with me here, because we’ll discuss the history of SPACs, how they’re used and the best investors in the industry. At the end, you’ll find the fast growing subReddit group tracking the SPAC market.
No oversight resulted in more regulations
In the 1980s and 1990s, SPACs had very little oversight. In some cases, these investment vehicles were considered shady, even fraudulent. Most of the deals were sponsored by unknown investment banks and inexperienced managers.
In the 90s these vehicles received more regulatory oversight to protect investors. Several notable managers like Martin Franklin have done major deals in the 90s. But only until recently have we seen a surge in issuance.
Why SPACs are a popular exit strategy..
SPACs are great exit strategies for companies that have limited funding options in the private sector. For example, venture capitalists are focused on high growth companies and willing to invest in losses for the short-term. But the challenge arises when companies have low growth returns and need to achieve profitability. This inflection point is difficult for investors to grasp. It can be more challenging for public investors if the company wants to IPO.
SPACs solve this problem. They are fully funded investment vehicles prepared to merge with a private company. When a SPAC launches, investors have a two year period to identify a suitable company to acquire. But one caveat is the SPAC sponsor is not allowed to prescreen investments or sign any letters of intent before going public. Did I lose you yet?
This two-year window may seem like a lot but it is short in the investment world. Due diligence on a nine-figure deal can take at least six months. Especially if you can’t pre-screen deals.
In the short period at best, you can close a deal in six months. But making investments isn’t that easy. Investors will need to sort through several deals which can take 12-18 months of searching before finding a sweetheart deal. The SPAC can extend the terms to 36 months but this is not always the case.
With that said, SPACs have become excellent exit strategies for private businesses. It is a seamless transition to go public, with fewer obstacles. It is no surprise that these vehicles are becoming hot as we hit all-time highs. Investors want more deals!
How are SPACs structured?
Let me walk you through the process. First the founding team will invest initial capital to form the SPAC. The founder shares are sold for a nominal value and designed for the founders to keep 20% of equity after IPO, also known as the “promote.” Those shares will benefit from a rising stock price.
SPACs consist of units, made up of shares and warrants, set at $10 per unit. The warrants are long-dated options to incentivize investors to own for the long-term. But remember SPACs have restrictions just like any other security. First the deadline to close a deal is usually within 18 to 24-months. Next there's a size requirement, i.e. 80% of net assets, are needed for the business deal. And then there's no compensation to the founders or managers.
These SPACs will have a core corporate governance board like any other operating company. More than 90% of the proceeds will be placed in a trust account until a deal is done or the SPAC fails. These funds will be invested in treasury bills or money market funds to generate interest income. Some of the money may be used for taxes or working capital as well. I know that’s a lot to take in, but bear with me now [pun intended].
Now for the transaction
The SPAC sponsors cannot speak with any potential targets or sign deals before the IPO. This means you cannot take your own deal public. So let’s begin with the benefits for the seller.
First, it is a fast-track to going public. Managers have the ability to provide additional guidance on business prospects. The seller also benefits from the Sponsor's management experience. Remember, the seller only has to speak with one investor instead of doing a roadshow as in an IPO.
Now the investor, maybe you in this case, has access to aligned high-quality sponsors without management fees. These deals are structured like private equity Investments. It is a free call option betting on the SPAC sponsor to close a great deal. Investors receive immediate liquidity and equity exposure with warrants for additional upside. Also, the 24-month time horizon means investors may receive the full principal back with interest if a deal does not close.
Measure the Risks
Last month was a record for new listings. $38 billion in deals closed. With the surge of new retail investors, the market has never been higher. Remember, the number of public companies has more than halved in the last 20 years. So some investors have found SPACs the best way to take private companies public.
But it is important to remember the due diligence process is not as rigorous as the traditional IPO. IPOs have an extended due diligence process held by investment banks and then a roadshow with institutional investors. A SPAC is reliant mostly on the fund sponsor’s track record.
It’s feeling like 1999 all over again
One concern raised by smart money is that we're in a SPAC bubble. There might be too much public money chasing too many private deals. We’ve seen this with the increase of electric car companies coming to market like Nikola or Lucid Motors.
“Billionaire investor Sam Zell says some SPACs remind him of the speculation in Internet companies during the 1990s dot-com bubble. Although SPACs can be effective transactions, Zell is worried about the fundamental business prospects for some companies that go public via a SPAC, CNBC reports.”
But I'm not too concerned about a bubble in this space. The main reason is because the money can be returned to investors. The only concern is retailers may invest in poor-performing SPAC businesses. Venture-backed companies have a history of losing money and taking them public only provides them a lifeline. It does not make them profitable nor a good investment in some cases.
The most active SPAC managers
If you’re interested in SPACs, I recommend following the top fund managers. You see, as an investor you're writing a blank check to make an investment. Whether the deal closes or not, it is important to back the best and the brightest. So when deciding on SPACs, look for managers with best track records.
Here are a few I’ve come across on SPACtrack:
- Apollo Strategic Growth Capital managed by private equity giant Apollo Global Management. Tickers include APGB, APSG, SPAQ, SPRQ
- Michael Klein is a former Citigroup executive and sponsor of the Churchill Capital SPACs. Tickers include CCIV, CCV, CCVI, CCX, CVII.
- Social Capital Hedosophia sponsored by the King of SPACs, Chamath Palihapitiya. Tickers include IPOD, IPOE, IPOF.
- Pershing Square Tontine Holdings [PSTH] is the largest SPAC with $5 billion in buying power and managed by billionaire investor Bill Ackman.
- The Gores Group is another private equity sponsor with several notable SPACs. Tickers include GHVI, GIIX, GMII, GRSV,GSEV, GTPA, GTPB.
- Reid Hoffman, co-founder of LinkedIn, also announced his third SPAC at Reinvent Technology Partners. Tickers include RTP, RTPZU, RTPYU.
SPACs are here to stay
America has the deepest and most liquid capital markets. It is our competitive strength as a nation. Even as we compete with superpowers like China, no one beats us at free enterprise. It is the main reason why companies choose to trade on American exchanges [i.e. Alibaba’s IPO on the NYSE in 2014].
So when investors are in the driver's seat, capitalism will continue to evolve. This is why new funding vehicles have been grown in the last 20 years. Most notable are crowdfunding, Angel investing, direct listings and SPACs. If you’re unfamiliar with direct listings, I recommend listening to Bill Gurley’s interview to understand why the IPO process is broken. Spotify did a direct listing in 2018 if you missed it.
But they aren’t for everyone
We have democratized access to capital in America. It comes along with freedom and other rights as Citizens. So SPACs are no different in this regard. In fact, I believe we will see more SPACs come to market this year. But there’s a catch.
The pyramid becomes smaller at the top. There are fewer good businesses at the billion-dollar plus range. And these investors, hundreds of them, are chasing the same deals. I think we'll see a lot of unprofitable venture-backed companies go public. And Valuations will continue to be inflated until interest rates pick up. But what does that mean?
A lot of fund managers won't be able to close deals. Which means investors will get their money back and warrants will expire worthless. This is the nature of the game. But this won't stop investors. Bankers need to do deals and new ones will get done. I expect IPOs and direct listings to pick up more as we reduce friction in the financial markets.
P.S. If you don’t know, the SPAC subreddit has been one of the fastest growing groups in 2020. If you missed out on the GameStop trade last month, I’d recommend paying attention to Reddit trends in the future. There’s a lot of money to be made unbundling Reddit.