What is a SPAC?
SPAC is an acronym, short for “special purpose acquisition company”, which became extremely popular recently due to a record-breaking number of companies choosing to go public via SPAC.
A SPAC is a shell company with no operations, created in order to buy another company. So essentially, SPAC could be explained as a “bag of cash that exists for a purpose of a merger”. For private companies, SPAC is just an alternative way of going public. The whole procedure is this – SPAC raises cash through its IPO, identifies a target and then merges with it. In this way the previously private company (i.e. the target) gets a public listing without having to go through the burdensome IPO procedures. SPAC founders/sponsors in turn receive a sweet compensation for their efforts – a significant equity ownership in the merged company without investing any capital.
The more detailed structure of events would be:
– Generally, a SPAC is formed by an experienced management team or a sponsor, which initially invests their own money in the company. Founders decide what industry they want to target (e.g. media, electric vehicle, etc.) and then go for an IPO to raise money for the acquisition. A SPAC’s IPO is typically based on an investment thesis focused on a sector and geography. Although no specific target company is identified yet, management’s background and industry in which they want to merge give IPO investors a certain sense of what they’re getting into.
– SPAC IPOs are usually priced at $10 for a share and a warrant or fraction of a warrant, which is a security that gives a person the right to buy a share at a specific price (usually $11.50/share) after the merger. If the company’s price after the merger goes above $11.50, the warrants are “in the money” and may bring additional upside for the IPO investors.
– SPACs are usually listed on one of the major stock exchanges (NYSE, NASDAQ), while funds raised through IPO are then put into an interest-bearing trust account. These funds cannot be used in any other way except to complete an acquisition or to return the money to investors who choose to redeem their shares. A SPAC generally has two years to complete a deal and if it doesn’t, the company is liquidated and the IPO funds are then returned to the investors. In this case, management/founders lose a lot of money as they’ve been basically working “for free” for two years and had to cover various additional costs (IPO related and other).
– If the SPAC manages to find a suitable target, investors are then required to vote if they agree with the merger. If they don’t, they can vote against the merger and redeem their shares (get the investment back). If enough investors redeem their shares (and SPAC doesn’t have enough remaining funds to complete the merger), the whole transaction could get cancelled, unless SPAC manages to convince other private investors (PIPE) to put their money in and save the merger.
– Once a merger is completed, management/founders/sponsors usually get rewarded with certain equity ownership in the deSPACed company.
Here’s a usual timeline for SPACs:
* taken from PWC.
So the whole life cycle of a SPAC generally lasts for two years – that’s the amount of time it has from the IPO until completion of the merger (some small extensions are possible). A target company must be found in 19 months at most, because there must still be sufficient time left to finalise and close the merger. For an average SPAC, it takes about 4.5 months from finding a target and closing the transaction. The average time from a SPAC IPO to the actual closing of the merger is 15.5 months.
A bit more background
SPACs are actually not something new. They’ve existed since around 1980’s, however, until recently they had been regarded as somewhat shady blank check companies. Before 2000’s SPACs were mostly pump and dump schemes and scams, but then with the law changes they’ve became more of an additional way of going public. Nonetheless, at the time most investors were still very sceptical of SPACs, mainly because of SPACs poor performance after the merger, significant dilution as well as obvious conflicts of interest – the sponsor is mostly interested in getting the deal past shareholder vote and not in the actual value that the initial SPAC investors receive.
So the general opinion among investors used to be that SPACs are even worth looking into – if the company is not good enough to do an IPO and chooses SPAC, most likely its crap. Most of the time this was exactly the case. Several various studies (The Wall Street Journal, Financial Times) showed that most SPACs eventually fall significantly below their IPO price ($10/share) and most SPAC investors were badly losing money.
All of that changed over the last year. The total amount of SPAC IPOs during 2010 was 248, with a total gross proceeds of $83 billions (compared to 13 SPAC IPOs and $3.5bn raised back in 2016).
* taken from statista.
Why did SPACs become so popular recently?
– Influx of retail investors, which got fascinated with extremely high returns of some of the success cases. This created a massive hype in the market, when a nice story (particularly in electric vehicle, artificial intelligence industries) became more important than the actual fundamentals of the target company. One of the more vivid recent examples is Nikola ($NKLA). Despite having no available products other than the designs and some promises of future revenues, the company was positioned as Tesla 2.0 (only with electric trucks). The market got so hyped up that after the merger, $NKLA price shot up over $90 (at the peak). Despite being far from having a real product and revenues, at its peak levels, Nikola had a larger market capitalization than Ford or Fiat Chrysler. However, later on, due to the pressure of short-seller research reports and various fraud accusations, its CEO resigned from the company, while the share price tumbled and now fluctuates around $20/share levels. SSI also covered NKLA in a form of interesting capital structure arbitrage, which ended up wildly successful (read it here).
– During 2020 (year of pandemic) market conditions were much less favourable for the IPO market (vice-versa for SPAC IPOs). In a traditional IPO, a private company files to go public and then goes through a roadshow trying to get investors interested for its initial offering and determine what the price of its shares should be. There’s uncertainty around your valuation until pretty close to the offering, while the time it takes to launch IPO could take over a year (SPAC merger take 4.5 months on average). IPOs also involve negotiations with multiple institutional investors, which adds additional complexity. Overall, the pricing of an IPO can vary significantly depending on the times of the pricing. The point is – 2020 with its COVID-19 outbreak and looming presidential elections added a lot of uncertainty and volatility to the markets, which were not good conditions to go for an IPO. In contrast, SPACs are very different from the normal IPO as it simply pledges to investors that it will eventually acquire an actual company. Before identifying a target, SPACs already have a considerable amount of funds secured, thus it can provide private firms an access to capital, even when market volatility and other conditions limit liquidity.
– “Dry powder” or unspent capital of the private equity firms was extremely high in mid-2020 ($1.5 trillion) and the SPAC boom offered an attractive place to pile in their funds. Even before the IPO, SPACs usually look for private investments (PIPE) and offer securities at very attractive prices. If the merger is completed, after the vesting period (when share’s can’t be sold) PIPE investors usually unload their stake at very high profits.
– Some of the high-profile SPACs (Virgin Galactic, Bill Ackman’s PSTH) and involvement of well-known funds and managers with proven track record has somewhat increased the credibility of SPACs inviting more players to join the boom.
Investing in SPACs
Investing in SPACs is actually quite easy – you can buy it in the open market like any other security. One just needs to open an account with a broker (IB, Fidelity, Schwab, etc.) and once you’ve got that, you can acquire any stock that is available with your broker.
There are a couple more points you should know:
– Each SPAC has a certain trust value depending on the price of its IPO (initial public offering). For most SPACs it is usually $10/share. Trust value is important as it basically secures your downside. SPACs have target date to make a merger and have to liquidate if target is not found by that date. If SPAC doesn’t manage to find a target to merge and ends up liquidated, holder of shares receive a payment equal to the trust value. The same happens if the majority of shareholders or individual investors vote against the proposed transaction – their shares are redeemed in exchange for payment equal to trust value. Therefore, trust value per share (usually $10/share) is basically the support line, and most of the time SPAC shares trade at or above it (but almost never below it).
– SPAC companies usually have 3 types of securities – shares, warrants and units. Intitially, a the time of the IPO, SPAC issues only units, however, after the IPO those units become separable into shares and warrants. So, each unit consists of a share and a warrant or a fraction of a warrant (most of the time it’s ½ of a warrant).
– Warrant is a security that allows you to buy one share at an exercise price (generally $11.50/share). It is worth noting that most warrants have a 5 year expiration period and that full warrants are exercisable (you won’t be able to exchange a faction of warrants for a fraction of a share). Warrants often trade at a discount to its intrinsic value (share price minus the exercise price) because it doesn’t have the downside protection (if SPAC is liquidated, warrants are worth 0), and are not redeemable. On the other hand, warrants offer substantially higher reward potential if for one reason or another, SPAC shares jump up. So purchasing warrants could prove to be an attractive strategy (if you’re what you’re getting into), however, keep in mind that in case things go wrong, they could very much be worth 0 (100% downside).
How to select SPACs to invest in?
First of all, there is a difference in whether you plan on investing in a pre-announcement SPAC or after the target has been already announced, or maybe even after the merger has been already announced. The biggest distinction is uncertainty. Pre-announcement SPAC is basically just a bag of cash and you don’t know what it will be piled into yet. The most important aspects to look for in his case are the management and the industry it targets. Management/sponsor or the people behind the company might give you a good indication on the potential outcome of your investment. If they have a good track record of creating value for shareholders (e.g. John Malone and Greg Maffei) or, for example, the sponsor is a very well-known and credible company/investment fund, it definitely increases the chances of things running smoothly in the future. Watching for PIPE investments is also important as prominent investors (e.g. Bill Ackman) adds substantial credibility or even hype for the company. For example, after several very successful SPAC mergers (Virgin Galactic, Opendoor Technologies) venture capitalist’s Chamath Palihapitiya’s name now seems to add significant premium to every other of his new SPACs.The industry is also quite important as recently certain industries, particularly electrical vehicle and artificial intelligence seem to receive more love from investors (especially retail). Attractive industry results in an attractive story and story nowadays seems to be the most important thing for SPACs. So if a SPAC is targeting lets say EV industry and manages to find a target there, there’s a good chance that the stock will fly. In contrast, industries like insurance, food & beverage, brick & mortar retailing, education (non-online) are not so hot and might even result in a price fall after the merger announcement, as investors decide that the company is no longer attractive and exit. All these things are important to consider to make a more compelling pre-deal SPAC investment.
After the merger has been already announced, the focus should naturally turn towards the target company. All the needed details on the target are included in the S-4 filing, which you can find on the SEC website. It is important to thoroughly review the target company’s fundamentals, understand the industry situation and comparison with peers. It involves valuation work, but it’s needed so that you can see the whole picture and where that particular company could fit into after the merger gets completed. So at that point, it’s all a case by case scenario. Worth noting, that nowadays the importance of fundamentals is decreasing as with the influx of retail investors (Robinhood/reddit guys) the market seems to care more about a good story (e.g. NKLA), hype and future promises. So predicting/following the hype could be a short-term investment strategy as well, however, it’s very risky and if the hype suddenly turns (negative news/rumours are announced, etc.) you could get burned pretty badly.
After the merger is already completed, the combined company becomes a “normal” public company and as various risks that were present before the merger (shareholders vote, transaction termination) no longer apply. At this point, investing into a post-deal company is hardly different from investing into any other public company. Many things mentioned in the paragraph above still apply (fundamentals). Although, it’s important to note that for some time after the merger share price volatility could be greatly enhanced and it’s not rare for the stock to skyrocket as the market becomes excited that the company is finally listed (NKLA, SPCE, OPEN). It’s important to watch out for these bubbles as getting in at the wrong time (peak of a temporary jump), could bring very negative results afterwards.
Besides the more traditional investment approach, you could also look for more of a special situation type of plays as SPACs offer plenty of them. For example, potential warrant or option arbitrage trades, various warrant exchanges and so on. Warrant/capital structure arbitrage plays are particularly present in post-deal SPAC companies and are very lucrative. Recently we’ve closed several such trades – $METX (generated +175% in a month), $ATCX, $NKLA.