SPACs are all the rage these days and given the potential for large gains if you walk into the next DraftKings or Lucid Motors, it is no surprise that they are at the center of so much speculative activity. But that begs the question, what exactly are the risks and how can one go about skewing the risk/reward profile in their favor? Hopefully, this guide can help you do just that.
When a SPAC first comes to market, it is just a publicly-traded pile of cash -- thus the nickname of a “blank check” company. As there is no target and managers are simply in search of a deal at this point, it is almost like a scratch-off ticket -- not exactly an investment, but it can still be a fun way to speculate. We just want to do that speculation with as little downside risk as possible, so we must be sure not to pay too much for that ticket.
In general, the IPO price of a unit (which consists of one class A share and a fraction of a warrant) is $10 per share and after underwriter fees the net asset value (NAV) is something around $9.50 per share, with the principal sitting in an interest-bearing account. For our purposes, since each share is redeemable for $10 cash should investors not approve of the acquisition target, we will go ahead and assume that the “cash floor” is $10 per share. That tells us that in order to reduce risk as much as possible, we need to pay as close to $10 as possible.
Now, you may have noticed I said a “unit,” not a share. Once the IPO is complete, units are traded for about 52 days before being split into shares and warrants that trade separately.
However, units are not available on all platforms -- Robinhood for example does not provide the ability to purchase units, only class A shares or warrants after the split. So if you can get units, you are in a way legally front running those retail traders that have not made the jump to a more sophisticated platform. For that reason, my preference would be to target units as close to $10 as possible.
So now, we have two criteria to work with -- target units (not crucial, but preferable) and look to pay as close to $10 as possible (crucial to reducing downside risk). These are basically the two check points we need to consider to help us minimize our risk. I don’t care how good the management team is or how hyped-up the target industry is, if you pay too much, you are setting yourself to be holding the bag -- just ask those that helped bid CCIV (the SPAC taking Lucid Motors public) up to roughly $60 per share.
Of course, with all the SPACs coming to market these days, that still leaves a lot of choices to pick from when focusing on the potential reward side. On this side, seeing as no target has been announced yet, we are focused on three things: The investors behind the SPAC, the target industry and the size of the SPAC.
What to Focus On
First, you want a high-quality management team since this is essentially who you are handing your money over to. That said, since we are playing hype to an extent, especially if you plan to bail on any pop, we not only want diligent investors on board (though that is, of course, crucial), we also want a recognizable name and someone that is themselves a brand to get investors excited and the hype going. Because like it or not, as I mentioned before, playing SPACs prior to an announced target is about market mechanics and speculation; it is not investing and therefore we want to leverage hype whenever we can.
Second, make sure they are targeting an industry you have an interest in. While you cannot know the ultimate target company, having an idea of the target industry will at least provide some idea of the type of company you may be looking at, be it fintech, electric vehicles or something else entirely.
Finally, have an idea of the size of the SPAC. While larger cash piles are likely to draw attention because a larger SPAC will have to target a larger company, this can also limit the universe of choices. After all, a $1.5-billion SPAC probably isn’t targeting a company worth $250 million and vice versa. While a private investment in public equity (PIPE) round can add to the size of the SPAC if needed, we won’t really know to what extent that might happen if we are trying to get in as close to the ground level as possible.
So, ultimately the filter one may consider using when targeting a SPAC would be as follows:
- Pre-split units
- As close to $10 per share as possible
- An all-star management team -- the addition of a highly recognizable name is a plus
- An exciting target industry
- Consideration for the size of the SPAC
The final consideration would be to spread the bet. Rather than target a single SPAC, since we do not know what we are getting at this stage anyway, I would determine how much money you plan to allocate to SPACs and then divide that up across several SPACs of various sizes, allowing you to increase your universe of potential targets. The easiest way I have found to go about searching out these names is to use SPAC Track, a simple website that lays out all the information provided above, as well as other filters that one may find useful such as key dates.
Finally, since we are using a strategy focused on keeping you as close to the cash floor as possible, there are a few things to be mindful of -- primarily, valuation and dilution.
First, as noted above, the underwriting and search fees (those managers get paid after all) can slowly reduce the cash in the trust, so be sure to keep up to date on the filings (all of which can be found via the SEC’s Edgar tool).
Second, understand that once a target is announced, you can no longer rely on the hype game. At this point, you need to buckle down and do some actual diligence on the company the same as you would for any investment. And remember, whatever valuation they tell you the deal was done at is based on the IPO price of the units (usually $10), so if shares are above $10 you need to adjust the numbers. So, for example, if shares IPO at $10 and the equity value of the deal is $1 billion but shares are now trading at $15, well, the valuation you are paying if you were to buy shares at $15 is going to be 50% higher than what’s being advertised.
Third, once the target is announced, investors may or may not begin to redeem cash if they don’t like the deal. Moreover, once the business combination is finalized, founders shares (which are given for much less than $10 per share) will come into play and dilute your ownership. So that $10 cash floor we were talking about -- your “safety net” -- is going lower. In fact, a recent study concluded that “although SPACs issue shares for roughly $10 and value their shares at $10 when they merge, by the time of the merger, the median SPAC holds cash of just $6.67 per share.”
To better understand how the dilution works, consider this example from Robert Huebscher, who advises financial advisors:
“Let’s assume we have three individuals – Moe, Larry and Curly. Moe is the sponsor, and he approaches Larry and Curly to invest sizable sums in his SPAC. Moe explains that he will retain 20% ownership of the entity without contributing his own money. Larry and Curly make their investments at $10/share and receive their stock and rights and warrants. Moe subsequently identifies a target company to acquire and presents the transaction to Larry and Curly. Larry redeems his shares, but Curly does not. The transaction proceeds, although Moe now has less capital to make the acquisition because of Larry’s redemption. The merger is completed, and the new entity begins life as a public company. Moe is ecstatic with his newly acquired wealth as a share of the public company, for which he contributed no capital. Larry is happy too. He earned a risk-free return on his $10 investment and retained the rights and warrants, which have value that will increase if the public entity thrives. Curly is despondent. He discovers that his $10 investment is now worth only two-thirds of the price he paid for it. He was the victim of the dilution that came from the sponsor’s shares and the underwriting fees and other expenses incurred by the SPAC. A third of his wealth was destroyed.”
One Last -- and Important -- Thing
The last thing we must be mindful of is the inherent conflict of interest present in the SPAC structure. Pay attention because this is perhaps the most important thing to understand about SPACs -- I can’t stress this enough.
Because the insiders only see those founders shares come into play once a business combination is finalized, and because they pay next to nothing for those shares (oftentimes $25,000 is the aggregate cost of the founders shares that entitle them to ~20% of the post-merger shares outstanding), the one thing a SPAC sponsor really does not want to do is give the money back -- they would much better off financially by bringing a, shall we say, “sub-optimal” deal to the table than to admit defeat, return the money to investors and never see the founders shares come into play. After all, they paid next-to-nothing for that ~20% ownership.
The point is, there is an inherent conflict that does not get much attention, despite the risk it poses to uninformed investors that think sponsors have their best interests at heart. That’s not to say the sponsors are purposely trying to wrong retail investors, but this is the stock market, the most cutthroat place in the world, and at the end of the day, the only one watching out for you, is you.
So, hopefully, in addition to better understanding of how to play the SPAC game both prior to a target being announced and as the deal is being finalized, my hope is that you come away from reading this with a better understanding of the inherent conflict with SPACs (not that a traditional IPO doesn’t have its own conflicts but that is a discussion for another day), and the dilutive dynamics working against should you overstay your welcome in a name that perhaps would have best been left out of the public markets.
That is not to say all SPACs are bad -- some have been absolutely fantastic. But given how long this has been going on, added skepticism is warranted because when just about any deal is better than no deal at all from the perspective of the insiders, you can rest assured that a lot of garbage is likely going to be coming to the market in the months ahead as favorable targets become fewer and farther between. This makes the due diligence you do after a target is announced even more crucial than ever.
Zev Fima is a research analyst for Action Alerts PLUS, Jim Cramer’s Charitable Trust portfolio. Click here to lean more and get the latest on information on the market, access exclusive videos from Jim Cramer, receive trade alerts in real times and learn the portfolio management process.