Special Purpose Acquisition Companies (SPACs): How Sound of an Investment?

by: 10Q Detective
“Blind pools" are investment vehicles that raise capital by selling securities in a public offering without telling investors how their monies will be used. A common form of blind pool is the "blank check" offering. While the blind pool will usually provide at least some indication of what general industry the funds will be invested in, blank check offerings do not identify any proposed investment intent whatsoever. They are literally "blank checks" that the promoter can use at his whim.

Fraudulent abuses in blind pools—the most common being the "pump and dump" scams of penny stock promoters—resulted in stepped up enforcement by the SEC. The Penny Stock Reform Act of 1990 and 1933 Act Rule 419 now restrict their activities. An amendment to 1933 Act Section 7 lets the SEC impose special standards on their registration statements.

One of the most notorious blind-pool scams of the 1980s was a Fort Lauderdale, Fla., shell company called Hughes Capital Corp., which raised more than $650,000 from investors, promising to plow the money into profitable private companies. Instead, the Hughes blind pool turned out to be a plain old "pump and dump" stock swindle allegedly dreamed up to help pay off a former stockbroker's mob debts.

Blind pool offerings, which first surfaced in America during the stock market boom of the 1920s, and then again in the Reagan ‘go-go’ years of the 1980’s, are back again. This time, however, they have morphed into new investment vehicles, called Special Purpose Acquisition Companies [SPACs].

Like blind pools, SPACs are investment vehicles that allow retail investors to invest in areas sought by private equity firms. SPACs are shell or blank-check companies that have no operations but that go public with the intention of merging with or acquiring a company with the proceeds of an initial public offering [IPO].

SPACs are forming in many different industries and are also being used for companies that wish to go public but otherwise cannot. They are also used in areas where financing is scarce. Some SPACs go public with a target industry in mind while others do not have preset criteria. With SPACs, investors are betting on management’s ability to succeed. A potential risk for investors, however, is if management of a SPAC buys into an industry where those at the helm have scant experience.

Advocates promulgate that unlike blind pools, all SPACs operate within a carefully structured investor protection framework. At least 80 percent of the funds collected are set aside in escrow for the acquisition and if no acquisition takes place within a specified time, typically 18 months, at least 80 percent of the funds invested in the shell company are to be returned to investors. If the SPAC is unable to complete a business combination and is forced to liquidate its assets, the per-share liquidation amount will be less than IPO price because of the expenses related to initial offering, ongoing general and administrative expenses, and the anticipated cost of seeking a business combination. Furthermore, any warrants issued in conjunction with the public offering will probably expire with no value.

Placing the funds in a trust account may not protect those funds from third-party claims—something SPAC enthusiasts usually fail to mention. Accordingly, the proceeds held in trust could be subject to claims that could take priority over the claims of the public stockholders and the per share liquidation price could be less the purported 80% liquidation value.

For practical purposes 80% of investors must approve a target acquisition. (The 10Q Detective does not view this particular item as a safeguard, for it is very unlikely that the SPAC investors will vote against the acquisition if the SPAC Sponsor is recommending it.)

Since 2003, sponsors have launched IPOS for about 50 SPACs, raising about $3.33 billion, according to The Reverse Merger Report. Ten of those have announced mergers and six have completed them. The 10Q Detective mentions these stats because all of this increased competition from numerous “blank check” companies (with similar aspirations) seeking to effectuate a business combination, might make it more difficult and/or expensive to complete desired business combinations (at fair value).

EXAMPLES of SPAC Initial Public Offerings (IPOs):

NAME: e-Trials Worldwide / (ETWC) / AVG. Daily Volume: 21,682
IPO Info: Formerly known as CEA Acquisition Corporation, a special purpose acquisition corporation, which traded under the symbol CEAC, commenced with an IPO on Feb. 19, 2004. According to the prospectus, CEA issued 4.5 million shares of common stock, including 500,000 shares for underwriter over-allotments at $6 per share. Each share also included two warrants to purchase additional common shares priced at $5 each, exercisable by Feb. 12, 2005, or by the time CEA Acquisition makes a purchase, whichever comes later.
INTENT: CEA’s status as a shell company changed on February 9, 2006, when CEA consummated its merger with eTrials, which offers clinical trial management software for the pharmaceutical industry.
e-Trials Worldwide Unit Value (ETWCU): $7.37/ % Gain: 22.8

NAME: Cold Springs Capital / (CDS) / AVG. Daily Vol: 69,100
IPO INFO: On November 16, 2005, Cold Springs sold 20,000,000 units in its initial public offering. Each unit consists of one share of common stock and two redeemable common stock purchase warrants. Each warrant sold in the initial public offering entitles the holder to purchase from CDS one share of common stock at an exercise price of $5.00. The company received net proceeds of $109,966,924 from its initial public offering. Of those net proceeds, approximately $107,426,000 (plus an additional $2,400,000 attributable to a deferred underwriters’ discount) was placed in a trust account and will not be released until the earlier of (i) the completion of an initial transaction or (ii) company's liquidation.
INTENT: CDS will focus on specialty finance companies.
Cold Springs Capital Unit Value (CDS-U): $6.31 / % Gain: 5.2%

NAME: Grubb & Ellis Realty Advisors/ (GAV) / Avg. Daily Vol: 1,000 units
IPO INFO: The company closed the offering on March 3, 2006 and received net proceeds of approximately $133,400,000 after payment of related offering costs.
INTENT: The IPO will serve as a vehicle for the acquisition of one or more commercial real estate properties or assets. $6.00/Unit [1-share – 2 warrants]
Grubb & Ellis Realty Advisors Unit Value (GAV-U): $6.80 % Gain: 13.3

NAME: Star Maritime Acq. (NYSEARCA:SEA) / Avg. Daily Vol: N/A
IPO INFO: $10.00 per unit. On Friday, March 31, 2006, Mr. Akis Tsirigakis, President and Chief Executive Officer on behalf of the management rang the opening bell at the American Stock Exchange. The Company had previously consummated the Public Offering of 18,867,500 units on December 21, 2005, and received net proceeds of $174,581,364. Of the proceeds of the Offerings, $188,675,000 is being held in a trust account. Each unit consists of one share of our common stock and one warrant. Each warrant entitles the holder to purchase one share of our common stock at an exercise price of $8.00 per share.
INTENT: A blank check company recently formed for the purpose of effecting a merger, capital stock exchange, asset acquisition or other business combination in the shipping industry.
Sea Unit Value: (SEA) + (SEA-WT): $10.68 / % Gain: 6.8

NAME: Acquicor Technology/ (AQR) / Avg. Daily Vol: 92,100
IPO INFO: March 17, 2006/ $6.00/Unit [1 share- 2warrants]
INTENT: Companies that leverage the adoption of Internet Protocol-based technologies.
AQR Tech Unit Value (AQR-U): $6.95 / % Gain: 15.8

VALUATION METRICS: Typically, valuation analyses have focused on forward EBITDA. For example, shipping SPACS have been trading at 4-to-5 times forward 12-month EBITDA.

PERFORMANCE REVIEW: The average unit (stock plus warrants) price for SPACs that have not announced or completed a deal, is currently trading at a slight premium to the IPO price. [These gains disguise the inherent price volatility in trying to sell shares in thinly traded SPACs; the listed %-gains do not discriminate between bid-offer pricing].

Performance results are mixed for those SPACs that either have announced or have completed deals: Soon after NationsHealth, Inc. (NHRX) announced a merger deal with MillStream Acquisition Company, the units peaked at $13.00, providing stakeholders in the IPO with 116.6% upside. Deteriorating fundamentals have since anchored the units back to earth—after reporting sequential operating losses, the units were recently quoted at $3.05.

Prior to its August 2005 acquisition of Navios Maritime Holdings, a Greek shipping company specializing in the dry-bulk shipping industry, units of International Shipping Enterprises (BULK), peaked at $10.50 (+). Fundamentals—once again—have righted this ship, too, and today the unit price (BULKU) is down 5.3% from its IPO.

Contrary to what the 10Q Detective has read on the Internet, the SEC is not actively seeking to ban future SPAC public offerings. Nonetheless, investors should pause before leaping in—on faith in management alone—to purchase shares of any SPAC. Like going to the beach, investors ought to read the signs, for SPACs contain the following statement in their Form S-1 Registration filing with the SEC: “The Company has neither engaged in any operations nor generated any revenues to date.” If you are thinking of swimming in the SPAC market—BEWARE UNDERTOW.