A Primer On SPACs

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Includes: HCAC.U
by: SPAC Research
Summary

Special purpose acquisition companies (SPACs) are an underappreciated asset class and present compelling risk/reward opportunities.

It's important to understand the dynamics at work as a SPAC seeks an acquisition target.

Handicapping a SPAC's set of potential outcomes is imperative for evaluating an investment.

This article is intended as an introduction to investing in SPACs (special purpose acquisition companies). SPACs are a compelling investment vehicle, with features that are both enticing and opaque. Our research focuses on the structural elements of SPACs that create investment opportunities, as well as the specifics of SPAC transaction details which allow for the handicapping of outcomes for individual SPACs. My goal is to broaden the base of investors who are interested in SPACs and to facilitate easier evaluation of the securities available under this umbrella.

I hope to explore a number of lenses through which to view the securities within the SPAC universe, as well as some ways to filter the opportunity set in ways that match one's own investment objectives. I will assume that readers have basic familiarity with SPACs' operational objective of using the proceeds raised at IPO to make an acquisition, as well as with SPAC structure and features such as the trust account, shareholder redemptions, and the SPAC IPO mechanism of offering units comprised of common equity and one or more derivative securities. To learn more about SPACs in general, readers can visit the SPAC Research FAQ.

SPAC Components

The current generation of SPACs sells units for $10.00 each at IPO. Since SPAC unit offerings generally contain both common stock and one or more derivative securities (usually out-of-the-money warrants and/or rights that convert into common equity upon consummation of a business combination), there are multiple investment opportunities to evaluate once the offering is completed. Each SPAC has different terms depending on what the market is willing to purchase from the sponsor at IPO, but a frequent offering structure is a unit comprised of one common share and 1/2 or 1/3 warrant to purchase one full share at a strike price of $11.50. Only the units will trade at the time of the IPO, but the components will typically separate for individual trading within 52 days after the offering.

Yield-focused investors will find an interesting alternative to Treasuries in SPAC common stock that is linked to a secure trust account. SPACs are structured such that the trust account contains at least $10.00 per public share. SPAC common shares often trade at a discount to their eventual per share cash redemption value. While liquidity may be limited in the open market, the defined liquidation term of SPAC common equity can provide for a relatively attractive yield with very low risk that carries a free option to own a SPAC's future acquisition target. The result is very similar to a zero coupon bond, often with higher rates of return than Treasuries.

More aggressive investors will find fascinating opportunities in SPAC warrants, almost all of which carry a five year term after any merger has been consummated. SPAC warrants, which will expire worthless if the SPAC can't close a business combination, are thus a binary proposition on a five year warrant on a hypothetical future company. The speculative nature of this situation lends itself to wildly inefficient price swings. Institutional capital often eschews securities with a material risk of going to zero, which frequently contributes to compelling values.

Hypothetically, a five-year warrant with an exercise price of $11.50 on a common stock worth $10 per share might be worth $1.60. Pre-deal warrant pricing is often so far below this level that implied value calculations suggest the market is putting the odds of a completed transaction that doesn't bury the common equity at well below 50%. While there have been plenty of SPAC deals struck that destroyed shareholder value after closing, there have only been two SPACs that wound up and liquidated since January 2017, as compared with 19 which have completed a business combination.

SPACs have a mixed reputation, in part because of how frequently sponsors have executed deals that appear to depreciate rapidly from an approximately $10 cash in trust redemption value. Any analysis of the universe of SPAC returns over time will appear lackluster when compared against the cash in trust benchmark. However, moderately careful analysis can make it fairly straightforward to avoid some of the landmines that occur in a subset of SPAC deals. In fact, following a simple quantitative strategy of buying all SPAC units with IPOs between 2015-17 and liquidating the components at the time of a business combination (or redeeming common shares for cash in trust) would have averaged an annualized 8.35% return. Not bad for an asset with essentially zero principal risk!

Source: SPAC Research database; past performance does not guarantee future results.

While the units' downside is protected by the fact that shareholders can always redeem their common shares for cash in lieu of shares in the new company, much of the upside comes from the performance of the warrants included in SPAC units from IPO. Once an actual acquisition target is presented and a path towards closing a deal appears, warrant valuations often increase dramatically. This table shows the average warrant "pop" on the day-of announcement for deals that went on to be completed within the last few years to be 54.69% (with further average appreciation of 46.41% between announcement and deal closing).

SPAC Warrant Results on deal announcement

Source: SPAC Research database; past performance does not guarantee future results.

SPAC Management

SPACs are, at their core, a blank check. The capital stored in a SPAC's trust account can only be accessed to fund shareholder redemptions or to fund a business combination that has been approved either explicitly (by shareholder vote) or implicitly (by tender offer) by a majority of common shareholders. Handing a blank check of a few hundred million dollars over to a management team is, on its face, a significant risk. That risk is mitigated for common shareholders by the redemption mechanism which allows shareholders to redeem their shares for a pro rata portion of cash in the trust account if they don't like the acquisition target. However, any investment in a pre-deal SPAC is ultimately an investment in the management team in charge of finding and executing a business combination. This holds especially true for an investment in warrants or rights, whose value is derivative upon a SPAC's future acquisition target and will expire worthless at the end of a SPAC's charter if no business combination can be consummated.

It's always useful to spend some time evaluating a SPAC's management team. Read through the track record and bios of the SPAC's officer roster. Do they have a history allocating capital at scale? Do they have a history securing financing? Do they have experience managing public companies? What is their background and performance in the area in which the SPAC is searching for a business combination? Sponsors are also generally happy to discuss their approach if you call and ask sensible questions.

It is also worthwhile to review any history a SPAC's sponsor has with previous SPAC transactions. You can gain valuable insight into its ability to source and finance a credible deal in the SPAC format. Some serial SPAC sponsors have a history of acquiring successful companies that continue to accrete over time, while others have a history of finding deals that barely secure enough financing to close and whose common stock has cratered almost immediately after closing.

In the graphic below, you can see the SPAC Research company page on Hennessy Capital Acquisition III (NYSEMKT:HCAC.U). Daniel Hennessy led two successful previous SPACs -- Blue Bird Corp. (NASDAQ:BLBD) and Daseke (NASDAQ:DSKE) -- and operated a middle market private equity firm for over 25 years. He has board experience in public companies and in the industrial & infrastructure sectors in which HCAC is seeking an acquisition. The management team he is working with has mostly been together since their first SPAC in 2013. All of this is useful information when considering an investment in a SPAC that has not yet announced a business combination.

HCAC_Screenshot

Source: SPAC Research.

Unit purchasers in a SPAC's IPO buy their units for $10.00. SPAC sponsors structure offerings such that their founder stake is equal to 20% of the SPAC's outstanding shares at IPO. Sponsors get their founder stake for a nominal capital contribution, and then generally buy enough private placement warrants or units at "full price" to fund the anticipated capital needs over the life of the SPAC and the up-front underwriting fees for the IPO. The net result is that sponsors end up with approximately 20% ownership in the SPAC at a deep discount (although in practice, the sponsor ownership percentage is often adjusted downward during the course of business combination negotiations or as an incentive to would-be investors).

Since the founder shares and any private units or warrants will expire worthless if the SPAC is unable to consummate a business combination, the founders have a heavy impetus to complete a deal, lest they lose their initial investment. This fact can lead to a classic agency problem where the sponsors and the common shareholders have conflicting objectives. Fortunately, common shareholders can always redeem their shares for cash if the deal presented to them is undesirable. This same issue can be beneficial for warrantholders, whose objectives are often more aligned with the sponsor, in that warrants will also expire worthless if no business combination is achieved (and are frequently priced accordingly).

SPAC Financing

While SPACs generally mandate that any acquisition target must carry a fair market value of at least 80% of the balance of its trust account, in practice, founders generally aim significantly higher than that. SPACs often seek acquisitions with an enterprise value that is three to five times its cash in trust. Sponsors have a lot of flexibility in structuring transactions, balancing a seller's desire for cash vs. rollover equity and sourcing the funding necessary to consummate a deal (which may come from the SPAC's own trust account, a private placement or debt). Total merger consideration paid to the seller is often a mix of cash and stock in the combined company, and deals are frequently arranged to provide for a minimum cash condition the SPAC must have available to consummate the transaction.

SPAC merger agreements generally carry various closing conditions, many of which are perfunctory in nature or guard against any material adverse change in the financial condition of parties to the agreement. In practice, the minimum cash condition often functions as the primary deal hurdle for sponsors to overcome in order to get a deal over the finish line. Since most SPAC common shareholders are also warrantholders, they are likely to vote in favor of any reasonable business combination to protect the value of their warrant position even if they plan to redeem their common shares for cash (shareholders are allowed to vote in favor of a deal and still redeem their shares for cash). Consequently, when selling the deal to prospective investors it is important for a sponsor to get common equity into the hands of long-term holders who will not redeem for cash and who buy into the ultimate vision of the acquisition target. Sponsors may have a tough time selling a prospective deal to the buy side without certainty as to whether or not the deal will close.

SPAC sponsors sometimes arrange for investors to backstop shareholder redemptions from the trust account up to a certain threshold, materially improving the SPAC's prospects for getting a deal over the finish line. Paying attention to backstop, subscription or PIPE commitments (especially relative to a deal's minimum cash condition) can be critical for assessing a SPAC's prospects for securing enough capital to ensure closing of its business combination. In the example below, Pacific Special Acquisition Rights (PAACR - each representing the right to receive 1/10 common share upon consummation of a business combination) hovered in the $0.45 area for months after the announcement of their merger with Borqs Technologies (NASDAQ:BRQS), an IoT and connected devices provider.

The market correctly assessed that the deal as written was insufficient to convince enough shareholders to retain shares and meet the $24mm minimum cash condition required to close. On May 12, 2017, the Sponsors re-cut the deal and announced a backstop agreement, ensuring the availability of $24mm in cash after shareholder redemptions, after which the rights traded up to the $0.60 area. It's worth noting the rights essentially predicted the post-merger valuation, with shares settling around $6.00 in the weeks following consummation of the business combination.

PAAC backstop example

Source: Barchart.

PAAC SPAC Research excerpt

Source: SPAC Research.

Conclusion

Whether you're involved via the common equity or the derivatives, handicapping a SPAC's future outcomes and understanding how the components may perform are extremely important elements of investing in SPACs. In the future, we hope to walk through various important events in the life cycle of a SPAC and explore their impact on the pricing of component securities.

Disclosure: I am/we are long HCAC.U. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Author is long HCAC/W, DSKE, DSKEW, BRQSW. Author may maintain positions in securities from within the SPAC performance tables shown above.