To SPAC or Not To SPAC: Breaking Down The Hottest Investment Trend of 2020
Hey, what's up, everyone! Henry here from Disruptive Money Management, and today we're talking about one of the hottest investment topics of 2020. You may have already been hearing these new investment opportunities blowing up all over the news media. Everyone from CNN to Forbes and Fox is all talking about it. Your Google or Apple News feed is probably throwing new articles out every other day about them. At one point or another, you're probably wondering if it makes sense to have these in your portfolio. That's right, today we're going to be talking about SPACs.
SPACs! That's right! Now, before you decide to SPAC or not to SPAC, it is best to understand better what they are. SPAC stands for Special Purpose Acquisition Company, and these companies are the hottest trends to come out of 2020. A special purpose acquisition company is created to bring a private company to the publicly listed status.
SPACs up until this point have been relatively unknown, but historically speaking, they have been around since the early 2000s. It hasn't been until now that they are picking up mainstream media news, and a lot of that has to do with the significant acquisitions and public stock debuts that have happened these past twelve months. Virgin Galactic Holdings, the Richard Branson commercial space tourism company, became publicly traded on the New York Stock Exchange in 2019. DraftKings, one of the biggest names to go public in 2020, was brought to market under a SPAC vehicle. Nikola Motors, which mainstream news media calls the Tesla of commercial trucks, also went public in 2020 through SPACs.
Virgin Galactic was one of the first most prominent company to be listed on the NYSE through a SPAC merger.
But before we go into what they are precisely and how they work as well as whether they should be in your portfolio, we're going to do a quick recap of how companies go public.
All companies that are publicly traded started as a private company. Whether it is Amazon, Facebook, Google, or Netflix, these household brand names that you and I love in our portfolios all started as a private company. Private companies would have a CEO and a full C-suite team of Vice Presidents to run the company. For those that are large enough and have been growing with outside venture capital, they most likely also would have a board to help the CEO and executive team govern the company and make sound decisions. Private companies and you hear this a lot with tech start-ups generally grow with private venture capital. Think of these VC firms as giant investment firms that listen to hundreds of ideas and creations each year, when they find that one company with a sound business plan and a product that could be profitable, they invest.
Facebook was without a doubt one of the most well-recognized company to have undergone an IPO this past decade.
The VCs would invest millions of dollars to grow these start-up companies. The VC money would allow a private company such as Facebook back when it was private to hire the staff they needed to continue building out the brand. You have to remember, start-up companies generally make no money or are typically running a negative deficit each and year during its infancy state. Private companies run off of private investor money and venture capital money. As the private company grows and expands its customer base, there will come the point in time where the private company would want to go public. Private companies, and using Facebook as an example, could also be forced to go public because of the high number of private shareholders.
Traditionally speaking, companies that want to go public would enlist a central investment bank to help them underwrite the IPO process. They'll determine how many shares are to be issued, how much those shares are priced, and then allow other investment banks to buy in while still private. This arduous process can take years to complete. Additionally, retail investors such as mom and pops cannot buy into a private company until after it has hit the open market and gone public.
SPACs were created to streamline the process. These special purpose acquisition companies are generally formed and trading publicly on the stock market from the very beginning. This allows it to have two things:
Already publicly traded status backed by institutional investors;
Outside retail investment money
The process of raising capital becomes more accessible when the acquisition company is already publicly trading, and it also opens up the public shares to mom and pop's. Now, the primary purpose of a SPAC is to identify a target company in a specific sector. That part is critical. SPACs generally would always have an underlying industry that they want to target, whether fintech, electric vehicles or hospitality. However, I will say that a SPAC may form under the purpose of acquiring something in a sector, but they can venture out of their preferred industry and into something else. What I mean is that a SPAC could be formed to acquire a fintech company, but if they cannot find something suitable in that space, they may go out and acquire an EV company. Sometimes the SPAC may not even have an identified area they want to be in, but through the sheer publicity of the management team, they can still raise capital and garner investor interest. The reason why SPACs are known as "blank-check" companies is going back to the fact that these companies are holding onto many investor funds without a clear indication of what they are going to buy. In short, they are given a blank check to buy something.
SPAC’s raise capital with the intention of buying a private company to take it public.
The process of acquisition can take up to two years. All SPACs created are given a time frame of two years to identify a company, acquire it, and go public. If that does not happen, the SPAC dissolves, and investor funds are returned to the individuals or investment firms at a stated minimum share price. This part is essential, and we'll get to that later on.
Now, at this point, we should dive into how they are created and how it applies to you, the retail investor.
When a SPAC is formed, they are already publicly traded, and they come in three flavors that a retail investor can purchase. These are:
Common Stock;
Warrants; and
Units.
Starting with the easiest to know which is common stock. The common stock of a SPAC is traditionally priced at $10/share. There is no rhyme or reason why it is at $10 a share, but that is just the norm. I will say that Pershing Square and Bill Ackman, who recently released Pershing Tontine Holdings have set their common stock price at $20 a share instead. Again, no rhyme or reason, but it is just the way it is.
When that blank check company becomes available to be traded, you can buy that blank check company at the publicly traded price. Now, even if they are setting the common stock price at $10, volatility can be upwards. Generally, these movements are relatively small in the early stages because there are no acquisition targets. Remember, these acquisition cycles can take up to two years. During this pre-acquisition time frame, the blank check company stock will almost always have a floor of $10, meaning if you were to buy that stock, it would stay relatively flat until they are in the acquisition phase. If the blank check company cannot identify a company to purchase by the two-year time frame, they must return the capital to investors, and that return will be set at the $10. However, if you bought the common stock after a hype and let's say you purchased it at $10.50 a share instead if that company does not go through with an acquisition, you will only be returned the stated $10.
Warrants are generally also available to purchase for blank check companies. Warrants are typically priced lower than the company stock price because they are not actual company stock. A warrant is the right to purchase a stock or a percentage of a stock at a future period. Most blank check companies will offer warrants that are later redeemable at a pre-set price. Using an example, you may have a SPAC offering common stock at $10/share. However, the warrants may be purchased at a much lower amount, maybe in the $2 range. The difference is that the warrants allow investors later to buy the common stock at a predetermined price, and for this example, we'll say it is set at $11.50. That means you can have up to 5 years to go back and buy the stock at $11.50. This creates an arbitrage where if the SPAC is undergoing an acquisition and the common stock is now trading higher, you can redeem your warrants to buy the stock at $11.50 and effectively sell the stock at a higher price.
Now obviously, if the stock does not break past that $11.50 price point and your cost of buying the warrant, then you're not going to want to execute on that. What's also important to know is how many warrants are needed to convert to common stock. It is not always 1 to 1. It can sometimes be two warrants are required for one stock. Additionally, what is essential is that the underlying company can accelerate the warrant expiration time frame of 5 years. This happened with Nikola Motors, where the warrants were accelerated and would expire this year instead of being pushed out further. Furthermore, the warrants have a lock-up period where you cannot inherently exercise them under a set time post-merger.
A unit is essentially a common stock paired together with a warrant. By purchasing a unit, you inherently own the blank check company's common stock and a warrant or a percentage of a warrant. These can vary across SPACs, so it's crucial that you understand how many warrants you receive and not that just but how many warrants it takes to convert to common stock.
It is critical to note that all three of the items, the stock, the warrants, and the units are all publicly traded, meaning you can purchase them and sell them as you wish. The execution of the warrants is what has a lock-up period. It is also essential to know that all three typically move in lock-step with one another. If the underlying stock price goes up, the warrant value and the unit value also goes up. Inversely, if the common stock price slides, then both the warrants and the units again slide downward.
Now, are these things right for you? Well, it's going to depend on your appetite for risk and the unperceived time value. As I mentioned earlier, a blank check company can go months or even over a year without an identified target. This means if you purchase the shares, units, or warrants early on, you most probably would not see much inherent upside or any relative movement at all during that time frame. It isn't until the blank check company has identified an acquisition target that the stock, warrant, or units' price starts moving upwards from investor interest.
All investments have an underlying risk and investors should assess their risk tolerance before making decisions on whether they should invest into SPACs.
However, it's not a given that these upward fluctuations are going to remain. Just like stocks of any publicly traded company, the stock price can reverse and move down. That is something you must keep in mind because from my experience of watching and reviewing SPACs; it is not uncommon for the price to go up after an acquisition target has been announced and then fluctuate back downwards as investors lock in profits.
This up and down cycle happens pretty frequently, and I think this year especially it is much more common than the previous years because of the higher influx of retail investors. You have many individuals that are staying at home, and without the usual avenues of sports betting and casinos, many individuals are taking it to the stock market.
Before you go SPACing around, I recommend you take a moment to assess your risk tolerance and understand that investing in blank check companies do have inherent risk as much as anything else. Yes, they have the growth potential, but unless you have a clear indicator of whom the acquisition target is, I suggest staying on the sidelines rather than jumping right when a SPAC is formed.
As always, I'm not providing any recommendations because I don't know your situation, so please do your due diligence and research on who the management team is. Some of the more prominent names raising the most capital like Bill Ackman's Tontine Holdings, or Michael Klein's Churchill Capital, and Chamath Palihapitiya's Social Capital have had prior experience targeting companies, creating economies of scale. They have the financial backing to see the merger through to the very end. You want to know the management teams' backgrounds, the capital interest, and follow what they are eyeing to acquire. Once an acquisition target has been preemptively released, you'll want to make sure the underlying company is one that can indeed go through and become a disruptor in the area they are in.
Knowing the past success and experience of the underlying management team is critical to gauging the success of the SPAC.
What I mean by that is making sure the target company has a tangible product or service that can truly change the industry. Also, know that if a company has concrete products like electric vehicles, it may still only be in the very early infancy stage. You want to keep your exposure low and not consider this a golden opportunity to become an instant millionaire. You want to make sure you have a predetermined entry and exit price and do not be afraid to take profits off the table so that you are only investing with investment proceeds.
For the 2020 year to date, there are still companies going public through the traditional IPO method, especially now that the markets are hitting back to all-time highs. Yet, companies becoming publicly listed through SPAC acquisitions are definitely in the limelight. As of the beginning of August, over 50 SPACs have been formed, raising over $21.5 billion in capital. And for now, I see this trend staying as more attention from mainstream media is shone on this new trend of investing.
And that's it for today, my friends. I hope you enjoyed this episode. Please subscribe, share, and hit me up with your questions or feedback. I love hearing from you guys and knowing what topics of interest are. Until next time, I wish you all the best, stay healthy, and SPAC responsibly!