It’s 2021 and rich capitalist Charles has a plan. After striking gold with one of the most successful tech companies of all time as an early investor, he now possesses the fame and adulation: The masses believe he has the magic touch to make himself and his followers rich a second, third, fourth and maybe even fifth time.
Luckily, there is a financial product that is able to provide Charles with his second fortune. But his followers may not be so lucky.
Charles approaches a friendly investment bank to help him launch a Special Purpose Acquisition Company, or SPAC. The idea is that Charles using his deep connections and industry knowledge can use the funds raised in the IPO of such a “blank check company” to identify and takeover a private company that desires to go public but doesn’t want the hassle of an IPO.
Charles at this point doesn’t need anyone to believe that he can find and close a profitable investment. That is because the initial IPO investors are “insiders” who are not at all interested in whether or not Charles has any chance of making money. These initial investors will win in any case, as we shall see.
The SPAC is formed with arbitrage hedge funds investing $500 million dollars for 50 million shares, or $10 per share. Plus they receive detachable warrants that will gain in value if the stock price rises. Charles puts in $100,000,000 of his own at $10 per share and also gets warrants. But, as SPAC sponsor, he also receives 10,000,000 shares for nothing. All of the proceeds are put into an interest-bearing account. The investment bank also takes 3% of the sale, so the SPACs balance sheet looks like this on day one of the IPO:
Net asset value (NAV) per share: $582mm/70mm = $8.12
This looks like an extremely bad deal for the hedgies (paying $10 for $8.12 of assets) but it turns out it isn’t.
Charles has two years to fins a “good” investment. If he doesn’t, the deal collapses, he has to pay $10 per share to the hedgies plus interest (and sometimes extra fees). After paying let’s say $500mm back to the hedgies (assuming no interest or fees), he would have lost $100mm - $82mm = $18mm dollars, assuming no other costs (and there are a lot of them!). Therefore he is highly incentivized to find and do any deal.
If he finds a deal, the hedgies can choose to redeem their shares for $10 per share (plus) or stay in the deal and let Charles effect the merger with the private company target. All else equal, it is a very bad deal for them to stay. If half the hedgies redeem and leave, the other half will carry more of the initial expenses and NAV premium as follows:
NAV per share: $332mm/45mm = $7.37
If they leave they get $10 plus interest and sometimes an additional fee, and they get to keep the warrants, so they keep upside exposure to the deal.
Therefore, hedgies that remain want some quid pro quo for voting for the deal. Unsurprisingly, they generally get this, and in three ways:
1. A undisclosed fee;
2. An opportunity to invest in new shares significantly below the stated par value of $10 per share as a private investment in public equity (PIPE); and
3. A chance to invest directly in the company at undisclosed prices.
Let’s say that hedgies controlling 40mm shares leave, but those holding the remaining original 10mm remaining invest 120,000,000 in 20,000,000 shares (cost of $6 per share).
The old hedgies get their $400mm, leaving only $182mm in assets. The new share sale puts in $120mm, so the NAV is $322mm. The balance sheet now looks like:
NAV per share = $302mm/50mm = 6.04 per share.
Note that (I have not included the other possible rewards to the remaining hedgies (fees and direct investment).
Now the alchemy happens. The announcement of a transaction attracts the interest of retail investors. They have a chance to invest in a new private-to-public IPO approval by Charles, with a gazillion twitter followers, tight abs and best friends with Elon. And anyway, it must be a great deal, as Charles has his own money in it, right?
Let’s assume that this created a pop in the SPAC stock to $12 per share. After all, it was worth $10 when it had nothing, and now it has something, right?
Who earned what:
Redeeming hedgies: Paid $10 but received $10 back, plus interest (and, often fees) and get to keep warrants. Thy also had the free option to participate and receive the below
Participating hedgies: Got stock at an average price of $7 per share, with those shares now worth $12: A mark to market return of 71% gross.
This is not risk free, as many of these shares are locked in, and therefore cannot be immediately sold.
Charles: Just taking the share compensation, Charles as sponsor owns 20mm shares at a cost of $100mm, or $5 per share (assuming that no PIPE shares were bought). They are now worth a whopping $140mm more than at issue, a return of 240%.
At this point I haven’t brought up the retail stock holders position post-announcement. Perhaps Charles really did negotiate an amazing deal and the company that went public through the SPAC merger really could be worth much more than the SPAC effectively paid out of the $302mm proceeds ($6 per share), but in this simple example it would have to be worth double just for the new investors to breakeven.
In the meantime, all of the insiders can stand a huge fall in price and still make money. The hedgies are profitable until the stock falls to $7. Charles is profitable until the stock hits $5.
The retail investor needs the company to perform unbelievably well to generate any return, while even a dud will be acceptable to Charles and his enablers.
The conflicts of interests and skewed economics outlined in this hypothetical and over-simplified case explain why most SPACs greatly under-perform post-acquisition.
Meanwhile, the insiders bank on the gullibility of retail.