Special Purpose Acquistion Companies (SPACs).
Few terms have been more heavily used in the market these days than the abbreviation “SPAC.”
In the investing world, a SPAC is also called a blank check company. It raises money (primarily from institutional investors), collects the proceeds in its holdings, and then searches for a merger target. The merger target is typically a well-performing, sometimes early-stage, company in a trending sector, which is currently private. The IPO process is quite expensive and time-consuming for any company; however, merging shares with an already-public company makes the process a lot easier
Although the idea of collecting funds into a “shell” or “blank check” company is a common way to acquire private companies and bring them to the market through a reverse-takeover (RTO), SPACs are a touch different, in the sense that:
A) The amount of capital pooled is often much larger (in the billions), and
B)The shares of the SPAC, including the warrants from the financing, are traded publicly on the marketin advanceAlthough SPACs have been around for a while, it wasn’t until 2020 that they surged in popularity. In fact, an astonishing US$64 billion was raised for SPACs in 2020 alone, which equates to an amount greater than all of the IPOs last year combined! This statistic is especially mind-blowing when noting that the SPAC activity from 2016-2019 came to a total of just 59 SPACs and US$13 billion.
Popularity comes with side effects. What once used to be as easy as searching up a SPACs merger date on Reddit and betting your book on it, suddenly became a lot trickier. Like most occurrences of market mania, there is always a pullback.
What Was the Big Deal?
There must be something about a company becoming another company that excites investors more than the company itself. No longer was the hot move to collect massive financings for IPO shares privately, and then launch it on the market. People are now wanting to be a part of the even earlier stage, with the rationale that getting in early by investing in a 10-figure blank check company was more exclusive of an opportunity. Ironically enough, anyone with an online broker app could get in on the action, sparing the networking, minimum buy-ins and documentation required for a traditional IPO.
A notable selling point for SPACs is the idea of a “floor” at $10/share. As SPACs tend to open at this price, considered its net asset value (NAV), investors read into the fact that should any merger fail, all shareholders can be redeemed at precisely $10/share. While the share price can, of course, fall below this, investors take comfort in the fact that there was somewhat of a minimal risk should sh*t hit the fan.
Publicly traded warrants were a big attraction as well. Most SPACs debut in the market as “Units” before being split into common shares, starting at ~$10/share, and warrants, usually debuting at $1/share. As you may recall from our options edge-ucational posts (introduction and advanced), warrants give you the right to buy the stock at a fixed price. While they are usually non-transferable and packaged into financings as a value-add, some warrants actually have a value per unit and are traded on the market under their own symbols.
The warrants for SPACs almost always hold a strike price of $11.50/share, meaning for every warrant you own, you have the right to buy a share of the underlying SPAC (or share, if held until merger) for $11.50. This would pose an average cost of $11.50 + the price you purchased the warrants for. Warrants typically maintain an on-the-money value and, for that reason, move almost cent-for-cent relative to the underlying SPAC. That being said, the price gap between the underlying SPAC and its warrants can vary dramatically, depending on a few conditions (such as dilution). However, we will stick to a direct relationship, for ease of explanation.
As a reintroduction of the leverage ability of warrants, a warrant that started off with a value of 1/10 of the underlying SPAC has 10x the growth potential. That’s right, for every 1% the SPAC’s price moves, the warrants price moves 10%.
If our fictional company $SPAC was currently trading at $15/share, its warrants, which we will call $SPAC-WT, were likely trading at $3.50/share. Should $SPAC move up to $20, (a common first run for SPACs), that would be a $5/share, or 33.33%, increase. $SPAC-WT however, would also move up $5/share, maintaining its $11.50 difference from the underlying security. This would mean the warrants now trade at $8.50/share; still a $5/share increase, but now a 142% increase.
Although more rewarding, $SPAC-WT also poses more risk, as the same applies for downwards movements. In addition, should a merger fail, warrants expire completely worthless, unlike their underlying counterparts. It is very common to own SPAC shares and a smaller amount of the warrants for diversification.
What Are Some Notable SPACs To Date?
Enthusiasm for the blank check vehicle was propelled by wildly successful SPACs near the start of 2020. Notable transactions include:
Social Capital Hedosophia Holdings ($IPOA), which merged with the highly coveted Virgin Galactic Holdings, dubbed $SPCE. This merger was successful, being completed in a non-inflated environment when $IPOA was well under $20. $SPCE hit a high of ~$37 before succumbing to the COVID-19 market correction. As of recent, $SPCE has regained its position (closing at US$32.51 on March 16th, 2021) and continues to accelerate towards, well… the moon we suppose.
VectoIQ Acquistion ($VTIQ) merged into the highly-anticipated Nikola Motors ($NKLA), a single day after shareholders approved the transaction. $VTIQ was trading at around the $20-$30 range (which was quite high compared to most SPACs at the time). A week after the merger went through, Nikola went on an absolute tear, touching $93/share at one point. It was a matter of weeks before the stock crashed back to its pre-merger levels, and has been floating around there ever since. This was the first major case of SPAC inflation the market had witnessed.
Tortoise Acquisition Corp ($SHLL) was set to become Hyllion Holdings Corp, an electric vehicle-maker focusing on semi-trucks. $SHLL showed one of the most prominent inflations yet; the stock had reached almost $60/share before the merger occurred, with the warrants ($SHLL-WT) nearing $40/share. Although this led to much of the retail community calling for a $100/share target for the new $HYLN, many were disappointed when the stock immediately tanked post-merger, down to its non-inflated value. This was a tell-tale sign of the mass inflation of SPAC hype that seemed to occur whenever a certain SPAC boomed with popularity.
The most recent case of “spacflation” was undoubtedly Churchill Capital Corp IV ($CCIV). With a target to merge with electric vehicle–innovator Lucid Motors (are we seeing a trend here?), $CCIV blasted all the way to $64/share, with $CCIV-WT surpassing $40/share at its peak. In this case, the inflation started deflating before the merger actually happened. Immediately after the announcement, $CCIV shaved off half of its value, and currently sits at US$31.1/share at the time of writing. Still to actually complete the transaction, we are yet to see how the stock will continue to perform leading up to the merger.
Why Would a SPAC Lose Market Value Upon Merging?
Although this is a good question, the real question should be more along the lines of, “Why was the SPAC valued so high upon merging?”
The hype of a stock is often inflated much past the actual value of the company in question. Unlike the small-cap companies we normally look at, companies on the NYSE tend to stray back to their intrinsic value. Such is the case for companies like Nikola Motors and Hyllion Holdings.
Like most market trends that seem to reward any retail investor with a great return after simply throwing money at it, the SPAC market seems to have reached bubble territory, where caution and diligence are extra important. While everyone with a discount broker is running around trying to find the next $SHLL or $CCIV, it may be wiser to deploy some strategy into blank check investing, rather than to cruise chat rooms looking for the next home run.
Some common things to look for in a SPAC:
Management – Looking into who runs the company is critical when it comes to investing in a SPAC. If you don’t recognize any of the names on the board, a few minutes on Google can work wonders. Check out what kind of achievements and credentials are on the web for any members of management. If a company they previously ran got sued or bankrupt, it could be a sign to think twice.
The Rumor – Most SPACs start to announce tentative merger targets months ahead of the proposed merger date. In fact, most of the time they announce a vote for all shareholders to decide whether to pursue the proposed target or not. During this time, the company in question is typically disclosed. Be sure to conduct due diligence on the company that the SPAC is eyeing, finding out their revenue, management, and the economic outlook of the sector they belong to.
The Chart – If you’re interested in a SPAC that has moved already, be sure to take a look at past price movements. You don’t want to buy a SPAC that has already surged in anticipation of a merger date. The phases of the typical SPAC are actually fairly distinguished on a chart. While there are a few buying points during a SPAC’s bull run, quite often its best to buy a SPAC before any major catalysts have been priced in.…
You May Be Asking Yourself This Question
Aren’t all of the SPACs with promising targets already inflated?
In short, sometimes. Depending on when you catch wind, some SPACs can see a 100% increase within a week. Before the rumor starts spreading though, the SPAC was just an ordinary blank check company blending in with the rest. How can you bet on these ones?
There is of course, a popular diversification approach when it comes to SPACs. We’d like to take a moment to remind you that:
We are not financial advisors and everything that we say should be considered educational entertainment information… not advice. Repeat, not advice. Click here for the full disclaimer.
With that out of the way, here’s our diversification approach to SPAC hunting. It involves finding 5-10 SPACs near NAV, (~$10), conducting some diligence on the management, and then distributing an equal amount of capital amongst them. This method makes it easier to safely bet on a handful of blank checks, rather than put all your eggs in one basket and hoping for a home run. The earlier a SPAC is in its life cycle, the harder it is to tell what it’s going to do.
Step 1: Determine a budget. For this example, we will use $10,000.
Step 2: Carefully choose 10 SPACs (near their net asset value) that don’t currently have merger rumors.
Step 3: Invest $1,000 into each SPAC.
This, alone, is a sound strategy. Minimizing your risk while increasing the potential for a 2-4 bagger on one (or maybe even two!) of them. However, if you are eligible for, and familiar with options, there is more to this method.
Step 4: Sell covered calls at $15. This will pay you a premium upfront, for the obligation to sell the shares to the call holder at $15. Unlike a naked call, where you don’t own the underlying shares and would have to buy them yourself in the open market, you already own the underlying stocks at a cost basis of $10, netting you a $5 return, should you be exercised.
Step 5: If you’re feeling extra spicy, you can use all the proceeds of your covered calls and put them into the warrants of your SPACs. You can spread them equally, or simply toss them all into your favorite 1-2 picks. Remember, be quick to make a move the second a merger “rumor” is incepted, as warrants move quickly!
We hope you enjoyed our comprehensive overview on the SPAC craze of 2020, and our favorite ways to stay afloat in these high waters. Until next time.
Best,
Edge