MT13 | Watch This SPAC (SPAC Stocks)

Tech companies have really soared in price over the past year or so. So it’s almost impossible now to find good growth prospects in today’s market. That’s why lots of people – myself included – are waiting for cash in hand for a new generation of tech unicorns to IPO, so we can scoop them up before they too become unaffordable.

Unfortunately, IPOs are long, painful and costly affairs for the startups in question, so many of them are now opting for a different, more direct route to market by merging with shell companies called SPACs. This saves them a lot of time and money and guarantees their valuation, all good things for the startup. But is the SPAC mania also good for retail investors like us?

Discussion Topics: Watch this SPAC (SPAC Stocks)

• Many noteworthy tech unicorns are opting to go public via SPACs
• What might have been the world’s first SPAC, and what SPACs are
• How SPACs work
• Why they are popular amongst investors and startup founders
• SPACs are a fantastic deal for their Sponsors
• But in all this the retail investor can get a really raw deal but you could make money if you’re patient
• How to buy SPACs to make risk-free, guaranteed returns
• In summary, SPACs are the Wild West of IPO markets but you can make risk-free money if you’re patient

Transcript: Watch this SPAC (SPAC Stocks)

Hi, everyone, welcome to another episode of MoneyTok, where we help make personal finance and investing simple and accessible through both my own experience. I’ve been doing this for about 20 years now. This show is about money and wealth creation. And we talk about so many ways of making money, bought retirement planning about stocks, bonds, gold, real estate, crypto, and so many kinds of things.

Regular listeners would know that most episodes of MoneyTok come with a free tool or template that you can use to accelerate your own financial journey and this one is no different. Today we bring to you a comprehensive cheat sheet for how to invest in SPACs that you can download and use as part of your own investing strategy.

I’m based in Singapore and the hottest news in the tech industry is about Grab, the Uber of SE Asia, which is about to go public at a valuation of around $40B in what is said to be the largest-ever SPAC merger to date. But though it’s the biggest, it is definitely not rare. Apart from Grab, other noteworthy tech darlings in Asia using the SPAC route are Traveloka and the Gojek-Toko merged entity called GoTo. And in the US we have 23andMe, BuzzFeed. And a lot of others as well. But why is that? Well, in a nutshell it’s because IPOs have a higher burden of regulation and hence are slower and more costly to execute whereas SPACs are more lightly-regulated and hence offer an easier, faster route to public markets.

So it’s clear that as long as regulations don’t change, SPACs will continue to dominate as the preferred way to list on the US stock market. But what makes them great for startups is exactly what makes them riskier for retail investors like us and we need to be extra careful investing in them. But not to worry, we did the research for you and found a few ways to invest in a relatively safe manner. I’ll share these ideas with you towards the end of today’s episode but, more useful for you, we also summarised them into a handy cheat sheet that you can download for free online.

What SPACs are

The year was 1881. It was the age of the American Dream, a golden period of industrial and technological innovation in the US. Railroads, in particular, were the hot new growth industry, expanding significantly to bring even remote parts of the country into a national market economy and making fortunes for their promoters and investors. Pretty much like the tech industry today.

Enter this gentleman called Henry Villard, who wanted to acquire the Northern Pacific Railroad. Unfortunately, he didn’t have the money to buy it outright (by the way it was just a few million dollars, today that would be pretty much the price of a luxury apartment in downtown Mumbai or Singapore or Manhattan) So he decided to raise funds from the public, but how? The moment he advertised, the owners of the railroad would see it and jack up their asking price. So he hit upon a plan. He’d ask the public to invest in a ‘blind pool’ in other words to give him the money on the promise of revealing the purpose after a few months. It was a gamble. He really didn’t expect people to just give him money sight unseen just based on trust.

But guess what. Not only did he get the funds he needed, it was oversubscribed within 24 hours! And that’s the world discovered a new truth about the psychology of money. If you don’t tell people how you will use their money, they seem to get even more eager to give it to you. And thus in a way was born the first SPAC.

SPACs are Special Purpose Acquisition Companies that list and raise funds in public markets for the sole purpose of acquiring other – usually private – companies, even if the acquisition target is not yet known at the time of listing. this is obviously very different from an IPO which is an operating company trying to sell its shares and hence raise funds from the public for its own future growth and expansion. In the clever words of Don Butler, managing director at Thomvest Ventures, an IPO is a company looking for money whereas a SPAC is a money-looking-for company.

And because SPACs actually go through an IPO themselves in the process of raising funds, when they do acquire or merge with their target private companies, they completely eliminate the need for the private company to go through an IPO. And this is how they create a shortcut for startups to go public.

So now you know what they are, let’s see how they actually work

How SPACs work

We’ll focus this discussion on US SPACs because that’s where 90% of the action is. For those other countries that have their own variants of SPAC, the US explanation applies more or less to all of them

Step 1: All SPACs are started by a so-called SPAC sponsor, who comes up with the theme or concept of the SPAC (eg it might be focused on a particular industry). This SPAC, unlike the startup it will eventually acquire, is the company that will actually go through the IPO process and becomes a listed company. However, at this point, the SPAC is still a private entity in search of funds

Step 2: The sponsor advertises their SPAC and by virtue of their networks or expertise or perhaps their celebrity is able to attract investors who believe this person has some unique edge that will help them find a great future acquisition. These folks come together to invest in the SPAC like they would fund any private company. Do note that at this stage the check sizes are pretty large in the range of millions per check, so it’s not something you or I can get into with the few hundred or thousand dollars we have at our disposal.

Step 3: Early investors SPAC are given shares in the company, just like with any other private investment. However, if that’s all they got it would be a pretty unattractive investment – a huge risk of the unknown compensated by relatively controlled returns that they could get from other stock market or private investments. So SPAC investors also get an extra reward over and above the shares they buy. They also get free warrants at a small premium over the IPO price. Warrants are special kinds of financial instruments that can be converted into shares at a pre-defined price in the future, kind of like options for those of you familiar with options. In the case of SPACs, these warrants are typically set to trigger at a price typically around 15-30% higher than the eventual IPO price of the SPAC. This is a great deal because these options could potentially generate a substantial number of free additional shares for the holder if the price goes 15-30% above IPO.

Step 4: Once all early investors have put in their money, a typical SPAC would have raised several hundred million dollars. At this point, the SPAC will go through an IPO process to become a public listed company. However, because it isn’t an operating company, there is not much to report in terms of business metrics. It’s basically just a glorified bank account. So most SPACs are allowed to list with very little trouble from regulators. Most list with a standard share price of $10 which is pretty much all backed by cash in the bank. It’s at this point that regular people like you and me can buy these shares from the open market. Now, if the SPAC has a lot of hype around it, and which one doesn’t nowadays, you might end up paying more than the IPO price of $10 even though the company still has only $10 per share in the bank and nothing else.

Step 5: Now that the IPO is done, management starts to identify acquisition targets. Now the key issue here is that SPACs typically have only 2 years to complete a deal. If they fail, the money raised is returned to investors. And obviously, nobody likes that. The sponsor stands to gain incredible amounts of money from the SPAC (I’ll talk more about this in a few minutes) and the investors too, with their shareholding and warrants, have quite a significant stake in the process. So what’s an ideal target company? Remember, SPACs investors want to make a killing, not just some inflation-adjusted rate of return. So the target can’t be just any old company. It needs to be something err SPAC. A great target would meet these four criteria. It should be a) IPO-ready, so it doesn’t collapse under the compliance requirements of a public company in the future b) has a private valuation lower than a comparable public company, so there’s room for the price to rise post-IPO c) big dream and vision that makes for a great public story d) perhaps most of all, it should be in a super-hyped sector that the entire world wants to invest in. think Food Delivery during Covid, for example.

Step 6: Once an acquisition is identified, this will be announced to the public and diligence will start on the target company. If the acquisition target is exciting, the. listed SPAC share prices will probably start rising already, in anticipation of a great deal.

Step 7: (This one is the key point that to note if you want to make big money on SPACs, so listen carefully) After diligence is complete all shareholders of the SPAC, including post-IPO retail investors, get to vote on the acquisition. If you vote against it, you can exit the investment and redeem your funds at close to the original $10 per share (less costs, but to keep it simple I’m just going to say it’s the original $10 per share). But get this, you still get to keep the warrants! Isn’t that amazing? You essentially get to hold on to potentially valuable warrants for zero money invested. Now you better hope that not too many people exit because then the acquisition falls through and the SPAC needs to start looking for a whole new target. Given the 2-year timeline, it would be really tough to try and find another great company and complete the acquisition so the parties will try hard to save the deal either by cutting the management share or by reducing the valuation of the target company. A failure would also not be great for the resumes of these celebrity-type promoters so they would indeed try hard to make it work.

Step 8: If the acquisition is voted through, the next step is to raise even more money to fund the deal. Yeah, you heard me right. The hundreds of millions aren’t enough, partly because a large chunk is always redeemed and hence not available and partly because nowadays great startups command really high valuations. So a SPAC always needs to raise more money, and there is nowadays no shortage of funds that are more than happy to throw in a billion or two. This additional funding is called Private Investment in Public Equity or in short, PIPE. I guess they call it that because you’ve got to be smoking something to want to invest at these valuations

And then it’s on to the last step.

Step 9. The SPAC applies to regulators for permission to merge with the target company, which is a relatively light process vs an IPO. Once it’s all done and approved by the regulators, the SPAC merges with the target company in a so-called de-SPAC transaction. The SPAC takes on the name of the target company and starts its new life as an operating business and its shares start being valued like an operating business rather than a bank account or a speculative bet.

Benefits of SPACs

So given the amount of money needed to set up a SPAC, how many SPACs do you think are currently out there? Ten, twenty, 50? Nope, there are 426 right now seeking acquisitions, with another 292 awaiting their IPO. Together they represent almost $200B dollars seeking companies to acquire. In fact, 85% of all SPAC money in the last 20 years was raised in just the last 1.5 years. So why are they suddenly so popular?

First of all, if we just look at the broader picture, it is obvious that there’s a lot of money sloshing around looking for ways to make good returns. According to some statistics, 20% of the entire US dollar supply was created in the past 1.5 years to help combat the economic impacts of Covid. Most of this money has ended up in institutional or ultra-rich hands, who prefer to invest it rather than spend it. And the very definition of a SPAC is money looking for an investment! These investors get to buy into shares of a potentially hot company and even make some extra from warrants. And they can walk away from the investment risk-free with all their money back, while still keeping the warrants. Compared to most other ways of putting money to work, SPACs are therefore an excellent risk-adjusted investment.

Then let’s look at the Founders. If they choose to IPO they get a very fancy listing day experience with the NASDAQ bell. But on the flip side, the whole process is cumbersome, expensive, long, and very distracting for the management team. Plus their valuation isn’t known till pretty much the last day! On the other hand, if they go the SPAC route, founders need only negotiate with the SPAC for a valuation, not with dozens of all-powerful institutions, getting them a much more favorable – and firm – number in a much shorter time. Plus prior to the merger, there is no barrier to advertising. You can sell the dream how much ever you want to small investors and whip them up into a frenzy of speculation. As an example, a company called Archer was valued at $16M when it was private. But a year after the last valuation they went public via SPAC at a jaw-dropping $3.8B

Finally, we come to the Sponsors, the people who kick off the entire Spac process. Why do they even do it? Well, it’s because they have the best deal of all – a compensation structure that allows them to make truly incredible gains with very little money down.

The dark side of SPACs and why you should watch out

In 2019, Michael Klein a former Citigroup banker, set up a SPAC that took a company called Clarivate Analytics public in what turned out to be one of the most successful SPAC deals for a private company. But what focused everyone’s attention was the windfall gains that Klein was able to negotiate for himself as part of the deal.

When all was said and done, Michael Klein made $60M from sales of stock while holding onto a further $300M in unsold shares. In addition, he also made almost $50M from advisory fees. And all this for a piddling $25k initial investment. Amazing, right? Well yes, it is because it’s probably the best return ever made by a SPAC sponsor but it’s not completely on the fringe either. In general Sponsors have the sweetest deal of all, making astounding amounts of money for almost laughably small investments. It’s a three-pronged strategy

First, the laughably small investment: Unlike other investors, a Sponsor is mostly bringing their network, their knowledge, and their celebrity. So they often come in with very little money compared to others. Even if the SPAC has middling success, because of their small investment their ROI can be massive.

Next is something called promote: In return for their unique expertise and role in dealmaking they get something called a ‘promote’ ie a chunk of shares in the post-acquisition entity as an incentive to complete the transaction. And this is where the money is. This promotion isn’t some little $1-2M bonus. It is usually something like 20% of the SPAC. So for example, if a SPAC is raising $500M, the Sponsor could be awarded $100M worth of shares in the final company. Clarivate stock did very well after acquisition and this is how Michael Klein made his several hundred million in shares

Finally, they can even make a bit of cash on the side: As part of the acquisition, the SPAC usually needs to raise additional funds as we discussed earlier. This fund-raise comes with costs such as legal, due diligence, etc. Sometimes, a Sponsor can actually serve as a service provider in the process and make money off the fees for these services. And these fees could easily run into the millions for a large acquisition. When there are billions involved, what’s a few million here or there? This is how Michael Klein made the additional $50M – from on advisory fees from three different SPACsSo what does all this mean for the retail investor?

By now I’m sure at least some of you want to become SPAC sponsors – and good luck with that. Do count me in! But irrespective of what you think about the system, the big issue in all this is for the retail investor. Because they don’t know that for every dollar they invest in a pre-acquisition SPAC, over 20% of it will be skimmed off by the Sponsor when the acquisition happens. And after other costs are paid, they are likely to be 25% down. In other words for every $ they put into a SPAC share, they will only end up with 75c worth of the final entity. So the post-SPAC fully diluted stock price has to gain by more than 30% for the retail investor to even get their money back, let alone make a profit.

Worse, we currently have hundreds of SPACs chasing very few good targets in a short, 2-year timeframe. So obviously all the target companies will play off SPACs against each other, inflating their prices and making the resulting listings pretty poor investments for everyone other than the Sponsors and perhaps the early backers. And this has been proved in the past. With very few exceptions, the vast majority of SPACs have fallen below their IPO price or underperformed the market as a whole. This is obviously terrible for those who buy at speculative, inflated prices. But, if you can be patient, it’s also the trick to making substantial gains in SPACs. Let’s see how.

The smart way to invest in SPACs

Now there are several ways to participate in SPAC listings. You can buy SPAC stocks directly in the market. They are easy to identify as most have the word Acquisition or Investment in their names. And successful sponsors typically raise multiple SPACs so they might even have a number like Roman I, II (eg Khosla Ventures Acquisition Co III) or letters A, B, C (eg Chamath Palihapitiya promoted SPACs with ticker symbols IPOA, IPOB, etc).

You could also invest via a few SPAC-focused ETFs such as SPAK and SPCX. Though let me warn you that their performance is obviously going to be broadly in line with the SPAC market. And given that most SPACs underperform, these ETFs are unlikely to be great bets overall in my opinion.

Finally, you could buy the SPAC warrants only, which are actually listed separately from the SPAC stock. Warrants behave similarly to options in that they are worth something only if the underlying stock rises above the warrant price. So you could make a killing if you’re lucky but if the deal falls through or the resulting stock underperforms you’d lose all your money.

So speaking for myself, I’d avoid the ETF or warrants and focus on the stocks themselves. Now remember three things.

• Most SPACs before they actually merge with a target have $10 of cash for every $10 IPO price share. So if the price falls below $10 you’d actually be buying $10 of cash in a bank account for less than $10
• As a shareholder of the SPAC, when the acquisition is put to a vote, you can actually vote to redeem your shares and exit with $10 in cash. So, if you can get into the SPAC at less than $10, I think you’d be guaranteed to make money whatever happens. If the announced target is great, the price rises to more than $10 and you can sell at a profit. If it is not a good acquisition the price could drop but you’d just vote to redeem your shares and recover $10
• Best of all, given that there were hundreds of SPACs launched in the last year or so, many will struggle to make good acquisition announcements within their 2-year limits. This should create plenty of buying opportunities for all of us in just a few months from now. Happy hunting!

Summary

SPACs are pretty good for their early investors and company founders. And they are pretty much heaven on a plate for their sponsors. But they are really the wild west of the IPO market and more likely than not will burn retail investors who buy into the hype.

But if you have patience, you can buy in below their IPO price and make a guaranteed upside within months. Sure the returns won’t be stratospheric and make you 10x your investment, but it will be risk-free. And that in today’s market is itself quite amazing – some might even say SPACtacular!

That’s it for today folks. SPACs are a new topic for me and I had a lot of fun making this episode. And if you enjoyed this episode as much as I did making it then please do subscribe and also tell your friends to have a listen, so we can all try to make some risk-free money in the market. God knows we need some of that!

Before we close, a quick reminder that today we have for you a free checklist on how to invest in SPACs. It covers a lot more than what we discussed in the episode so I highly recommend you check it out before you jump into your SPAC research. Do register, download and let me know how it goes!

Thanks for tuning in. See you next time. And for my friends in Indonesia – Sampai Jumppa Lagi! This was Amit, with MoneyTok