I have never found any blank-check investment vehicle attractive. No matter what the reputation or what the sponsor might be. . . . They are the ultimate in terms of lack of transparency.”

— Arthur Levitt, former SEC Chairman

Have you ever gone a bad blind date? Or eaten food in the pitch black? When jumping into just about anything blind, it’s really important to trust the person leading you through the dark.

SPAC Is a Funny Name

This segues into my discussion of special purpose acquisition companies, or SPACs. A SPAC is a shell company with no operating history and no business plan other than the intent to find one or more operating companies to acquire. The SPAC issues units (usually composed of one share and one warrant) in the $6 to $10 range as part of in an initial public offering (IPO). Buyers are basically investing money in a blind-pool which gives the managers of the SPAC a blank check to buy something completely unknown.

Many Shareholder Safeguards

It sounds completely crazy, especially if you are old enough to remember the blank-check penny stock scams of the late 1980s. But the SPACs of today are considered a “poor man’s private equity fund” and provide IPO buyers with a multitude of safeguards that make them quite safe, at least prior to an acquisition being made. To wit:

• Approximately 98% of net IPO proceeds go into escrow and are invested in risk-free U.S. treasury bills, earning interest until an acquisition is made.
• Management receives 20% of the SPAC’s shares for a nominal fee of $25,000, but they do not receive a salary or any asset management fees. Consequently, they only make money if an acquisition occurs.
• Shareholders have the right to receive their pro-rata share of the escrow amount in cash if they disapprove of a proposed acquisition that takes place.
• Management cannot acquire a company unless a majority of shareholders approve and no more than 20% of shareholders elect to cash out.
• At least 80% of the escrow amount must be used to make the acquisition
• Management must make an acquisition within two years of the IPO or it is required to liquidate the SPAC and return the escrow money to shareholders.

Short Cut to Public Listing

SPAC acquisitions are often attractive to private companies because it is a fast and cost- effective way for them to become publicly-listed without going through the time-consuming and expensive underwriting process. Furthermore, SPACs pay all cash, whereas other potential acquirers come with their own set of liabilities and often want to use stock. Not all SPAC acquisitions are private equity, however. For example, a SPAC named BPW Acquisition used its cash to purchase shares in publicly-traded Talbots (NYSE: TLB).

Hedge Fund Obstructionists

Ironically, the largest impediment to a SPAC making a successful acquisition comes from certain SPAC shareholders who purchased the IPO with absolutely no intention of ever voting for an acquisition, regardless of its merits. The vast majority of these obstructionists are hedge funds who buy SPAC shares on margin as a leveraged two-year interest rate play. By selling off the attached warrants, their cost basis per share is less than their pro-rata share of the escrow proceeds, upon which they are earning interest. Consequently, they lock in a virtually risk-free return that they don’t want jeopardized by an acquisition. It’s not a surprise that two of the hedge funds that have invested in SPACs are managed by Seth Klarman and Steven Cohen, both of whom are notoriously risk-averse and genius investors to boot.

A Failed Innovation

Back in 2008, Goldman Sachs (NYSE: GS) attempted to issue its own SPAC with revolutionary terms – including fewer warrants – in an attempt to make SPACs more attractive to “fundamental” investors interested in consummating acquisitions, as opposed to the obstructionist interest-loving hedge funds. But the financial crisis put a kibosh on the plan and Goldman ended up withdrawing the offering.

Mixed SPAC Performance

According to the SPAC Analytics website, the SPAC market returned to partial life in 2011 after coming almost to a standstill during 2009 and 2010. Whereas 66 SPACs came public in 2007 with total IPO investment proceeds of more than $12 billion, the number of SPAC IPOs dropped to only 1 worth $36 million in 2009 and 7 worth $503 million in 2010 before rebounding to 16 worth $1.1 billion in 2011 .

Part of the problem comes from the fact that SPACs that have succeeded in making acquisitions have severely underperformed the overall market. Out of 162 SPACs that have come public since 2003, 91 (56%) have completed acquisitions and on average they have returned a negative 19.7% per year, compared to a negative 2.7% for the Russell 2000 small-cap index. In contrast, SPACs that are still looking for a combination partner or have announced a proposed acquisition beat the market by significant amounts.

A Yale study on SPAC returns reached a similar conclusion. While looking for an acquisition target, SPACs trade at a discount to the pro-rata value of the escrow account 81% of the time and by an unexpectedly large 3.9% on average, so it is almost always safe to buy during this period of a SPAC’s life. But the really big returns occur after management has announced a proposed target but before it has held the shareholder vote:

SPACs in the Target Found (TF) category earn an annualized excess return of approximately 11%, providing evidence that the market appears to positively assess SPACs’ proposed acquisition targets. However, SPACs in the Acquisition Completed (AC) category – in which shareholders have approved a firm’s proposed acquisition – have an average annual excess return of -36.5% per year.

Private Equity Investments Are Mediocre

Why should SPAC returns subsequent to shareholder approval of an acquisition be so miserable? Part of the cause probably is just a correction of the price run-up prior to the shareholder vote. But it could also be that SPAC management teams overpay for acquisitions or pick bad businesses. A New York Times article reports that private equity funds have performed the same or worse than the S&P 500. One study found that between 1980 and 2003 private equity funds (after fees) underperformed the S&P 500 by 3.3 percentage points annually. The authors of the study ask a good question:

An interesting area for further research is to understand why investors allocate large amounts to this asset class given such a low performance. To what extent have apparently sophisticated institutional investors mispriced this asset class?

SPACs may provide the average retail investor with access to private equity investments, but such access does not appear to be worth much. For you Star Trek fans, I’m pretty sure Spock would find SPAC investing illogical.

Where to Find More Information on SPACs

Because SPACs have limited life spans, it’s not easy to find ones that are currently active. An investment bank that specializes in SPACs is New York–based Morgan Joseph, which updates the sector periodically. Another online resource is the SPAC Wire. An example of a SPAC still looking for an acquisition is Hicks Acquisition Company II (NasdaqCM: HKAC). A SPAC that has announced an acquisition but is waiting for shareholder approval is RLJ Acquisition (OTC BB: RLJA.OB). Lastly, an example of a former SPAC that is now a regular company is Retail Opportunity Investments (NasdaqGS: ROIC).

Source: Bloomberg