Return of the SPAC

You may have heard about how Jamba Juice (Nasdaq: JMBA  ) , American Apparel (in the process of being bought by Endeavor Acquisition (AMEX: EDA  ) ), or Hill International (Nasdaq: HINT  ) got bought out by special purpose acquisition vehicles, otherwise known as SPACs.

Thanks to ultra-low global interest rates, excess money has been sloshing into nearly every asset class, and like a blast from the past, the SPAC is back. (Say that five times fast.) At first glance, SPACs seem downright toxic, a vehicle that no sensible investor would embrace. However, it appears that in certain situations, SPACs can serve a useful purpose in a value investor's portfolio.

What the heck is a SPAC?
In a nutshell, a SPAC is a "blank check" acquisition company. If a management team wants to buy a company, but doesn't have an acquisition target yet, it forms a SPAC -- it's kind of like a publicly traded private equity fund, except that the fund consists of only a single acquisition, and not as much leverage is involved. Since it's difficult to get someone to write a multimillion-dollar blank check, an investment banker is hired to help slice the SPAC into millions of different pieces and sell them off to investors.

The investment bank usually has distributional strength with institutional investors, and access to thousands of retail investors. It may even have a retail brokerage arm, through which its brokers can pitch the SPAC to its clients. To drum up interest in a SPAC, the investment bank takes the acquisition team on a song-and-dance road show to various potential buyers. Though most SPACs raise something in the neighborhood of $60 million, or 10 million shares at $6 each, recent successful SPACs such as Marathon Acquisition (AMEX: MAQ  ) and Freedom Acquisition (AMEX: FRH  ) have raised between $300 million and $600 million. Each unit of the SPAC sold usually comprises one common equity share of the SPAC and two warrants -- the warrants are often added to make the unit more "sexy."

Checks and balances
After raising the money, the investment bank typically takes its fee of roughly 6%. The SPAC management team might take half a million dollars of the accumulated funds to pay for travel and legal expenses while it seeks a suitable acquisition. The rest of the money gets placed in a trust. The SPAC management team also sells itself a bunch of "insider shares" for very low prices, perhaps $0.10 a share. These insider shares often amount to 20% ownership of the SPAC. Because a blank check has enormous potential for abuse, a number of checks and balances are put into place:

  1. A SPAC shareholder doesn't want to wait forever for something to happen, so usually, a deal must be completed within 18 to 24 months. Otherwise, the funds it has amassed are returned to shareholders.
  2. A SPAC shareholder also has the right to reject the acquisition target -- any shareholders who reject the acquisition deal get their pro-rata share of the liquidation trust back. If you've ever wondered why so many SPAC shares seem to be trading in the $5.60 range, it's usually because the SPAC originally sold 10 million units at $6 each, or $60 million. The investment bank took its $4 million cut, leaving $56 million, so each share's liquidation value is roughly $5.60 ($56 million divided by 10 million shares).
  3. Managers' "insider shares" aren't eligible to receive anything in a liquidation -- because they pretty much got their shares for free, their shares are only worth something if the acquisition is approved. If it's rejected, their shares are worthless, giving them a huge incentive to get a deal done. On the other hand, if the deal is approved, management's insider shares, which might amount to 20% of the SPAC, become worth millions.
  4. If too many SPAC shareholders decide to take their money back (usually 20% or more), the deal doesn't go through, and all the investors get their money back.
  5. The warrants that came with the units can only be exercised if the deal is approved.

Splitting the pie
In any acquisition deal, it's always important to ask how the funds are divided. In a SPAC deal, the three key players are the investors, the insiders (the management team), and the seller (the owners of the acquisition target). If the acquisition gets approved, the insiders' shares (which were pretty much bought for free) account for 20% of the company. So one has to ask, if investors put up nearly 100% of the funds the SPAC used in its purchase, where is management getting its 20%?

The seller has the most information on the acquisition target's true value, so it's unlikely to sell a company for 80% of its worth. Nor is management's take coming from the investment bank, which already got its cut up front. That leaves the regular shareholders, who paid full price for their shares. Unless SPAC insiders were able to buy a company at a bargain price, or unless their management skills are so astute that they can increase the value of the acquisition candidate, their ownership is usually coming out of the shareholders' stake in the company.

A dubious deal?
If management automatically grabs 20% of every shareholder's investment, why should Fools have anything to do with SPACs? Their chances of proving to be a good deal seem pretty low. SPAC insiders also have to compete with hedge and private equity funds, as well as strategic buyers, making it much harder to find an acquisition target at a good price. Nevertheless, SPAC shares can be attractive for a couple of key reasons. Stay tuned for part 2 of this article, in which we'll explore their benefits.

For related SPAC commentary:

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

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