Why SPACs Are So Popular

In this episode of Industry Focus: Wildcard, Nick Sciple and Motley Fool contributor Luis Sanchez talk about SPACs. Discover what they are, what's behind their growing popularity, how they are different from regular IPOs, and what advantages and disadvantages they offer. The hosts also tell you what due diligence investors should perform before investing in an SPAC, which ones to watch, and much more.

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This video was recorded on July 8, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. It's been a big year for special-purpose acquisition companies, commonly known as SPACs. The number of high-profile businesses, including DraftKings, Virgin Galactic, and Nikola Motor all coming public via a SPAC. Today I'm joined by Motley Fool contributor Luis Sanchez to help me explain exactly what SPACs are and why they've become so popular. Luis, thanks for joining me on the podcast once again.

Luis Sanchez: Always, Nick. Happy to be back.

Sciple: Great to have you on the show, as always. Just off the bat, Luis, what is a SPAC?

Sanchez: A SPAC is, it stands for special-purpose acquisition company. A common nickname for it is a blank check company. And it's an abstract concept, but it's basically an empty shell company that raises money to go public. And it's sponsored by some kind of asset management company. They usually pair up with a reputable manager, professional executive, and they're looking to buy a company at some point in the next two years after they IPO.

And that cash that they raised sits on their balance sheet collecting interest for a couple of years, and once they find a deal, they bring it to the people who invested in the SPAC, and the shareholders can vote to approve the deal if they want to invest in it, or they could use what's called the redemption rights and ask for their money back.

And it's a little bit obscure. These things have been around for a long time, at least a decade, but in the past year or two, there's been a lot of high-profile examples, including, as you mentioned up top: Virgin Galactic, DraftKings, Nikola Motor. And as many investors would know, these stocks have all done really well. So there's been a lot of growing interest.

And just to put some numbers on it. So far this year, over $12 billion has been raised through SPAC IPOs in over 38 deals. So last year was actually a really big year for SPACs too, where $13 billion was raised. So we're already at last year's numbers, and we're only halfway through the year, so it's probably going to be the biggest year ever for SPACs. So it's probably a topic that investors should start familiarizing themselves with if they haven't already.

Sciple: Absolutely. As you mentioned, SPACs have been around for a really long time. There's been times when SPACs have been very hot and there's been times when they've been less popular. Why do you think SPACs are becoming so popular right now?

Sanchez: Yeah. It's a little bit of "right place at the right time" kind of thing, in my opinion, because most of these SPACs that are announcing deals this year, like, DraftKings, they raised that money back a couple of years ago, 2018, 2019, and they're just sitting with these huge pools of cash. So at a time where a lot of companies are looking for liquidity, these guys are liquidity providers. And some companies might not view the IPO market as being all too hospitable with all the volatility. We've certainly seen a few IPOs get derailed basically.

And I think there's a larger question here too about just the IPO process, the traditional IPO, if it still works for most companies, because there's a lot of data that would show that the number of IPOs has actually declined over the past 5 to 10 years. And that could be through a variety of things, but I would view SPACs as like another tool that companies can use. Direct listings is also another technique that's come out to kind of work around. So it's a little bit of the right place at the right time, it's a little bit of trying to figure out how to fix the IPO.

Sciple: Certainly. I mean, [laughs] when people need capital and you're able to write access to capital, you're in a position to have some leverage. When you compare a SPAC bringing a company public via a SPAC versus a traditional IPO, what are the advantages and disadvantages of that approach?

Sanchez: Sure. I'll start with the advantages for the selling company, because if there's no sellers, there's going to be no IPO. I think the biggest one is really just the ease to market. So in a traditional IPO process, it'll take companies months to prepare for that, if not a full year, and what they're doing is they're talking to banks, they're going on an IPO roadshow, they're negotiating the price of their future offering with a ton of investors. But with the SPAC, it's been reported that some of the SPAC deals are getting negotiated and off to market within weeks, which is really great.

And instead of having to negotiate with a ton of institutional investors as part of an IPO roadshow, they could just negotiate with the SPAC itself, which is managed by one person. So they can have a greater certainty of the price they're going to get, quicker to market, and there's also a few things that are a little bit lighter on the regulatory side. So they don't need to have an S-1-level amount of disclosure. They're not subject to the IPO lockup rule that a lot of exchanges enforce. So there's a couple of interesting advantages there.

Sciple: Okay. And you mentioned, from the investor's perspective, what is the advantage?

Sanchez: Yeah, exactly. So from the investor's standpoint, there's a couple of interesting things. I think the biggest one is there's transparency on the NAV [net asset value] and there's that -- it's kind of like a put option, which I referenced earlier, it's what's called these redemption rights. Where basically, if you invest in a SPAC before it announces a deal, you can use your redemption rights and basically get your money back if you bought it at NAV or net asset value, which is huge, it gives you a lot of optionality. And if the company actually presents you a really great deal, well then, you got in before everyone else, you know, and potentially there's a pop that you get, there's like this IPO pop, that as everyone else finds this great deal that you've already invested in. So that's really cool.

The other thing is that if you really like the people who are running the SPAC, the SPAC gives you a chance to bet on managers, bet on the guys who are sponsoring the SPAC, bet on the CEOs who will go on to run the companies. And some of these SPACs have truly outstanding managers and some really interesting investors in there.

Sciple: Yeah, Luis, I want to talk about how you evaluate a SPAC, you mentioned earlier, one of the advantage is you get quicker to market, there's fewer hoops to jump through from a disclosure point of view. That provides some upside to the company when it comes to you can get public. But also, from an investor's point-of-view, there's opportunities for you to be misled or some issues. I think we talked about before the show that, you know, hey, if WeWork had done a SPAC approach to coming public, it's quite possible they could have made it to market. So as you're an investor evaluating these companies, how do you do it given that there's, really, less disclosure and we don't really know what these companies are going to go buy either?

Sanchez: Yeah, look, I've been investing in SPACs for a few years now. And I'll be the first person to tell you that not all SPACs are created equal, some SPACs have better terms for investors; some SPACs, in my opinion, have better managers with better track records. So the first thing that I always start with is who are the people who are running the SPAC? What have they done previously? Why should you trust that they'll find you a good deal? Why should you trust that they'll negotiate a good deal on your behalf? Part of that is their track record. Part of that is just how much money they're personally putting into the deal themselves, right? You want to be aligned with those guys who are investing on your behalf.

The next thing is, if you want to get more technical, you could look at the actual structure of the SPAC. And it's interesting. So when you buy a SPAC at IPO, they come in what's called units, which is one share of the common stock when it eventually becomes a deal. And it usually comes with warrants. Some SPACs are a little bit more generous with their warrants; they'll give you half of one warrant for every two shares you own. Some SPACs are a little bit more stingy; they'll only give you one warrant for every four shares you own. And just this week, we saw the first SPAC IPO proposing not to give investors any warrants. So the warrants give you upside. They're kind of like a call option. It's a nice kicker if the company gives you a good deal, your warrants will be valuable, they're worth something. We don't know what they'll be worth, there's usually an exercise price above the IPO price at some level. So familiarizing yourself with the terms is helpful.

The last thing is, when you actually get a deal, view it as investing in any other stock. Look at the merits of the deal, look at the valuation they negotiated. Is this a good deal? Would you have invested in the stock if you weren't already invested in the SPAC? So don't suffer from what's commonly called "endowment bias," right, where you already own something, so you stick with it. Some of these deals are clearly better than others: They're more attractive assets, they are priced at better valuations. And there are also some deals that frankly run some red flags.

So one deal that I would say that, kind of, illustrates maybe a red-flag deal is this recent announcement of Landcadia acquiring Golden Nugget Online Casino. The reason why I say it could be a red flag -- it could also end up being a good IPO; I'm not 100% sure -- but it's just that the person who is sponsoring the SPAC, Tilman Fertitta, is also the person who is selling the company. So you have a guy who's sitting on both sides of the transaction, which obviously creates a little bit of a conflict-of-interest. So when you see something like that governance-wise, maybe you want to be a little bit more careful.

Sciple: Right. Given the points you've made about needing to understand the structure of the SPAC, question marks around evaluating management, you don't know what company they're going to go buy, given all that uncertainty and some technical natures of what's going on here in this particular type of investment, do you think SPACs are appropriate for the typical individual investor, and why or why not?

Sanchez: Sure. I would say, just like anything else in investing, do your homework, know what you're buying. If you understand the basics of a SPAC and you've read the offering documents, you're in good company. A lot of people pile into these SPACs after they see some flashy headline, and they're paying pretty high prices, or they don't know what they're buying.

So I'd say there's probably two strategies when it comes to SPACs, some people will buy the SPAC before there's a deal, like, pretty soon after the SPAC IPOs and have that blank-check nature to it. And the downside to investing in a SPAC before there's a deal is you're going to have to wait, right. You could wait two years. The SPAC possibly could -- it might not even find an investment; they might just give you your money back. And that's not attractive to a lot of people, because there's something called the time value of money. There's opportunity cost; you could have been investing in something else.

If you're going to invest before a deal, try to figure out what the NAV is. Try to figure out what that cash is actually worth. If you're paying way above the NAV of a SPAC, you might be overpaying, especially if the deal doesn't work out well.

The other strategy I would say is, analyzing a SPAC after it's announced a deal, and that's really going to be no different than looking at any other stock, except that maybe you need to do a little bit of math and figure out what the pro forma company is going to look like after the transaction is over.

Sciple: There's also warrants you mentioned in all that shakeout.

Sanchez: After the warrants, yeah. And, no -- exactly, if you're buying the units, are you getting some warrants, are you buying the shares, does that mean you don't have any warrants, do you want the warranty? You could also buy the warrants separately. Some people who want to be levered might [laughs] go for that. Yeah, there's definitely a few ways to play it. There's more than one way to skin the cat in this asset class.

Sciple: Okay. So you talk about two ways of investing in SPACs: Either you can invest after they've announced the deal or before they've announced a deal. Let's talk about a couple of companies that catch your eye, that fall in both of those categories. So the first one, when it comes to companies that already have a deal; any SPACs that catch your eye today, and if so, what are they?

Sanchez: Yeah, there's a couple of interesting ones right now in the market that have targeted a company, and it's pending on shareholders voting for the transaction and getting approvals. So one that I think is really interesting is a SPAC called Collier Creek, which the ticker is CCH. And it's announced a deal to acquire Utz Brands, which is a regional snack brand. I know that we have Utz chips up here where I live in New York City. It might just be an East Coast brand; I'm not sure if people have it on the West Coast. I didn't grow up with it in the Southeast, but it is a really interesting brand, kind of like Doritos or Lays.

And a couple of reasons why I like this deal. First, the sponsor of the deal, a man by the name Chinh Chu, he's a really smart deal maker. He was a longtime executive at Blackstone. I have a lot of faith that he negotiated a good deal. Second, the CEO that he paired with is the former CEO of Kraft Foods. So clearly a guy who knows the snack industry well. I feel like bringing in that institutional knowledge from Kraft will probably help Utz out a lot.

And then lastly, I just like Utz as a brand. I think it's a solid consumer staple. It's going to be a $1.5 billion deal when this is all said and done. So pretty small. There's probably some upside. They could probably grow this brand, maybe taking it national or maybe even selling the brand to a larger company down the road. So I like that one. I think it's interesting.

A couple of other ones I'd mention that are a little bit splashier. There's one SPAC called Tortoise Acquisition, which announced a deal to acquire electric truck company Hyliion. And those who are familiar with the Nikola Motor SPAC, there's a lot of parallels with that. This is another company targeting the clean energy space, especially in the automotive transportation area. There's clearly a lot of growth opportunity. But I would actually caution people on this one specifically, because it's an attractive area, there's a lot of interest. However, the stock has moved. I think the stock has actually doubled from where it was before the deal was announced. So just be a little bit careful about buying into this deal after the stock has appreciated so much.

And then the last one I would mention is a company called Graf Industrial, the ticker is GRAF. And they very recently announced a deal to acquire Velodyne, which is another electric vehicle company. They claim to have invented LiDAR [light detection and ranging], which is used for EVs, it could also be used for robotics. And they've been around actually for a while. In fact, I believe they're the market leader. Last year, they actually generated $100 million in revenue. So they have a real business. They have an interesting technology. It's another $1.5 billion deal. However, again, be careful, because it's an exciting company in an exciting industry; therefore, a lot of investors have piled in and the stock has also appreciated after the deal has been announced.

Sciple: Yeah, Velodyne is one that, you know, it's been rumored they were going to come public for a while. As you mentioned, one of the premier LiDAR makers, at least what a lot of autonomous-vehicle companies believe is necessary to scale up and the success of that technology. I think all those are interesting. I do think that, to your point, that some of these electric-truck companies have been bid up to a point that there's certainly a lot of potential, but there are certainly some execution risks that are being heavily discounted right now in the price.

When you start looking at SPACs that haven't yet acquired a deal, I think there are some interesting names rumbling around in that space. You've got Chamath Palihapitiya, who's had success in the past with Virgin Galactic. And then we have heard Bill Ackman is going to be coming out with a SPAC here pretty soon. When you see these folks still looking for a deal, what jumps out to you from these gentlemen?

Sanchez: Yeah. So Chamath Palihapitiya, he is a very well-known tech investor, early employee at Facebook, very successful VC. He invested in companies like Slack when they were still private, which led him to become a billionaire. So he's a very successful investor in his own right, very well networked in Silicon Valley. And he's already done a successful SPAC. So I think, I believe you and I had a conversation on this podcast a year ago where we talked about the Virgin Galactic IPO, which Chamath was behind, and that's been a success story. The stock is above where the SPAC was trading back then. And there's been some really interesting news lately about some partnerships that they're doing.

So when I look at a SPAC that hasn't announced a deal yet, I see the Social Capital ones managed by Chamath. And I see a guy who has a really great network, who has a track record. And that gets me excited. So he has two SPACs out right now. He has one with the ticker IPOB and another one with the ticker IPOC. And the reason he has two SPACs is because they're targeting different-size companies. So IPOB is a $360 million SPAC and IPOC is a $720 million SPAC. So IPOC is most certainly going to go after more of a unicorn company, and IPOB maybe will go...IPOB could actually take down a smaller unicorn, but it'll be a different size.

And it's interesting that Chamath is behind these, and he is calling them IPOB and IPOC. He's kind of poking fun at this idea that SPACs are like a replacement or a substitute for the IPO itself, and he's been a big, outspoken proponent of that idea.

Sciple: Chamath has come out pretty aggressively; I don't remember where the interview was, but he essentially came out and said that he thinks, over the long term, that the SPAC process of coming public is going to become more and more popular, and perhaps squeeze out some of the traditional IPOs. Do you agree with that, Luis?

Sanchez: I think there's a lot of merit to it for the reasons we discussed earlier. There's clear advantages to going public through a SPAC. And I'll just throw out the example of WeWork. I personally believe WeWork would be a public company today if they had chosen to go public through a SPAC, as opposed to going through a roadshow process where investors scrutinize their deal and they had to give all sorts of disclosures that made them look bad. I would argue a company like that maybe should have opted for a SPAC IPO to give them some more cover and more certainty. So I think that's an interesting example.

I think that the other thing actually Chamath is familiar with is the direct listing, because I believe Slack went public through direct listing. So clearly companies themselves are showing that they have an appetite to do alternatives to the IPO. And maybe -- you know, I'll leave that to policy makers to figure out what that means, if they need to change the IPO rules or if they want to have these multitiered systems, but I definitely think there's a clear appetite, and there's definitely some rationality to doing it differently.

Sciple: Right. And I can see the arguments for both sides; from the company's perspective, it makes the process much easier, you can get access to capital quicker. But from the perspective of regulators, the idea that a company like WeWork might be able to come public could be discomforting for some folks.

But before we go away, I did want to talk about this Bill Ackman SPAC that's been rumored, it hasn't officially come public, but it's reported to be plans to be the largest SPAC ever. It has an interesting structure to how he's putting together the deal. What do you make of this move by Bill Ackman to move into the SPAC space?

Sanchez: Yeah, well, Bill Ackman proves yet again that he plays by his own rules. He is taking something that he sees as an interesting capital vehicle and he's putting his own spin on it. So Bill Ackman, as many would know, is a famed hedge fund manager, he managed a hedge fund called Pershing Square, which he actually IPO'd his hedge fund in Europe, under the ticker PSH, to give him a permanent source of capital. So he already did something kind of interesting with this hedge fund, which a lot of people have said, the fact that he got that permanent basic capital may have saved his hedge fund in this last downturn.

So now he's looking at the SPAC world. And yet again, he's come up with an interesting structure. So he's putting together -- he has a S-1 out, so this hasn't gone public yet. It's still in S-1 phase. And the S-1 has a $3 billion [laughs] number on it, which would already make it the largest SPAC ever IPO'd. And there's been a couple of $1 billion SPACs, but there's never been a $3 billion SPAC. And then, he has a few other things that he put in there. So one is that he has pledged that his hedge fund may co-invest up to $3 billion, in addition to the first $3 billion, so he could have $6 billion of capital ready to take a company public.

And then, there's a few things with the actual terms that are different. So as we mentioned before, SPACs usually come with a warrant, but there's some interesting things around the redemption rights and whether or not people are incentivized to go through with the deal. So Bill Ackman created a structure that he believes will incentivize more people to stick with the deal after it's announced. So he wants his early investors, who buy into the IPO, to stick with him. And the way he's done that is essentially by giving the investors who stay with the deal, giving them more warrants. So if you use your redemption rights, you maybe don't get any warrants or you have fewer warrants, but if you stick with the deal and you're a long-term holder, your warrants actually vest over time. And that's a pretty interesting structure, and it aligns investors with the operators of the SPAC.

Sciple: Right. And I guess, by incentivizing people to hold, I think, one concern that I have sometimes with some of these big players coming in, as you mentioned earlier, they're kind of capturing that IPO pop and maybe they're going to flip the stock as soon as that's over. If you create a structure that disincentivizes that behavior, as an individual investor, it can make you a little bit more comfortable with buying into the space.

Luis, with these huge, huge fund managers, like Ackman, big names like Chamath moving into the space, do you think that that fundamentally changes SPACs going forward? Do you think SPACs' role in the market will be larger going into the future because of this?

Sanchez: Yeah. I think that the current crop of SPACs have much better-quality companies, they have better management teams, they have better sponsors, they're getting more press. I think this creates a virtuous cycle on a number of fronts. I think that the investors who were in this asset class early, who've made money, they're going to keep investing in SPACs. I think that private companies who see their peers go public successfully are going to want to mimic that success. And when everyone sees the success of a SPAC, you know, it's going to get seasoned executives more interested in being a part of it, it's going to get banks, higher-quality banks, like, Goldman, which has its own SPAC out, it's going to get them involved. All-around, this asset class is attracting more and more money, which tends to attract higher-quality and higher-tier companies and investors all around the board.

Sciple: Right. Winners keep on winning. That's one of the things we say a lot at The Motley Fool. And over the past year SPACs have performed quite well. As this continues to play a bigger role in the market, Luis, I know you follow this space closely, and we'll have you back on the podcast to break it down again sometime soon.

Sanchez: Awesome! Happy to be here.

Sciple: All right. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the glass. For Luis Sanchez, I'm Nick Sciple. Thanks for listening, and Fool on!