They wanted to raise money in the public markets, but they didn’t actually have a viable business idea at the time. Lobby the SEC, get a rule put in place, and voila, the Special Purpose Acquisition Company, or SPAC, was born.
The SPAC Explained
The concept of the SPAC is pretty simple. We all know someone who’s pretty good with money. They always pick the right stock (or at least don’t tell you when they lose money in a stock), and they started their own company at age 15 and are now retiring at age 25.
What if you could give money to that person, let’s say it’s Uncle Bob, and say, “Uncle Bob, just do whatever you did the first time with your money and make me rich too.”
Uncle Bob replies he can’t start another company, only one great idea per lifetime, but maybe he can find a company that is already in business that looks pretty good and he’ll buy it with your money and run it for you.
If you understand that example then you understand what a SPAC is.
There are various flavors of SPAC, maybe the management must buy a company in the restaurant business, or they can only buy in the technology sector, or maybe they can only buy a U.S. based company. But, the general structure is the same for most SPACs; raise money, find a company to buy, ask the shareholders of the SPAC to agree to the purchase, and buy the company, which the shareholders of the SPAC will now own.
Since we’ll be talking about warrants associated with SPACs, there are only a few specific characteristics that are important to us.
First, SPACs generally have a warrant and a common stock. We talk about why warrants are issued here, but if there were ever an IPO that needed a little sweetener for investors it’s a SPAC.
Second, the SPAC must make a purchase of a company in a specified time period, usually two years, or the warrants expire worthless and the remaining funds are distributed back to the shareholders.
And third, once the SPAC management (Uncle Bob) announces they are buying a company, the purchase must be approved by the stockholders of the SPAC.
Two Bites at the Apple (…and I don’t mean AAPL)
I’ve found that you can usually make two profitable trades in a SPAC warrant that have high degrees of success. The first trade is often the easier money, but a harder trade to get into due to the small time window.
It requires that you pay careful attention to a list of SPACs and that you get an email alert when a SPAC announces it’s plan to purchase a business. The hard part of the trade is that it can be very time sensitive and occurs only episodically.
You can follow your SPAC list by putting the term “SPAC” into your Google alerts or, if you want to limit the number of alerts you get, you can put a little more time into your alert creation at the beginning. You can also create your own list of SPACs and place those names into your Google alerts. I include SPACs in my warrant database.
When alerted you have to be prepared to execute the trade quickly. I’ve found that you have a good chance of making a nice return as long as you can buy the warrant on the first day of the announcement.
Generally, the SPAC warrant moves up for a few days before selling off prior to the actual approval of the takeover.
Which brings us to the second trade.
Approval of the Acquisition
This trade is harder because it requires you to actually do some work (imagine that, working for a nice return).
The warrant generally tends to spike the day of the announcement, and for the next few days. and then drop again prior to the shareholder vote. If the vote goes through the warrant will usually spike again when the vote outcome is announced.
Your job is to determine whether or not the takeover / merger of the SPAC and it’s target company will be approved. I’ve found that in many cases it is relatively easy to predict the outcome by following what the SPAC management is doing prior to the vote.
One positive indicator you can look for is management buying out other shareholders in order to control the vote. If you believe the acquisition will be approved you can get long the warrant just prior to the shareholder vote.
Bonus: Hedge Fund Impact on SPAC Acquisitions
When determining whether or not the SPAC acquisition will be completed pay careful attention to hedge funds invested in the SPAC. A SPAC can be a great place to park capital and take a relatively risk free shot at buying a good / undervalued / distressed company on the cheap.
The current low interest rate environment adds even more appeal to this option. As a result, you’ll find that hedge funds are often holders of fairly large percentages of SPAC shares.
Once the proposed deal is announced the invested hedge funds (as well as all the other shareholders) will conduct their due diligence and decide whether or not they want to be a shareholder in the new company.
If it looks like a good deal they can simply vote their shares for the acquisition and remain shareholders. But if they don’t like the deal they can sell their shares, generally at very close to the price they paid for them originally.
But, a large shareholder in a SPAC also has a third option. If management truly wants to get the deal done (and they may for various reasons) a large shareholder can offer to sell their shares to management at an above market price.
If management does not want to buy the shares the fund can vote those shares against the acquisition, and simply have it’s original capital returned when the SPAC is dissolved.
If you find management buying out other shareholders as the voting date for approval of the acquisition approaches, there is a very high likelihood the deal will close. You’ll want to be long ahead of the closing and sell into the pop after the approval.