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Five Traits Of A Great SPAC

Posted: Sep 12, 2008 13:13 PM by Will Ashworth

Tickers in this Article: EST, TOH, BX, GS, BPW, CHV

Special purpose acquisition companies (SPACs) are basically companies which go public first then raise money to purchase an unspecified target. In 2007, SPACs were front and center, accounting for one quarter of all IPOs. Although the pace has slowed, this year still has seen 64 go public with $12.1 billion chasing deals. As of August 26, 2008 40 acquisitions have taken place at a cost of $12 billion according to Dealogic.

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Two deals include Enterprise Acquisition (AMEX:EST) buying Workflow Management, a commercial printer, for $669 million and Hicks Acquisition Co. (AMEX:TOH), along with The Blackstone Group (NYSE:BX) have joined forces to buy Graham Packaging Holdings for $3.2 billion.

Deals are happening. Perhaps, that's why a well-known value investor, Seth Klarman's Baupost Group owns shares in over 20 according to its latest 13F. He's decided parking money in these vehicles is a better alternative than losing money in the markets. For all the Seth Klarman's out there, I'll run down five things to look for when investing in SPACs. (For more, check out Private Equity Opens Up For The Little Investor.)

Trait No.1 - Low Founder Ownership
Founding shareholders typically invest $25,000 in return for 20% ownership. As a result, IPO investors receive immediate dilution to the tune of 30% or more on their stock. Goldman Sachs (NYSE:GS) saw this imbalance for investors and chose to do its first-ever SPAC IPO with the name Liberty Lane Acquisition Corp., with founding shareholders getting 7.5% ownership, less than half the traditional amount.

It was a great idea in theory. Unfortunately, this ownership wrinkle along with others made the deal too difficult to sell and the IPO went away. That's unfortunate because that's exactly what is necessary if SPACs are to flourish. Wealthy executives don't need any more sweetheart deals. Only invest in those SPACs where the ownership is less than 20%. Don't budge on this one.

Trait No.2 - More Skin in the Game
A friend of mine who owns several businesses once taught me an important lesson about investing, whether in public or private companies. He believed that money talked and you know what walked. It didn't matter what skills or resume you brought to the table, if you wanted a seat at it, you needed to have skin in the game; proof that you were serious about the endeavor.

An investment by the founding shareholders beyond the initial $25,000 is critical. For example, BPW Acquisition Corp. (AMEX:BPW), already a good candidate with founding shareholders taking a smaller 15% ownership stake, also agreed, through its sponsors, to buy 8,600,000 warrants at $1 each (exercisable at $7.50) and to buy limit orders of up to an additional $25 million in common stock. That's what you want to see, something more than a nominal investment.

Trait No.3 - Enough Search Time
Most SPACs have 18 to 24 months to initiate or complete a business combination. When a blank check first goes public, this timeframe seems like an eternity. Time passes quickly. An example of this is Churchill Ventures (AMEX:CHV), which announced in August it was extending the search for an additional six months to March 6, 2009. As SPACs become more familiar to investors, it will become obvious that 18 months is too short a period in which to consummate a good deal. Part of the problem is target companies know this and tend to play hardball in order to negotiate a better agreement. Given this reality, rather than impose an unrealistic timeframe on management, perhaps the rules should allow for the payment of interest or dividends to investors from the trust so all can remain patient and focused on the ultimate goal of buying a business. Until this happens, I'd look at only those opportunities that have a 24-month search, if not longer.

Trait No.4 - Deferred Underwriting Commissions
In my opinion, the best endorsement of a management team is the underwriter's deferred revenue in any offering. Using BPW once again as an example, its underwriters agreed to defer 63% of commissions until a business combination was completed. That gives them the incentive to help management find a suitable target. According to some estimates, over $1 billion in deferred fees are still on the table for underwriters as the time ticks down on some blank checks. Look for deals where at least 60% of the fees come at the back-end. Make them sweat.

Trait No.5 - Laser-Like Focus
The average annualized return for SPACs that have made an acquisition is -1.4%; the average for those that haven't is positive at 1.7%. Most telling, those that don't find an acquisition and face liquidation have the worst returns of all, down 2.3% annually. To make matters worse, another study of 62 SPACs shows annual investor returns of negative 3% while management earned 1,900% annually. All I can recommend is that you look to those SPACs that have a very specific focus. While it might seem easier to widen the search, do you really want an oilman running a fashion company? I don't think so.

Bottom Line
I'm not a huge fan of SPACs but if Seth Klarman can buy them, so can you.

For further reading, check out SPACs Raise Corporate Capital.

By Will Ashworth

Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.

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