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In a Declining Stock Market, SPACs Could Offer Protection

Let’s say you and a bunch of other investors pool your money and hire an acquisitions expert. This dealmaker uses the large amount of cash raised as leverage to help negotiate a great deal to acquire an existing business. The agreement with the dealmaker is, if he finds something interesting, you will all get to vote on his moving forward for you. If the vote is yes to move forward, and somehow you’re still not interested, you can individually have your money back (less expenses, plus interest earnings).

The risk is that you and the others are tying up money that may have been invested elsewhere (although you can still sell at secondary market levels). In exchange for tying up your money while the expert searches for an acquisition on the group’s behalf, if an acquisition is found you get to opt-in or out, or as mentioned, sell shares if the proposed acquisition creates a spike in share price (potential to profit). If you opt-out, or if an acquisition is not found, the agreement is you get your money back adjusted for expenses and income.

This is the essence of a Special Purpose Acquisition Company or SPAC. Participants in the original SPAC IPO may set themselves on the path to a number of decisions and opportunities along the way. In the end, they may find themselves with the question that Let’s Make a Deal players are asked by the host, “Do you want to keep the cash, or take what’s behind the curtain?”

Keeping the Cash

As an example, two years ago the largest SPAC ever funded had an IPO at the unusual entry price of $20 per share. Typically SPAC IPOs are priced at $10 per share. There were 200 million shares at $20 sold during the IPO. The sponsor and stockholders agreed to a two-year period within which the sponsor has to target and move toward acquiring a target – or distribute to shareholders the funds held in escrow to make the purchase.

This SPAC, Pershing Square Tontine Holdings- Class A (PSTH), is now approaching the date when it may be required to distribute the money held in escrow back to current holders of the stock. According to Part I of their Balance Sheet as of March 31, 2022 (SEC 10-Q), the Class A common stock, subject to redemption then had a value of $4,004,044,295. This is an increase from the end of the prior quarter and in excess of the $4 billion that original shareholders paid in.

If the sponsors of PSTH and Chairman and Founder of the hedge fund Pershing Square Tontine Holdings, Bill Ackman, don’t find a match in the next few weeks, they will have to distribute what is likely still over $4 billion held in escrow. This will roughly equal the $20 per share paid at the original IPO. This escrow is effectively a floor on market losses for SPAC investors that get in at the beginning and make decisions on any merger and ownership as they arise.

The money tied up for up to two years does have an opportunity cost. For example, during the duration that PSTH holders took a two-year SPAC ride and now could net almost exactly where they began, the S&P 500 rose 16%.

Behind Curtain #2 and #3

While the S&P did rise 16% since this particular stock went public, the mood of the stock market has since turned and the broader market has suffered losses of 18% so far in 2022.

Original holders of the example SPAC (Pershing Square) may have hoped for the opportunity to one-day hold shares in stock of a world-changing company with a great future. But there are other owners as well that held it for other reasons. The stock from its first trading day rose and eventually reached a high in February 2021 of $34. For those trading the SPAC IPO, they could have beaten the market despite Pershing’s lack of success in finding an acquisition.

Since July 2021, the stock has been trading below the $20 IPO price, the capital paid in by stockholders has been earning interest in escrow, and any likely distribution may be in excess of where it has been trading for almost 12 months. This would outperform the 2022 S&P 500 returns by nearly 20%.

Take Away

Players chosen from the audience of Let’s Make a Deal are provided with an initial prize, often an envelope containing a few hundred dollars. They are then asked if they want to take a chance on something that may be bigger but could be worse. Their risk is limited in that they can always opt-out and know what they have (cash), or if they continue to take a chance, they may wind up with more than they came with.

SPACs are unique with a differing set of risks and potential rewards. A well-chosen name, trading secondarily near or under the original IPO price, limits the investors’ risk in a way other common stock purchases cannot. There is still potential upside as any talk of a merger or actual merger will move the price, but its price movements have low correlation to the overall market. This could be helpful with high volatility.

Particularly noteworthy, especially in a bear market, unlike the overall market potential, there is protection against it dropping substantially.

Paul Hoffman

Managing Editor, Channelchek

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