Weekly Corporate Growth Report: Risky Business: Gambling on SPAC Investments

There are many ways for capital to be invested in mergers and acquisitions. Corporate buyers, private equity funds, and hedge funds all invest in companies, hoping to grow their business and realize a profit on the investment. An alternative investment strategy has been on the rise in the first half of 2005: special purpose acquisition companies, also known as SPACs.

SPACs went into decline a decade ago, but now they are back. So far, 33 SPACs have filed registration statements with the securities Exchange Commission, and they are expected to raise $2.9 billion, according to investment bank Sanders Morris Harris.

Special purpose acquisition companies are essentially publicly traded shell companies. Typically, a group of managers make an initial public offering, creating a public company with the stated intent of seeking acquisitions in a given industry. There are usually a few other shareholder protections, such as placing a large percentage of the IPO proceeds into escrow and requiring majority shareholder approval for acquisitions.

When the SPAC finds a company to acquire, and the deal is approved by its shareholders, it merges into the target company. The shareholders get ownership of the new company and the managers of the SPAC usually collect about 20 percent of any profit eventually generated. Investors unhappy with the acquired company can sell off their shares. Until a company is found to purchase, the SPAC is merely an asset-less acquisition vehicle.

SPACs generally seek to find a target company within 12 to 18 months after their initial offering. If no acceptable company is found, the SPAC returns the money to the investors, less fees and expenses.

Investing in a SPAC is clearly a risk. SPACs ask investors to buy their stock on the strength of a management team, rather than a solid investment plan. They ask investors to provide them funds to invest in a company that has not yet been chosen. SPAC Millstream Acquisition Corporation listed its risk factors in a SEC filing with the statement, "Since we have not currently selected a particular industry or any target business with which to complete a business combination, we are unable to currently ascertain the merits or risks of the industry or business in which we may ultimately operate."

If special purpose acquisitions companies are such a great risk, why are they on the rise? The decline in SPACs occurred when regulators cracked down on abuses, which gave the investment strategy something of a seedy reputation. Recently, however, SPACs have gained in respectability due to the involvement of reputable underwriters like EarlyBird Capital, Rodman & Renshaw, and Broadband Capital. So why are reputable firms becoming involved with SPACs?

One reason is that successful initial public offerings raise money faster than private equity funds. Raising private funds involves wooing investments from pension funds, wealthy venture capitalists, and other large investors. By hosting a public offering, SPACs can attract individual and institutional investors from the open market. One appeal to investors is that they can exit an SPAC at any time by selling off their shares - assuming they can find a buyer.

Investment mangers may also be attracted to the freedom that operating a SPAC offers them. "They're an incredibly flexible and efficient way to raise capital to execute meaningfully sized private equity investments," says Nathan Leight, owner of private equity firm Terrapin Capital. Leight is also the chairman of Aldabra Acquisition Corp., a SPAC currently looking for a target company in the $40 million range. Aldabra raised $48 million in its public offering.

SPACs also provide an alternative for traditional funds. Equity firm McCown De Leeuw & Co. has almost run out of its current $750 million fourth fund and doesn't have strong enough performance to justify a follow-up. Instead of closing down, McCown De Leeuw is turning to the public markets to raise capital. If successful, the move might inspire other private equity firm to follow suit. McCown may also continue to produce special purpose acquisition companies. But if McCown's SPAC falls through, it will likely be the end of the fund's 23 year middle-market investing career. Market analysts give McCown's MDC Acquisition Partners a fair chance, noting that it offers the public an experienced private equity team.

SPACs may provide a valuable service in the marketplace. The market for small initial public offerings is currently weak, which leaves small but productive companies few options for raising cash. According to Thomson Financial, the amount raised by IPOs fell 26 percent between 1999 and 2004, but the amount for offerings under $100 million has fallen 68 percent. A SPAC can acquire a small company through a reverse merger, essentially creating a new publicly traded company overnight.

Despite the increasing number of SPACs in operation, only a few have actually completed acquisitions. But SPACs that have completed deals are seeing their share prices increase. Chardan China Acquisition went public in March 2004 at $6 per share. It announced in December that it would takeover State Harvest Holdings and convert it to a British Virgin Island company. Chardan China's stock is currently trading at $17 per share. Millstream Acquisition merged with NationsHealth Holdings and is currently trading at $12.62 per share. Like Chardan China, it debuted at $6.

Clearly there is the potential profit in SPACs, despite the risks involved. And profit will always draw interest. Whether specialty purpose acquisition companies will continue to provide an investment option along side more traditional funds will be determined by how they perform in today's market.

Sources: Buyouts, Corporate Financing Week, New York Times

By Andrew Dolbeck

Editor