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SPACs Get the Headlines… Here’s Where to Get the Profits

August 27, 2020

The term “SPAC” stands for Special Purpose Acquisition Company. They are also often referred to as “blank check” companies, as buyers of their initial public offerings (IPOs) as well as buyers in the secondary market are really just supplying cash to the companies behind the stocks to do something yet to be determined or disclosed.

US stock exchanges continue to welcome SPAC listings with little or no regard to disclosures to prospective or actual shareholders, beyond the basic financials. The financials tend to just disclose the price of the IPO shares as well as the targeted amount of the capital sought in the listing.

Even post-IPO, many of the SPACs that I’ve been examining provide scant details on what’s going on if they provide any at all beyond required SEC and IRS reported forms. Some of the most prominent SPACs don’t even have websites for shareholders or even provide investor relations information.

But the market loves them right now.

According to a group called SPAC Insider, 2020 has seen 57 SPAC IPOs, which represent 40% of the overall IPO market. Right now, there are some 120 SPACs listed with an estimated $40 billion in cash to spend according to SPAC Research.

These are not new, and I was involved with these some years ago when I was in investment banking. The structure is pretty straightforward.

Typically, a well-known name works with an underwriting bank to issue a blank check SPAC promising no more than that he and his pals will buy something. Details are limited, as are restrictions.

They tend today to be priced at $10 a share and come with warrants to buy more shares to entice folks to buy at the IPO. The sponsors also get additional warrants at a discount to the IPO price as part of their compensation. So, in reality, buyers start out with less than $10.

Then, the SPAC buys some smaller to mid-sized companies, and something goes well or not. But what’s being pitched now is the idea of the reverse merger, in which a highly touted company in alternative fuel vehicles or gaming, for example, sells itself in part or whole and the SPAC takes their name.

This goes around the underlying company doing the IPO along with all of the usual scrutiny involved. So, this is what’s feeding the SPAC-tacular frenzy right now. But they’re completely pigs-in-a-poke, unless you happen to be on the inside of the company or the SPAC.

And according to Bloomberg Intelligence, out of a recent new collection of 18 of these reverse mergers, 11 of them are trading below $10 a share. So, they’re far from sure-things.

But it’s the lottery-esque nature of the pitch that keeps pulling folks in right now. And with interest rates under 1%, the idea of parking cash in a new SPAC and seeing what happens has a lower carry cost.

However, I have better alternatives that I’ve followed and recommended inside Profitable Investing for years, some of which we have had since their IPOs years ago.

Holding Companies & BDCs

Like their SPAC peers, holding companies and business development companies (BDCs) are set up under the Investment Companies Act of 1940, which allows them to invest capital without having to pay corporate income taxes.

But they’re further codified under the Small Business Investment Incentives Act of 1980, which was passed to incentivize companies to finance or invest in small to mid-sized companies when the US banking market was in disarray during times of out-of-control inflation.

But these are different than SPACs. They come to market with specific objectives for lending and equity investment. And they report underlying investments and all of the rest of their financial data just like a traditional financial company.

They’re also up front with management salaries just like a regular company. And in turn, they lend to or buy and own companies, reaping cashflows and aiding their developments. Now and again, they sell the firms or cash in by taking them public.

And investors get a cut of those BDCs’ profits in the form of big dividends, since 90% of the profits have to be disbursed to investors.

In many ways, these are like smaller versions of Berkshire Hathaway (BRK/A) in operation, although Berkshire is susceptible to corporate income taxes.

Compass Diversified Holdings (CODI) is a holding company that buys, develops and sometimes sells companies that are strongly branded industrial or consumer product firms that generate lots of cashflows.

It currently has an impressive collection of these companies with piles of cash and credit. And it’s looking for more. Revenues have been consistently rising, with gains averaging 13.2% on a compounded annual growth rate (CAGR) basis over the trailing five years.

Compass Diversified Total Return Since IPO—Source: Bloomberg Finance, L.P. 

It pays shareholders well with a yield of 8.3%. And since its IPO back in 2006, it has returned 311.1% for an average annual return of 10.4%. And I see a lot more gains to come.

Hercules Capital (HTGC) is more of a traditional BDC, but with a very specific focus on early to mid-stage technology companies. It’s based in the US tech center of Palo Alto, California in the heart of Silicon Valley.

Hercules Capital Total Return Since IPO—Source: Bloomberg Finance, L.P.

It identifies companies in need of capital and financing and provides both, earning interest through their investment and capital gains via equity participation as they go through IPOs, acquisitions or even SPAC deals.

It has hundreds of companies in its current portfolio, and many are recognizable tech names. Its past holdings are some of the more famous in the tech space, including sports gaming companies, which are hot in the SPAC market.

Revenues are up by 28.9% over the past year, and this isn’t an abnormality. The company has been gaining revenue by an average annual rate of 34.3% on a CAGR basis since its IPO.

HTGC’s dividend yields 11.6%, and since its IPO in 2005 to date, it has returned 285.4% equating to an annual rate of 9.3%.

All My Best,

Neil George
Editor, Income Investor’s Digest & Profitable Investing
Author, Income for Life