nicola motor draftkings and virgin galactic have a lot in common for starters all these companies
have recently gone public and are still not profitable and while that's common for many ipos
neither nicola or virgin galactic have actually generated any revenue from their main service
lines for nikola they haven't even sold any electric vehicles and for virgin galactic they
have still yet to deliver on their space tourism services most people would consider these stocks
to be early stage and incredibly risky for wall street bets though it's a great idea perhaps the
most important thing to understand about these companies is how they went public and that's
through a spec or a special purpose acquisition company in this episode of compounded daily we're
going to look at specs how they're structured and answer why they become so popular among investors
specs are by no means anything incredibly new they've existed for a while now but have just
recently become popular again the general idea behind a spec is that their management
team raises money from investors to go public and then uses that money to buy another company
the process through which the acquisition occurs is called a reverse merger and how this works is
actually pretty simple a public company buys a private company so that the private company can
bypass the whole process of going public for the selling company there are tons of benefits to this
a typical ipo can take years in preparing reporting and then investment bankers hop on
their jets market the newly issued shares to a variety of institutional investors
and negotiate the stock price a private company going public through a spec avoids all of this
because the only buyer is the spac itself and the process for going public could take only a few
weeks the spac management team just have to seek approval from their shareholders and when a spec
acquires a company there's limited s1 reporting for those unfamiliar with financial reporting a
traditional ipo process and even direct listings require detailed s1s the document details
important financial disclosures such as historical financial statements and guidance for investors to
understand how the company is planning on growing in a way it gives investors a look under the hood
but perhaps the biggest benefit to the selling company is that the purchase gives them a cash
infusion it's a capital raise in a way much like a venture round or any other ipo this isn't always
good though when a company ipos it's typically the last time they end up raising equity they could do
a season equity offering or sometimes called a secondary equity offering but that's typically
frowned upon and for very good reasons a study from the journal of entrepreneurial finance found
that on average companies that did an seo had a negative 31.2 performance before the seo and a
negative 77 performance the three years following it this is because not only does it dilute
shareholders but it also sends a rather negative signal to the market if your company is diluting
shareholders instead of maybe seeking debt or perhaps you already have too much debt investors
might be worried about the company's survival and unlikely to invest in you now i should add
that an seo isn't always bad if a company's stock price is ridiculously high it's a great way to
take advantage of the high stock price to raise more money so spax can have their advantages and
disadvantages for the selling company but what are the advantages to the investors
the rise in popularity of spax has been big this year in 2017 almost 8 billion was raised through a
total of 34 specs but in 2019 59 companies raised 13.6 billion dollars however and more surprising
is that just this year 12 billion has been raised by spax and there have only been 39 of them but
what explains this the way that they are structured and their terms tends to be very
palatable for investors for example if you invest in a spac before it goes public and then after it
goes public you decide i want my money back you can claim your money back for net asset value
that means that if you put ten dollars in you get ten dollars back plus interest that was gained on
that money but you have to do that before the spax management team announces a deal as an investor
you also have the right to vote on whether or not a spac should make an acquisition if your spax
management team is trying to acquire a company that you think is overpriced then you can vote not
to go forward with it and if a spec doesn't make an acquisition within two years then they return
the cash to the shareholders and the company is dissolved these check companies also provide a
slew of upside benefits for the investors when you invest in a spec before it makes an acquisition
you technically own units and depending on the stack are granted warrants these warrants are like
call options and if you hold on to your units they give you the option to buy shares of the
company at a particular price so if you invested in chamath pala hapatia's social capital ipoa spec
then you might have the right to buy more virgin galactic shares at eleven dollars and fifty cents
which is great when the stock price is twenty five dollars spax add those warrants for a good reason
they want their investors to stay invested remember when an investor wants out the spac
management team has to buy that share for the net asset value then the spac manager needs to
make that money back so they sell it if enough people want to sell their shares then the spec
management team might not be able to sell it for the net asset value so they will have to use some
of the funds raised to make up the difference and that of course means less money to buy a company
another added benefit for spax is that investors who put money into the ipo are not held up by the
stingy lockup rule usually those who hold shares of a company before it goes public are not allowed
to sell those shares for a period of time after it goes public that's not the case with smacks
now that's a little bit on specs but who exactly is investing in them and why perhaps one of the
main reasons why spax have become so popular as of late is because of a lack of good investment
opportunities elsewhere the venture capital market which invests in early stage companies is flooded
with so much uninvested capital because there seems to be an imbalance between money to invest
and good investment opportunities this imbalance puts venture capitalists in a tough position
the dilemma here is that they can make investments in poor companies and get not so good returns
or not invest the funds and risk having to raise a smaller fund the next time around something no
venture capitalist ego would permit private equity is not much different at the beginning of 2020 it
was reported that there was over two and a half trillion in uninvested capital or as we in the biz
call it dry powder all of this money makes bidding for companies more competitive and drives up the
company valuations but that's only half the story interest rates are incredibly low right now and in
private equity firms use a mixture of money from their funds and debt to buy companies and when
that debt they use to buy companies is cheap that means they can use more of it further driving up
the company valuations so perhaps backs are just another way for deep pocketed billionaires to have
another venue to invest their money after all harvard economist lugwood straub's paper
discussing the savings glut of the rich emphasizes how savings for these billionaires has increased
over the past few years it could very well be that they haven't had good investment opportunities so
specs might be a new opportunity for them to get higher returns on that money than just
having them in a savings account if that were true though spax would have to perform well so do they
spax have historically performed poorly with one study finding that since 2003 they have returned
on average a negative 19.7 percent this might come as a surprise to most people who've seen the
performances of some of the most recent specs when tortoise acquisition core acquired highly on it
saw a 170 percent return virgin galactic posted a 62 return and nicola had over a 470 percent return
but what explains this one thing could be that these companies are being acquired at the right
place at the right time for many of them they have great ideas but need money to execute on them
the cash raised from the spac acquisitions could provide them that money and therefore
their plans are more likely to become profits this increases the likelihood of positive
future cash flows and those in finance know that increases a company's valuation perhaps though
there's a different explanation when that study looked at spack performance dating back to 2003
there was no robin hood or wall street backed back then allow me to explain most of these backs tend
to be pretty small when compared to the market caps of companies like tesla and amazon if all
10 million robin hood users bought seven shares of social capital hedo sofia when he was at 10
then almost all of the 49 of shares not owned by virgin galactic would be owned by robin hood users
that same amount however would only purchase about half a percent of amazon therefore the
purchase of virgin galactic shares is going to have a much bigger impact on the movement than
an amazon share and when wall street bets gets hyped up over these small cap shares
mass buying could contribute to upwards movement now i'm not saying bill ackman is planning on
hiring a team of internet trolls for his three billion dollars back but i am saying that if
he finds a trendy enough company to buy the internet could help him get a solid return