SPAC as a blind (private equity) fund

This is a continuation of the " How to Evaluate SPACs" series. You might want to read the preceding article here " Introduction to evaluating SPACs"

Due to the absence of any operation in the SPAC, some have defined and described SPAC as a blind fund (which would also explain why the retail investors generally greeted the Hibiscus' pending IPO with apprehensions). Blind fund are commonly equated to very very risky investment and we would have thought the regulators' would not have allowed such risky investment to be made available to the retail public. But before we delve deeper into the nature of a blind fund, let's look at what might have led people to say that a SPAC is a blind fund.


In an article on titled FROM BLANK CHECK TO SPAC: THE REGULATOR'S RESPONSE TO THE MARKET, AND THE MARKET'S RESPONSE TO THE REGULATION by DEREK K. HEYMAN, it was stated that the origin of SPAC could be traced back in the 1980s where the market in the United States were issuing blank check funds. However, the blank check funds were frought with fraud and deceits that it was severely regulated by the regulators in the United States (Rule 419). "The regulations may have been so limiting that no one would bother to do a blank check offering as a legitimate way of raising funds  public capital markets. The numerous restrictions made the blank check structure so limiting that it would be difficult to find investors for these vehicles, despite the investor protections that the regulations put in place." "Thus, in 1992 the SPAC was developed as a way to do blank check IPOs that would not be tarnished by the reputation of the 1980s blank checks, nor limited by the most oppressive features of Rule 419."

And there are plenty of literature out there which also defines and describe the SPAC as a blind fund (which focus on the absence of operation), for example:

• “Special purpose acquisition companies (SPACs) are blank-check companies that raise funds from investors through a public offering of shares and warrants (known as a Unit IPO) for the purpose of buying a private firm” – Special Purpose Acquisition Companies, Fordham Business Student Research Journal
• "A SPAC is a publicly traded shell corporation that has no operating business (current or previous) that must use the money raised from its initial public offering (“IPO”) to finance an acquisition of an operating business" – Guide to SPAC, Goldman Sach
• “means a corporation which has no operations or income or generating business at the point of initial public offering and has yet to complete a qualifying acquisition with the proceeds of such offering” – Equity Guidelines, Securities Commission Malaysia
• "In this context, blind cash pools, which are financing vehicles that take growth enterprises public, may well come into broader use.
• Blind cash pools have been adopted increasingly by stock exchanges around the globe. Generally, they involve shell companies that are created to raise money publicly and then use the funds to track down and acquire an undetermined business or asset.
• The shell companies are formed solely for this purpose; they contain no prior assets or existing operations.
• The Toronto Stock Exchange currently offers two forms of blind cash pools – the Capital Pool Company (CPC ) program on the TSX Venture Exchange (TSXV) and the Special Purpose Acquisition Corporation (SPAC) program on the TSX itself - Blind Cash Pools: Expanding Role in Business Financing? by Nadim Wakeam.
• "Although they have been around for many years, the period in the run-up to the financial crisis saw an explosion of special purpose acquisition companies (SPACs or ‘blank-cheque companies’). - FINDINGS, LONDON BUSINESS SCHOOL, ISSUE 9 winter 2013/14

Therefore, based on the above, if you think that a SPAC is a blind fund, you are not alone. The definition and description of a SPAC seem to focus on the fact that the company is blank, no operation, no income. Investing in such a company would require a 'blind' faith; hence a blind fund.

CONFLICT WITH THE STATUS QUO
But wait, this cannot be! We are not accustomed to regulators allowing such uncertainty, such high risk, to the general investing public. This does not make sense if we were to look back at how the regulators have been handling the stock market, things like prudence, informed investment decision…we cannot achieve all that with a blind fund. Well, these were the conflicts that would have greeted those who saw SPAC as purely a blind fund.

CONFLICT ASIDE, WHAT CAN WE DO WITH THIS?
Anyway, for the sake of discussion and analysis, lets assume that this is indeed the case. A blind fund has indeed made its way to the stock market. We stop the definition of SPAC at this stage, and assume that this is the nature of investment in a SPAC. What then?

Well, then we need to ask ourselves " how do we go about evaluating a blind fund". How do we check if a blind fund is a kind of investment that is worth investing and if so, which one should we invest amongst all the blind funds (assuming we have limted resources -- so true in my case).

What I did was to look at other types of blind funds and discovered that the closest in definition would be a private equity fund, one which has not made any investment yet. Both the SPAC and the private equity fund have no business nor income, both are a form of collective investment scheme and both rely on the ability and expertise of the management to generate values through acquisitions.

Do people invest in private equity funds? The answer is yes, and these investors invest in private equity due to many reasons, The first reason quoted by many is the higher expected return from peivate equity investments. An article titled "Why and How to Invest in Private Equity" published by www.venturechoice.com stated that: "The long-term returns of private equity represent a premium to the performance of public equities. This has been the case in the US for over 20 years and also in Europe, following an increase in the number of private equity funds, for over 10 years. For many institutions, such a premium over more conventional asset classes justifies the different risk profile of the asset class."

Therefore, as a matter of rule, if the SPAC is similar to a private equity, then the investment consideration must also be similar. And now that we have established that people do invest in private equity, lets see what would be the considerations.

I discovered that there are a systematic way on how to evaluate a private equity investments, but due to the absence of operations and with it the financial figures, most of the evaluation (pre-IPO) would be subjective in nature.

The article titled "Eight Steps for Analyzing Listed Private Equity Companies", written by Tim Spence of Graphite Capital Management & Monique Dumas, Electra Partners LLP (www.LPEQ.com) which neatly sums up the considerations for listed private equity funds. In summary, the eight steps comprise

• Take time to understand what you are intending to buy
• How experienced is the private equity company and what sort of track record does it have?
• How strong a board of directors does the listed private equity company have?
• Cash drag, over-commitment and leverage
• What about the dividend?
• Discounts and valuations
• Look at the Portfolio
• Transparency

In the article titled "Why and How to Invest in Private Equity" published by www.venturechoice.com, it was put forward that prior to making an investment in a private equity fund, it must be made relative to our existing portfolio, as mode of diversification. For a start, we need to filter the options by looking at the following variables:
"Stage There is negative correlation between returns from different stages of private
equity. Diversification can therefore reduce risk within a private equity portfolio and
this should be an important consideration.
Geography. Geographical diversification can be secured in Europe through the use of
country-specific, regional and pan-European funds. Non-European exposure is also
widely available, in particular through US funds, but also for example through Global,
Israeli, Latin American and Asian funds.
Manager. Selecting a variety of managers will reduce manager 3. specific risk.
Vintage year Timing has an impact on the performance of funds, as opportunities for
investment and exit will be impacted by external economic circumstances. For this
reason it has become a normal practice to compare the performance of funds against
others of the same vintage. There may be marked differences in performance from
one vintage year to another. In order to ensure participation in the better years, it is
generally perceived to be wiser to invest consistently through vintage years, as
opposed to "timing the market" by trying to predict which vintage years will produce
better performance.
Industry. In venture investing, most of the focus tends to be on technology based
industries. These can be subdivided, for example into healthcare / life sciences,
information technology and communications. Buyout funds tend to focus on
technology to a lesser extent, providing exposure to such sectors as financial
institutions, retail and consumer, transport, engineering and chemicals."

POSSIBLE ANSWER
Anyway, based on the above, it is clear that the evaluation of SPAC Pre-IPO is going to be very subjective. The absence of operations and defintive financial data basically took away all objective means of calculating the risk and expected value for the fund. In general, we would be left with the following areas of evaluation:

• The general industry that the SPAC is going to be in;
• Which area within the value chain would the SPAC be venturing into
• The governance of the SPAC (Board of directors)
• The management of the SPAC

In trying to understand what we are buying, the evaluation tend to always start at the macro level. This means that evaluations were done on either the industry focus, geographic focus or size of companies. In Malaysia, currently we only have one industry issuing SPAC, namely the oil and gas industry, but if other SPAC were approved for listing, for example the SPAC operating in mining, foodstuff, plantation and others, we would be able to evaluate the risk and expected reward of the SPAC by looking at the industry in general. This is because we would assume that a growing / table industry poses less risk of failure for any business that the SPAC might end up owning.
But, since we were only given the choice of companies within the oil and gas industry, we could also assess the risk based on the type of business they are planning to venture into. i.e where in the value chain is the SPAC going to end up in after they completed their acquisitions. Because the all are targeting the same business segment, it is difficult to differentiate them. In other words, under a blind find, these four have the same risk profile based on intended scope of business
Then we would need to evaluate the board composition of the SPAC and make a judgement call on the level of governance that the SPAC will be under. This is highly subjective in nature and there is no general rule as to how do you measure the expected governance level based on the experience of track record of the board of directors. However, it is a mean, a way, to differentiate one SPAC from the other if you have any knowledge about the characters of the directors who are going to be governing the SPAC and keeping the management in check.

Next we again need to make a subjective evaluation on the capabilities of the management, the capabilities to source deals, execute them successfully and subsequently operating the company successfully. We can look at the experience and number of years they have been in the industry , but assigning a success factor to the management is highly subjective. Sometimes, we tend to take comfort by thinking that the regulators would have made that assessment for us, found the management adequate. While that is fine and dandy, without the objective means to quantify the quality and quantity of the management's experience, we would not be able to differentiate one SPAC from the rest, we could not rank them objectively.

SPANNER IN THE WORKS…
So, there you go. By equating SPAC to a private equity investment, would could arrive at a certain level of evaluation or assessment with regards to SPAC. If you can evaluate and invest in private equity, albeit very subjectively, then you can also use the same evaluation to decide whether or not you would want to invest in the SPAC. But…

But is a SPAC really that similar to a private equity fund? Well, the answer to that is, in my opinion, not really. There are enough dissimilarities between a SPAC and private equity fund that making an investment decision based solely on private equity-based evaluation would be deficient.
What are the main differences? Firstly there is the trust fund and requirement for 90% of the IPO proceeds to be kept safe in the fund, until an approved acquisition. You don't have that in a typical private equity. In a SPAC, the investors gets exclusive authority to decide on acquisition; in a PE, that would be the job of the managers. In a SPAC, it acquires a business to acquire the operation; in a PE, it acquires a portion of many businesses to make capital gain and passive income (dividends); In a SPAC an investors can get their money back if they do not approve of the qualifying acquisition; in a PE, they can't do that. In a SPAC, the managers (including promoters) gets significant equity portion of the business ( 20% to 30% at nominal value) from the onset; PE managers just gets fees and performance kickers.

All these factors would affect the risk characteristics of investing in a SPAC, which in my opinion be significantly different from a blind fund private equity investment. In the end, while we might think that we now have a solution on how to evaluate a SPAC, that solution might be enough for us.
If there is no other mean of evaluating a SPAC other than this way, the too bad, we just have to accept it as it is. However, there is a still a way to look deeper into a SPAC, past the mere definition of the SPAC. That is to look at the form of the SPAC and evaluate it as a listed company that it is.
We will delve into this in the next article, where we will attempt to seek a more objective evaluation of the SPAC as a listed entity, by evaluating, amongst others, the 'total entry price' that are paid to the management through the equity stakes, the intrinsic value of the cash in the trust deed, price to book and total downside of each SPAC. It will also be our first attempt at arriving at the fair value for the SPAC.

In the article subsequent to that, we will focus on the non-ordinary aspect of the ordinary shares of SPAC to break the entire investment in a SPAc into its composite, attempting again to arrive at the fair value for the SPAC pre-IPO.