The ‘COVID-19 Crash’ Was a Good Thing for This Growing Corner of the Market

Doc’s note: The COVID-19 pandemic has devasted businesses around the U.S. But, according to Enrique Abeyta, there is something quickly emerging as a once-in-a-generation type of opportunity thanks to the pandemic. And we’re still in the early innings…

Things were going smoothly…

The market was at an all-time high, unemployment was at a 20-year low, and the U.S. Federal Reserve had trillions of dollars at its disposal, ready to inject into the financial system at a moment’s notice.

Then, seemingly out of nowhere, COVID-19 stopped the historic, decade-long bull market dead in its tracks. Over the course of two dozen trading sessions from mid-February to late March, the benchmark S&P 500 Index fell 34%.

It was the fastest and sharpest crash in market history, and it was the nail in the coffin for many struggling businesses that admitted defeat and filed for Chapter 11 bankruptcy:

  • Gym chains Gold’s Gym and 24 Hour Fitness
  • Rental-car chains Hertz, Dollar Thrifty, and Advantage Rent a Car
  • Clothing retailers J.Crew, Neiman Marcus, and J.C. Penney
  • Restaurants Chuck E. Cheese and Le Pain Quotidien
  • Energy companies McDermott, Whiting Petroleum, and Diamond Offshore Drilling

It even affected privately held companies that were eyeing their public debut. Practically overnight, home-rental giant Airbnb, food-delivery firm DoorDash, and online stock brokerage Robinhood shelved their plans for an initial public offering (“IPO”).

But while COVID-19 sent shockwaves rippling through most areas of the markets and put these high-profile IPOs on pause indefinitely, one type of investment was thriving…

I’m talking about special purpose acquisition companies (“SPACs”), sometimes referred to as “blank-check companies.” These are publicly traded investment vehicles where a team of experienced managers raise money through an IPO for the sole purpose of taking a private company public.

Management typically has 18 to 24 months to find a target company to acquire, otherwise it’s forced to return capital to shareholders. In the meantime, the money raised is kept in a trust account, where it is invested in super-safe U.S. Treasury securities and earns a modest interest.

When management identifies a company, investors and shareholders vote on the deal. Folks who don’t like the proposed acquisition simply get their money back, plus interest.

COVID-19 has placed tremendous pressure on small and large businesses, both private and public. Many will survive, but not without bleeding a great deal of cash to stay afloat.

But while the market volatility forced many companies into survival mode, it simultaneously enticed a group of brilliant investors to launch new SPACs to acquire high-quality companies that were desperately in need of cash.

This kind of market volatility makes it tougher for companies to access public markets via the traditional IPO route. When the market pulls back, private companies are wary of pricing their IPO too low. But a SPAC takes out the guesswork for the company, which knows exactly what price it’s getting.

That’s why more and more private companies have suddenly considered being acquired by a SPAC, which offers them a quicker and more efficient way to go public.

SPACs came about in the 1980s and were originally associated with penny stocks and fraudulent companies. They disappeared during the dot-com bubble era when virtually every tech company was going public via traditional IPO but made a comeback after the tech bubble burst.

Increased regulation attracted the interest of investors once more, and SPACs quickly re-emerged. Although they had modest success, their comeback was short-lived as the global financial crisis hit shortly thereafter.

Over the past five years, though, we’ve seen a resurgence in the space as it has attracted some of the highest-quality institutional investors in the world. The disappearance of medium-sized investment banks has caused the traditional IPO process to languish, opening the door for SPACs as an attractive alternative once again.

Instead of opening up to financial scrutiny, spending months doing roadshows, and paying hefty fees to investment banks, several private companies have elected to go public via SPACs. It’s a quicker, easier alternative to going public.

The resurgence has been a huge success…

Last year, several high-profile SPACs caught investors’ attention. With space-tourism company Virgin Galactic (SPCE), fantasy sports-betting app DraftKings (DKNG), and electric-truck maker Nikola (NKLA) all going public via a SPAC – and their share price skyrocketing shortly thereafter – the investing community took notice.

This year, SPACs have accounted for almost 40% of all IPO filings in the U.S. and raised $48 billion through the end of September – more than SPACs raised in all of the previous seven years combined.

The market’s appetite for SPACs is red-hot right now, and for good reason…

Many young growing companies depend on capital to drive their growth to profitability. The current uncertain market environment is leading many of the private equity investors who traditionally provided this money to be very cautious. This is creating an opportunity for SPAC sponsors to fill.

After years of inflated private company valuations and seemingly endless streams of capital plowed into unprofitable companies, funding availability has slowed down. As private company valuations come down and they search for new funding to keep them going, SPAC sponsors could fill a void that traditional IPOs left behind.

Again, traditional IPOs aren’t designed for every market condition. They rely heavily on market timing and tend to do best when markets are booming. A company learns how much capital it can raise late in the process, and a deal can fall through at the drop of the hat, especially during a global pandemic as the stock market is tumbling. While the SPAC process takes roughly the same amount of time, the target company and the SPAC iron out the details much earlier.

The recent COVID-19 market volatility put these IPOs on hold, giving rise to SPACs, which are much less correlated with the market’s performance.

Management knows beforehand how much money it was able to raise for its SPAC, which takes most of the uncertainty out of the process of going public. The relative safety, and the guarantee of the funds in the account, has made SPACs far more attractive to private companies looking to go public.

But I’m not the only one who has noticed that SPACs are becoming increasingly attractive…

In June, billionaire Wall Street titan Bill Ackman created his own record-breaking $4 billion SPAC, which his Pershing Square hedge fund could provide with an additional $3 billion in capital.

In Ackman’s filing with the U.S. Securities and Exchange Commission (“SEC”), he explained that the unprecedented market volatility was putting high-quality companies at a huge disadvantage “to execute a public offering on favorable terms.”

Ackman argued that the COVID-19 pandemic had created an “economic and market dislocation” that made launching a SPAC more attractive than at any other time in history, and he’s determined to capitalize on it. As he concluded…

We believe that our ability to recapitalize and facilitate a public offering of a family-owned business without the typical uncertainty, upfront costs and the time-consuming nature of the IPO process, will enable us to merge with a large, family-owned business on highly favorable terms.

More of Wall Street’s best investors continue to pour into the SPAC universe on what seems like a daily basis. This is quickly emerging as a once-in-a-generation type of opportunity like the early days of high-yield bond investing.

From my vantage point, it looks like we’re in the early innings of what I expect to be an incredibly profitable time for savvy individual investors.

Regards,

Enrique Abeyta

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