It’s Time to Look at the DeSPAC Trade
“All SPACs are frauds” seems to be the prevailing market sentiment lately. For those who are unfamiliar, SPAC stands for “Special Purpose Acquisition Company.” SPACs offer an alternative method for companies to go public. In the traditional IPO process, companies hire banks to underwrite and price their public offerings. In contrast, SPACs are publicly traded shell companies. These SPACs hold millions to billions of dollars in trust accounts, and they invest this money in private companies in exchange for X% of equity. For example, say a billion dollar SPAC wants to take company ABC public. If the SPAC gives ABC $1B for 10% of the company, the post-merger SPAC will be worth $10B ($1B / 10%). Once the transaction closes, the stock ticker will change to the newly “merged” company. Notable names such as DraftKings (DKNG), Virgin Galactic (SPCE), and OpenDoor (OPEN) all went public through SPACs.
SPACs have gotten a bad rap lately. This isn’t completely unwarranted, as several bad companies have gone public through SPACs, and plenty of deals were priced at sky-high valuations. Zero revenue EV startups like Nikola Motors (NKLA), Canoo (GOEV), and Fisker (FSR) went public at multi-billion dollar valuations, while Romeo Power (RMO) and ATI Physical Therapy (ATIP) cut guidance one quarter after their mergers closed. There are plenty of other examples to pull from.
What is the result? Pure carnage in the SPAC market. Before their mergers close, SPACs have a $10 floor as investors can redeem their shares for $10 cash. Once the merger closes, this safety net disappears. SPAC selling pressure coupled with general small cap weakness has less to some vicious price drops across the board. Check out these charts:
While the indices have flirted with all-time highs for weeks, market sectors like mid-cap growth, China stocks, and SPACs have been selling off as a group. The irony here is that SPACs aren’t a “sector” any more than IPOs are. Virgin Galactic (SPCE), DraftKings (DKNG), OpenDoor (OPEN), and Sofi (SOFI) have nothing in common other than their method of joining the public market. However, SPACs were “free money” for months. With the $10 floor, there were arbitrage opportunities if you purchased shares below $10. Additionally this floor provided a “max loss” point. Investors could bet heavily premerger and close their positions with 0 risk if the stock didn’t perform well. There was a lot of institutional money in SPACs, but the poor performance of late has led to derisking across the board. Some of these companies are profitable, some are 0 revenue. Some have demonstrated high growth, some have cut projections in half. Some are valued at sky-high prices, others are dirt cheap. I have a thesis that this recent uniform performance of former SPACs will yield a long-short opportunity to generate alpha over the next year. Many of these companies will fail, but those that do succeed will produce massive returns from their current levels. Entry points are everything, and we have several stocks trading at compelling levels now.
With dozens of SPACs and former SPACs trading at discounted levels, we have an opportunity to find some potential multibaggers if we put in the work. This isn’t the time to heavily load any former high-flyer just because its price fell. Nikola Motors is trash. Quantumscape (QS) won’t be going back to $100 anytime soon. But SPACs that had reasonable valuations and strong fundamentals a month ago are screaming buys now. Personally, I have taken a large position in Katapult (KPLT). This is far from the only intriguing option out there right now though. BarkBox (BARK), Matterport (MTTR), OpenDoor (OPEN), AST SpaceMobile (ASTS), Astra (ASTR), and several other former SPACs with interesting investment theses are now at their all-time lows.
The hardest time to buy is after a massive drop. After all, I thought the bottom was in on some of these a few weeks ago, and many continued to plummet until last week. Your mind becomes your own worst enemy. You doubt your process. “What if it keeps falling?” “What if my thesis is wrong?” “What if I overlooked something?” The paradox of falling prices is that these stocks are all now LESS risky than they were pre-fall. If the drop was unrelated to the company’s execution, you’re buying that same company at a discount to a month ago. Nothing tests conviction like falling prices, but you can make outstanding returns if you keep a level head.
A Call Option on Steroids
SPACs also have a unique tool that can help us make outsized returns: warrants. Call options give investors the right to buy 100 shares at a set price by an expiration date, while warrants give us the right to buy 1 share at $11.50 for five years. 100 warrants is essentially one $11.50 five year call option. Warrants tend to be more liquid than calls as well. The catch is that different SPACs have different warrant exercise clauses. Some warrants can only be called by the company if the stock trades above $18 for 20/30 days. Others can be called between $10 and $18 a share. While SPACs are in the $10 range, warrants typically trade around $2. If you find cheap warrants on a SPAC with strong fundamentals and the $18 exercise clause, you can turn massive profits.
At $18 a share, warrants typically trade at $7+ ($6.50 of intrinsic value and the rest being time value.) This is a 3-4 bagger from the ~$2 range mentioned above. Katapult is currently $9.50, and its warrants are $2.70. KPLT also has the $18 warrant clause, so early exercise is not a risk here. I think Katapult has the potential to triple from here, which would put the stock at $27. The warrants would be worth $16+ at this level, effectively a 600% gain. If I play it safe and sell when the stock price hits $18, I would still more than double my money from here. Warrants are often mispriced compared to LEAP options, making them a great tool for the savvy investor.
The hardest time to buy is when stocks are crashing. FUD is at an all-time high, and the bear arguments are louder than ever. That being said, it is time to dig through the rubble and find the turnaround stories. Look for revenue growth, profitability, and discounted valuations. Most SPACs will fail, but some will produce incredible returns. Let’s get after it.