SPACtacular Games, So-So Prizes?
The Bengal Bite
SPACs in 2020 raised more money than they did over the entire preceding decade. Last week we covered the “what” of SPACs, and this week we look a bit deeper and try to get to the “why.” Why have these vehicles gotten so popular, and what are the motivations of everyone involved?
Recall the basic SPAC pattern: A sponsor puts in a few million dollars to fund the costs of the IPO of a “blank check” company which has 24 months to search for a private company (the “Target”) which to buy/merge with (the “Qualifying Transaction” or “QT”), an experienced and credentialed management team (sometimes part of the sponsor, sometimes paired with the sponsor) that has a track record of success in a certain industry and want to repeat that success with another company, initial IPO investors invest in the SPAC IPO and get in at $10 share with a half warrant to buy another share at $11.50, the right to redeem out their stock for cash value ($10 plus interest) if they do not like the QT, and then investors who purchase the SPAC on the open market.
The Sponsor & Management Team: The SPAC sponsor is a combination of two things: the financial backer that puts in the “risk capital” that is used to get the SPAC ready for an IPO, usually a few million dollars. They also bring in or pair with the management team. If the QT is completed, these folks generally get 20% equity in the resulting company for their efforts and a relatively minor amount of capital. This is, as they say, a nice carrot or “promote.”
Initial IPO Investors: SPACs usually grab headlines with how much money they raised - as we highlighted last week, there’s currently a total of $1.6 billion in SPAC cash hovering over the cannabis industry looking for a target. But, the particular features of SPACs should make people a bit wary of reading just the headline numbers.
An IPO investor gets a share of stock worth $10, and a half warrant to buy a share at $11.50. That share of stock is really worth $10 or so - if the investor does not like the QT, they have the legal right to “redeem” and get their cash back within 24 months - with interest. Or, if they want their money back before a QT, they can sell shares in the market because SPAC shares are freely tradeable. But, critically, they get to keep their warrant even if they sell - so if the company does really well, they can still take advantage of some of the upside.
Put yourself in the shoes of a big fund manager looking at a market she thinks is overvalued - the PE of the market is way too high, COVID is unpredictable, the Fed is pumping money into the system, “yada yada yada” as they say in New Jersey. She has a bunch of money under management she doesn’t want to buy stocks with so she can put it in the bank, or buy a SPAC. It’s important to realize that oftentimes buying a SPAC is effectively putting cash in the bank because you have the legal right to get that cash back through your right to redeem a share. But, unlike putting it in a bank, you also get the chance that secondary investors might get excited about the SPAC, so you can sell your SPAC share for >$10 in the open market or that the company might have more value in the future, in which case the lottery ticket warrants you got in the IPO are suddenly worth something as well.
Open Market Buyers: What does the average buyer of a SPAC on the exchange get? They also get the right to redeem their share for $10, but no warrants. So what they are generally buying seems to be the “story” - that the SPAC sponsor and management will be successful, and the investor can join their team and profit from their success. You can see this in the cannabis SPACs from the fact that many of them trade at a significant premium to their redemption value - meaning that investors are valuing the right to “join the team” greater than the right to get $10 of cash.
SPACs are no longer new and untried, but have a history of performance that investors should at least be aware of:
- Of SPACs that merged between January 2019 and June 2020, the median percentage of IPO proceeds that was redeemed (that is the cash was given back to the holder of the share) equaled 73% - over one-third of SPACs had over 90% redemptions.
- Post-merger returns of SPAC stocks a year later were -35%, most likely driven at least in some part by a large number of redemptions.
- Redeeming shareholders averaged an annualized return of 12%
To be clear: We are not expressing an opinion on any particular SPAC in cannabis or otherwise - indeed, there is some evidence that “high quality” SPACs with strong private equity sponsors and former Fortune 100 executives at the helm sometimes beat the broader market. And, we do not think that SPACs’ recent history should be investors’ sole way of judging a specific opportunity in front of them. As we often argue, there is significant value to be found in specific situations on their own merits - and we will be looking at some potentially interesting opportunities in cannabis SPACs next week.
This Week's Bite:
- Eazy come, Eaze-y go: The twists and turns in the Eaze-connected $160m bank fraud case keep on coming. Eaze, a San Fransisco “platform marketplace” startup that styled itself as the “Uber “ of cannabis, and was able to raise capital from major venture capital firms at tech company level valuations, was perceived by many as having less risk than a plant-touching cannabis business. Former Eaze Chief Executive Jim Patterson has now pleaded guilty and is directly cooperating with the federal government in their ongoing case where they allege that two other businessmen conspired to deceive banks into processing cannabis transactions. Eaze is not directly charged and appears to be cooperating with authorities.
Major investors understandably avoided the clear federal prohibition on cannabis, but possibly underestimated the less-transparent but just as serious federal thicket of rules regarding banking and payments. The case has inadvertently revealed another data point about the high demand for legalized cannabis: evidence revealed that Eaze has generated credit card sales in the 9 figures. (Wall Street Journal | Green Market Report)
- Illinois Cannabis Sales Continue to Impress: Illinois cannabis (recreational and medical) sales were roughly flat between January to February 2021, and up 85% over last year. Illinois stores sold $110.3m (~$3.94m per day) in February vs. $121.2m in January ($3.91m per day but with three more days in the month). 28% of adult-use sales were from out-of-state residents. Product shortages are a likely cause of slower growth - Illinois likely has significant room to run as a market from here. New Cannabis Ventures gathers some more interesting sales statistics in the link. (New Cannabis Ventures)
- Drinks up! Sales of cannabis-infused beverages are up 40% compared to the overall cannabis market at… 39.4%? The above-par growth is even more questionable when you remember that beverages only consist of 1% of national cannabis sales. That all said, 80% of adult drinkers want to consume less alcohol, which has MSOs definitely noticing CANN's market traction. (Marijuana Business Daily | THCNet)
- California cannabis-use discrimination ban: A newly introduced bill in California would make it illegal to deny employment in most-situations due to a positive drug test for cannabis. (Ganjapreneur)
- You gon’ need a warrant for that: UPS, following FedEx’s lead, has announced that they will no longer ship any cannabis or tobacco vapor products in order to comply with new federal regulations. E-commerce sites in the tobacco, hemp, and vape industry are going to have to go back to the drawing board (or use USPS) in order to support their business model. (Ganjapreneur)
- Delta-8 gets its moment in the limelight: Following last week’s reports that delta-8, a lesser-known compound found in cannabis and hemp, was the most rapidly growing sector in hemp, a New York Times reporter dove in to learn more. (New York Times)
- White Widow to White House? Cannabis use is becoming more acceptable in the eyes of the Biden White House. Now, it's enough if you pledge not to smoke anytime while you are employed by the new administration. (NBC News)
Source for SPAC redemption and return data: A Sober Look at SPACs, Prof. Michael Klausner et al., Stanford Law School, Harvard Law Forum on Corporate Governance, <XXX LINK>, November 19, 2020
from the bengal bite
Cannabis is our little corner of the investing world, but sometimes developments from the broader world of finance seep in - like the enormous recent growth of Special Purpose Acquisition Companies (SPACs). A SPAC is a publicly-traded pile of money paired, in principle, with a bankable management team which has a recognized track record of success that is actively looking to acquire another company, the proverbial “target.” The SPAC acquires the target - effectively taking the target public, and the SPAC management team is now at the helm to drive even more value creation - again, in principle. Management gets up to 20% of the resulting company for their efforts if the target acquisition closes - a huge chunk of “sweat equity.” Investors get some protections, like the ability to sell their shares because the SPAC is public and to vote against the purchase of the target if they aren’t happy with the potential transaction. They also get some carrots, usually in the form of ½ warrants to purchase shares of the SPAC for $11.50 (SPAC IPO shares are usually sold for $10).