Friday, September 23, 2005

The ultimate trust test.

Not for the faint-hearted...or stout-minded.

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September 23, 2005

Crave Huge Risk? This Investment May Be for You

WOULD you hand over wads of cash to a money manager you didn't know, to invest in a company he hadn't yet discovered, and would you then also pay a boutique investment bank you had never heard of as much as 10 percent to get in on that deal?

If the answer is yes, then join the latest alternative investment craze: special purpose acquisition companies, or SPAC's.

They are essentially blank-check companies that allow their managers to raise money from the public to later invest in another company - although issuers do not disclose the target because to do so would mandate onerous disclosure requirements. Think of a SPAC (rhymes with smack) as a publicly traded buyout company.

Such companies have been around for ages, but they died out a decade ago after regulators cracked down on abuses. Now, they are experiencing a revival. Thirty-three SPAC's have filed registration statements with the Securities and Exchange Commission, and they are expected to raise $2.9 billion, according to Sanders Morris Harris, a boutique investment bank that has underwritten a number of them.

Here's how it works: A couple of investors want to buy companies in China, but they need $30 million to pay for the companies. They hire a firm like EarlyBird Capital, an investment bank in Melville, N.Y., which has been busy raising money from the public for the management teams of SPAC's.

These companies are typically priced at $6 a unit, which generally includes one share of common stock and two warrants with an exercise price around $5. If all goes well, the offering generates about $30 million to the managers who are then entrusted, for 12 to 18 months, to find a company to buy.

The underwriting bank collects an enormous fee - as much as 10 percent for the offering, more than the standard 7 percent for an initial public offering. The SPAC then puts 80 percent to 90 percent of the money in a trust, sets aside a minimal amount of funds - usually less than $1 million - and tries to find a company.

If they find one, and all the shareholders approve the deal, the management gets 20 percent of any profits eventually generated. The shareholders get ownership of a company that they may or may not want to own. If they don't, they can sell their shares.

If in 18 months the managers have not yet found a company, they give back the money, minus the fees and expenses.

SPAC management teams are clearly opting out of the onerous process of raising a private equity fund, which can take up to a year. They may be doing this because they are impatient: why make all the effort to persuade a big pension fund like the California Public Employees' Retirement System to invest $100 million when you can attract that much from individual and institutional investors in the market?

It is unreasonable enough that Wall Street can maintain a 7 percent cartel on initial public offerings. But SPAC underwriters can charge an additional 2 percent because underwriting alternative investments - like hedge or private equity funds - is the 2005 equivalent of the California gold rush.

But the "risk factors" listed in filings by SPAC's with the S.E.C. show the real risk in such entities. "Since we have not currently selected a particular industry or any target business with which to complete a business combination, we are unable to currently ascertain the merits or risks of the industry or business in which we may ultimately operate," reads a passage from one SPAC, the Millstream Acquisition Corporation.

In other words, SPAC's are not for the fainthearted.

But these acquisition companies are not without virtues. The market for small initial public offerings has evaporated, leaving few options for small, productive companies that want to go public to raise cash. A SPAC can buy a company, effectively creating a publicly traded company overnight through a reverse merger. Between 1999 and 2004, the amount raised in initial offerings has fallen 26 percent, according to Thomson Financial; the amount for offerings under $100 million has fallen 68 percent.

Unlike private equity investors, SPAC investors can get out when they want - if they can find a buyer for the shares. That may be difficult in many instances because the banks that underwrite the shares do not make markets in them.

And only a few SPAC's have actually completed acquisitions, calling into question the entire premise behind them.

Nonetheless, the prices of the companies that have done deals are rising. Chardan China Acquisition went public in March 2004 at $6. In December, it announced that it would buy State Harvest Holdings and convert into a British Virgin Island company. Its stock is currently trading at $9.15 and the unit, which includes the warrants issued to original shareholders, is trading at $17. In March 2004, Millstream and NationsHealth Holdings merged. Traded on Nasdaq's small-cap market, the shares (with warrants) are currently worth $12.62. It went public at $6.

While the S.E.C. has approved a number of SPAC's, some state securities regulators are concerned that small individual investors may become targets of unscrupulous promoters of such investments.

Indeed, the risks in investing in a SPAC are huge. If an investor is looking to buy private companies, a private equity fund, for all its high fees and lockups, at least offers experience and is usually accountable to some large, serious institutional investors.

The EarlyBird may get the worm, but that may not be to everybody's taste.

Copyright 2005 The New York Times Company

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