What Makes a Good Acquisition Candidate for a SPAC?
I have neither Mark Cuban’s panache nor charisma, so I hope you’ll excuse the dry title for this post. Cuban has told the story of how he got his start selling software. He’d read the software manuals:
Every night I would take home a different software manual, and I would read it….It was easy on the weekends…I wasn’t getting out of bed till about 9 p.m., so I had tons of time to lie on the floor and read.:
(Quote above is sourced from here.)
Cuban’s point is that reading dry and boring material gets you a leg up on the competition. You know details that your competitors don’t, you can answer customers’ sophisticated questions, customers see you as a font of knowledge, and you generate sales.
As with many pearls that Cuban passes along, this lesson has broad applicability. Reading boring documents is a way to quickly learn a lot about a topic and to make yourself stand out from the crowd.
In that vein, reading filing documents for SPACs can help us understand the market to a level of sophistication that others don’t. Pershing Square is pretty explicit about its SPAC’s acquisition criteria:
Simple, predictable, and free-cash-flow-generative.
Formidable barriers to entry
Limited exposure to intrinsic factors that we cannot control
Strong balance sheet
Minimal capital markets dependency
Large capitalization
Attractive valuation
Exceptional management and governance
Let’s take these criteria one by one, and see what they can tell us about Pershing Square’s thinking.
Simple, predictable, and free-cash-flow generative. Simple businesses are easier to understand than complex ones. Conglomerates like GE or Berkshire Hathaway are hard to understand, even though these two companies are very different. Retailers are easier to understand: they buy product from manufacturers or wholesalers and sell that stuff to end customers. Free cash flow refers to the cash that a company generates, after it has accounted for all cash spent on operations and maintenance of its capital assets. So rephrasing this criteria more simply: Pershing Square is interested businesses that are easily understood, and which generate cash in excess of the amount of cash needed to pay for company operations and maintenance of the company’s long term assets.
Formidable barriers to entry. This is fairly straightforward: In Warren Buffett’s words, Pershing Square is looking for a business with a durable moat. Pershing Square is looking for a business that can’t easily be copied by others. In the 1980s, Buffett argued that Coca-Cola’s strong brand created a durable moat.
Limited exposure to extrinsic factors that we cannot control. “Extrinsic” in this sense means “external”. One common criticism of SPACs, especially recent ones, is that their stocks don’t perform well post-acquisition. For example, in 2016 Silver Run Acquisition Corporation acquired 89% of Centennial Resource Production, LLC, an oil and gas exploration company. Oil and gas of course has collapsed in price since then, and with that collapse, so, too, have the SPAC’s prospects. Commodity price volatility is an example of an extrinsic factor that Pershing Square is looking to avoid.
Strong balance sheet. Strong balance sheets provide optionality. To adapt Milton Friedman (to whom I am not related), business constraints are always and everywhere a balance sheet phenomenon. A strong balance sheet means, at a minimum, that the company’s current assets are greater than its current liabilities (so it can finance debts due with its liquid assets), and that shareholders’ equity is positive (meaning that assets are greater than liabilities). A strong balance sheet ensures that the company has some excess cash to pursue new business opportunities, hire key personnel, or expand into new markets.
Minimal capital markets dependency. Broadly speaking, companies can be operating companies, or they can be financial allocators. Banks, hedge funds, private equity funds, venture capital funds, and mutual funds are all examples of companies which are capital allocators, and all of which are heavily affected by events in the capital markets. Operating companies like, for example, Toyota or Microsoft, produce products and services that consumers and businesses buy. And operating companies are not as affected by the vicissitudes of the financial markets as capital allocators are. Given that Pershing Square is itself a hedge fund, which has heavy exposure to the capital markets, it makes sense that Pershing Square’s SPAC offering wants to avoid exposure to the capital markets.
Large capitalization. Pershing Square raised about $4 billion for its SPAC. From that link:
In addition to the $4 billion raised in the IPO, Pershing Square has committed to acquire an additional $1 to $3 billion of units pursuant to a forward purchase agreement, resulting in a minimum of $5 billion at the SPAC’s disposal for its initial business combination. According to its prospectus, the SPAC intends to potentially acquire a minority interest in a “larger-capitalization private company (with market capitalization of $10 billion or more).”
Thus, this acquisition criteria is self-explanatory.
Attractive valuation. Pershing Square is looking for companies whose intrinsic value is greater than its current market value. Intrinsic value is determined by modeling a company’s projected cash flows for the next five to 10 years. The greater the spread between the current market value of the company’s equity and the intrinsic value of its equity, the more attractive the investment opportunity. Of course, forecasting future cash flows is a fraught and complex exercise, and those forecasts may not be accurate. This uncertainty is especially important to bear in mind with respect to SPACs, due to the private nature of the target company’s equity: the equity has not been priced by the public markets, so its market value may be unduly high.
Exceptional management and governance. Great companies require talented executives. Further, companies that are governed well are easier to acquire than companies that are governed poorly.
So, that’s Pershing’s thinking. Clearly they hope to avoid the pitfalls that other SPACs have encountered. Strong, durable, and predictable businesses with reasonable valuations are obviously attractive companies. And there is a lot of competition for companies that meet these criteria. As I’ve said previously, I remain agnostic on the question of whether SPACs will revolutionize capital formation. I think that they can, in principle, but SPACs also have a kind of stink about them that a lot of institutional investors don’t like. If Pershing Square’s SPAC, and other institutional-caliber SPACs can buck the trend of SPAC-related fraud and underperformance, Bill Gurley’s thesis may yet bear fruit.