Market watch: New M&A vehicles offer investment alternative

Jerry Grossman

Investors' interest in federal IT, defense and homeland security companies has been affirmed again through recent public offerings by special purpose acquisition corporations, or SPACs.

Two SPACs that target federal market companies raised more than $150 million in the last few months. Federal Service Acquisition Corp. (OTCBB: FDSAU) of New York has $117 million in equity capital to invest, and Fortress America Acquisition Corp. (OTCBB: FAACU) of Arlington, Va., has about $38 million.

Such "blank-check" companies ? before they own a single operating business ? offer stock to the public. Logically, shareholders would exercise their stock purchase rights after the initial acquisition has been completed. If the shareholders of the two new SPACs exercise all warrants, it would add nearly $300 million to the companies' coffers and enable more acquisitions.

With such substantial assets at their disposal, these SPACs enter the federal mergers and acquisition environment as knowledgeable, well-capitalized buying groups.

Some observers have interpreted the emergence of these blank-check entities as a sign of irrational investor exuberance and clear evidence of a speculative bubble in this market sector. They point to the risks of buying stock without a real business behind it, with only a promise to "buy a good company when we find it."

A view that I believe is more on target is that a SPAC is really a public market investment opportunity analogous to investing through a private equity shop. Most individuals and many institutional investors do not have access to private equity investing. The SPAC offers a vehicle for investors to participate at the outset of the business-building process. Their investment provides the core capital for the purchase of the foundation business around which the newly public enterprise will be built.

In these entities, investors are evaluating the directors and officers of the SPAC in the context of their knowledge of the targeted industry sectors, executive track record and domain expertise and their relevant transactional experience.

The founders and directors of Federal Service Acquisition Corp. have succeeded as board members and executives of federal services and defense companies, the identified target markets. The directors have been involved in numerous acquisitions, they have focused on homeland security businesses, and they have industry backgrounds that likely will be helpful in executing their strategy.

SPAC investors have other reasons to rationalize their investment decision. First, they are counting on the wisdom and seasoning of the founding teams, just as investors in private equity look to the general partners for sound decision-making.

Second, SPAC investors can vote to approve the initial business combination or to opt out and receive cash for their shares.

Third, investors anticipate that the privately owned platform company will be acquired at a private acquisition valuation, with potential for the SPAC to trade at a higher public market price. Other attributes of SPACs provide for time limits within which the initial platform deal must be done as well as the minimum valuation at which this platform will be purchased. Many other features are presented in the prospectus for each SPAC entity.

A SPAC must proceed with its inaugural investment pursuant to the guidelines identified, but the specific platform acquisition structure is flexible. Debt can be used to augment equity capital. Platform company shareholders who are selling can retain an investment in the SPAC at various levels, depending on their circumstances and professional objectives.

In many ways, the SPAC provides a means for sellers to migrate their company from private to public, while getting some liquidity and retaining substantial autonomy ? a powerful combination under the right circumstances.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

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