$SPAC

Recently, I’ve been seeing an uptick of something called SPACs being slapped around the internet. Now, I never saw them before, and honestly, I thought it was a ticker for the next pretentious space tourism company going public. I decided to jump into the void and check it out, so here’s my take on a primer for what a SPAC is:

SPAC stands for Special Purpose Acquisition Company, and it’s pretty commonly referred to as a “blank-check company”. It’s a corporate shell, sponsored by a well-known investor that goes public and raises money from other investors with a plan to find a private company to merge with. The merger effectively takes the target company public, WITHOUT an initial public offering; the SPAC effectively transforms into the target company. BOOM, there it is. It's the new trendy way to go public without dealing with the traditional IPO process (kind of, I’ll dig in more later). Investors who buy the SPAC in its initial public offering don’t know what they’re buying; it will eventually transform into a real company (the target), but they don’t know what company it will transform into. They are effectively buying the target company’s IPO in advance, without knowing what the target company is, or the price. (If they don’t like the target, though, they can get their money back before the merger closes by selling their common shares of the SPAC) This is where the [wall] street cred of the SPAC sponsor comes into play; they’re the ones who are responsible for finding the target company to take public, so they’re essentially the ones that investors are betting on when investing in a SPAC.

Side note: The “hot” IPO alternative last year was doing something called a direct listing in order to go public, but this one is different -- It actually raises money. I’ll make a post on direct listings later.

Before I dive in any further, it would probably be useful to lay out why the traditional IPO “sucks”, which kinda gives an explanation as to why SPACs even exist.

The way an IPO works is you (private company) hire an investment bank, and say “we think we’d like to go public, we need to raise around X many dollars, do you think you could help us with that” and the bank says “yup, that’s what we do, we will find investors for your stock.” And so you go on a roadshow and pitch your stock to investors all around the country, and then a few months later, depending on how the show went, you and the bank settle on a number for your initial offering price. The bank then makes a commitment to issue and sell a certain number of shares of you to investors, at that price. The bank’s job is to make sure that this process will go smoothly.

One thing Venture Capitalists complain about for the traditional IPO is it’s “suboptimal” price discovery mechanism of the offering price. When a stock first starts trading, there’s something called an IPO-pop that happens. Since the price discovery mechanism of a traditional IPO (they market it, and people put in orders, and they triangulate around an “optimal/consensus” price that raises a lot of money while still creating some aftermarket demand) is speculative, there’s a good chance that it could be wrong, and the resulting “pop” that you see in trading prices, whether it shoots up or down 10, 20, sometimes even 50 percent, has a big impact on the amount of money raised and the aftermath of the stock performance. Here, Bloomberg Columnist Matt Levine, lays out the outcomes of an IPO pop:

1. The IPO prices at like $15 and falls to $12, leading everyone to declare it a disaster and to worry that the unicorn bubble has popped.

2. The IPO prices at like $15 and then jumps to $25, leading everyone to complain that the company left money on the table and that the IPO mechanism is broken; or

3. The IPO prices at like $15 and then jumps to $18, leading everyone to give a quiet nod of satisfaction and then move on immediately to complain about the next deal.

Note: There’s something called a Greenshoe that banks utilize in an IPO that helps stabilize the trading price while mitigating its own risk from the price fluctuation of the stock post-IPO. The way a greenshoe works is that the bank actually commits to sell more shares than the company issues. In order to cover the resultant short, the bank also gets an offsetting number of call options to buy more stock from the company at the IPO price.

Now, the SPAC process is said to be free of this lengthy price discovery mechanism and IPO-pop because the price is negotiated only once. The SPAC and the target company negotiate the IPO price once and it’s set. Between the roadshow and the actual IPO, the traditional process can take over a year. The SPAC, however, makes this price discovery process quite literally as short as the discussion between the private company and the SPAC sponsor, so effectively instantaneous. Why does this matter? Well, the price is certain, and while the SPAC doesn’t know how much money they’re going to raise because it’s current investors could ask for their money back in case they don’t approve of the deal (I’ll get into the mechanics of that in a bit), they’ll be raising money at a fixed price. In addition, by cutting down the timeline of the price discovery, the SPAC insulates the price from market volatility.

Let’s take a look at an example company that could’ve benefitted from a SPAC. WeWork once had a $47B valuation and wanted to IPO. After releasing its prospectus, and uncertain market conditions, WeWork’s IPO absolutely derailed in the months after it’s mammoth valuation and its IPO prospects suffered multiple valuation slashes as well as the loss of investor interest. Due to the length and uncertainty of the traditional IPO process, WeWork was heavily exposed to market conditions/speculation that resulted in grim bailouts, investor litigation, general failure of IPO prospects, and you could even say the fall of the company.

Now if WeWork could have, at its peak, or with a solid valuation in general, gone to a company (SPAC) that speculated on WeWork and said “hey, we’ll take you public and guarantee that you’ll raise at least $X at $Y per share", albeit at a lesser-than-current valuation, that would’ve been a hell of a better deal than what WeWork ended up getting.

The lesser valuation is exactly what the private company is paying for in exchange for locking in its price valuation when going public through the SPAC. Instead of relying on multiple investors and general market demand/speculation to determine the price a company IPOs at, with a SPAC, the private company only needs ONE investor, and even then, the private company has negotiation power in the pricing determination. This is the point of SPACS, to cut out the middlemen (IPO bankers) and mitigate risks that come with IPOs that bankers can mitigate for themselves while the company foots the bill. Going back to my original point, when the market is being uncertain, ESPECIALLY at unprecedented times like right now with COVID-19, you can see the appeal of a SPAC since it locks in pricing and allows greater discretion of the private company in this process.

Now it’s also important to note that the SPAC process isn’t 100% immune to the concept of an IPO-pop and mitigating risk against market speculation. Matt Levine explains using the same breakdown as he did for the traditional IPO:

1. Unicorn sells stake to SPAC at a $1.5 billion valuation and then the public valuation falls to $1.2 billion, leading everyone to declare it a disaster and worry that the unicorn SPAC bubble has popped and also probably sue the SPAC for overpaying its unicorn buddies;

2. Unicorn sells stake to SPAC at a $1.5 billion valuation and then the public valuation jumps to $2.5 billion, leading everyone to complain that the company left money on the table and that the unicorn SPAC mechanism is broken; or

3. Unicorn sells stake to SPAC at a $1.5 billion valuation and then the public valuation jumps to $1.8 billion, leading everyone to give a quiet nod of satisfaction and maybe complain a bit about the SPAC's fees.

Looking at this, especially with the varying structures of SPACs today, it’s unclear how the SPAC ACTUALLY solves the problems of an IPO. It just seems like another gimmick IPO alternative that (in its current state) is just meant to reward sponsors and execs rather than being focused on transitioning to public trading. IPOs may be annoying, but they provide entry into a structured, understood, and supported market, whereas, with something as novel as SPACs, it doesn’t really relieve the company of any problems afterward. The problem of going public is not so much going public -- writing a prospectus, doing a roadshow -- as it is being public -- filing quarterly financials, dealing with investors, forever (unless they go private again, shoutout PE).

What I’m getting at here is, usually when you have an alternative that is trying to disrupt a market, typically the process of disruption involves cutting out the middleman and simplifying a process. With a SPAC, you (kind of) cut out the middleman (bankers), but you don’t exactly simplify the process. SPACs are novel, thus have a limited market interest, and can also have really complex structures that can result in lots of confusion that fails to address the actual issues that exist after going public that I mentioned above.

Speaking on the terms that VCs and sponsors love to tout: their SPAC’s cut out Wall Street and thus avoids expenses, I’m not too sure about that. While they may avoid regulations and expenses associated with their merger, the actual SPAC has to IPO on its own first, and wall street bankers are the ones who end up doing that transaction. So not only do the SPACs have to pay their sponsors for finding the target company for a merger, but they have to pay banks to do its own IPO (ironically with the traditional IPO process albeit with a few regulation differences) before it can even have a merger. The more complicated SPACs get (which they already are), the more banking services are gonna be required, which of course, will be done by the same bankers that SPACs are claiming to cut out. With the way SPACs are structured today, it’s just NOT true that the middlemen bankers are actually being cut out. In fact, banks probably LOVE SPACs right now.

Also, while SPACs are marketed as an asset class/investment vehicle and also as an investor-friendly alternative to traditional IPOs, it’s a bit unclear on how exactly they may be better value-wise. The fees are, effectively, much higher for a SPAC than in a regular IPO. In an IPO, you typically pay investment banks a fee of 1% to 7% of the amount the IPO raised. In a SPAC, the sponsor (according to the market rate given by Bill Ackman and Chamath Palihapitiya’s SPACs) charges a 20% fee on the SPAC post-IPO as a reward for finding a target company to merge with. What this looks like is that the SPAC pays its own IPO fees, and you, as an investor in the SPAC, pay the sponsor/advisors to negotiate the merger (at a premium to the IPO fees that the SPAC pays). Sponsors have justified the 20% “promote” fee by more or less stating the same as what Chamath’s camp released in a statement below:

But if his company acquires a business five to 20 times its size through a reverse merger, he said, the fee is the same as or smaller than a banker’s fee — and it is all in stock, so unlike the banks, Mr. Palihapitiya’s interests are aligned with the company’s.

I’m not too sure about that one, let’s break it down with a quick example. Chamath’s “unicorn” SPAC, Social Capital Hedosophia Holdings Corp., has now raised $600 million to go out and acquire a one billion+ valuation private tech company in a reverse merger. Now, SPAC holdings are typically accompanied by PIPE, a private investment in public equity, where the SPAC’s sponsors and their friends will put in a lot of their money in order to increase leverage and grant the SPAC greater purchasing power. Venture capitalist John Luttig explains more on PIPE here:

PIPE investments typically accompany the de-SPAC transaction, which essentially adds more equity leverage to the SPAC. SPAC sponsors coordinate the PIPE capital raise from hedge funds and PE firms, who are tagging along for the ride. The ratio of PIPE to SPAC money is typically between 2:1 and 3:1. This means that a $400M SPAC could effectively generate a total transaction size of $1.2-1.6B.

Note: Chamath’s $600M SPAC, however, is claiming to have the dry powder and leverage for a $3B to $12B acquisition. The final acquisition amount will likely be towards the lower end of that spectrum, but it makes sense as to why a sponsor would want more leverage, as it would essentially generate hype and increase investor interest in the SPAC trust (where the sponsor draws their fees from). I’ll make a separate post digging more into PIPE since it’s generating interest from PE and arbitrage funds in general.

Back to the example, let’s say Hedosophia decides to acquire a $3B unicorn (with leverage and through stock of course). Hedosophia could acquire the unicorn by giving the unicorn's existing shareholders 83 percent ($3B divided by $3.6B) of the combined company, leaving 17 percent ($600M divided by $3.6B) for the original Hedosophia shareholders (and effectively raising $600 Million for its business). In that case, Chamath’s (SPAC sponsor) 20% fee (call it $120M) would be only about 3.3% of the market capitalization of the combined company. At first glance, you could say that the 3.3% fee competes with the 1% to 7% fee of the bankers, however, there’s a very specific detail here that changes the whole game. Investment banks charge anywhere from 1% to 7% of the AMOUNT RAISED IN THE IPO, unlike SPACs, which charge as a percentage of TOTAL MARKET CAPITALIZATION. When you look at a recent unicorn IPO such as Uber, the underwriters were given a 1.3% fee of the total $8.1B raised in the IPO. Now, when you compare the $106.2M Uber’s underwriters were compensated in fees, it was only .15% of the total $70B market cap it had at its IPO. I do want to mention that with mega-IPOs such as Uber’s, the fees underwriters charge are usually very squished towards 1% since it’s a cutthroat bidding war between the banks, but EVEN if we ran the same IPO with a 7% fee (stupidly high for a unicorn IPO), the bankers would only get paid .8% of total market cap at IPO. Compare the .15% to .8% fees of the traditional IPO to the 3.3% fees expected from a SPAC (with extremely levered multiples that too), it’s clear that the SPAC is a MUCH more expensive alternative to the traditional IPO.

SPACs, however, can be structured to align the founders and sponsors to their target company, and can thus incentivize them to act in the interest of the SPAC target when public. Here, John Luttig explains an advantage SPACs have over traditional IPOs:

SPAC fees are mostly equity-based to align the SPAC sponsor and the company, in contrast to the primarily cash-driven fees for IPO bankers. SPAC fees can also be performance-triggered to incentivize fair pricing, such that a portion of the fees will be withheld unless the stock price crosses a certain threshold. Some SPACs use outside bankers to execute the de-SPAC process, which can add some cash fee overhead.

With SPACs evolving considering their limited market until now, their structures are flexible and constantly changing to gain more competitive edges over the traditional IPO. We see this with the performance triggers John mentions, and even with the stock compensation sponsors get. Additionally, we’re seeing whole new structures being legitimized by major investors such as Bill Ackman’s newly announced SPAC:

Ackman’s Pershing Square SPAC has optimized the structure for certainty-to-close, creating incentives around the warrants (1/9 issued upfront at IPO, incremental 2/9 if you choose not to redeem at acquisition) and backstopping the equity check with a whopping $3B forward purchase agreement (there's a bit more to this, but essentially Pershing Square will backstop any redemptions from SPAC investors at transaction in order to guarantee a transaction close). Pershing Square also does NOT receive a 20% promote on the vehicle, instead choosing for ~6% warrant coverage at a strike price 20% above the issuance price (higher than the 15% premium offered to public shareholders), which means they will lose money ($65mn upfront invested) if the stock does not appreciate significantly post-transaction. Not only is there a lot of investor alignment here that mitigates risks associated with SPACs, but the fee structure is starting to look a lot more enticing; As SPAC deal volume starts to shoot up, the process is looking to get more competitive, streamlined (actually cutting out the middlemen), and perhaps even cheaper as it looks to legitimize further and compete with the traditional IPO.

Now, Let’s take a look at this from the investor’s perspective. Traditional SPACs generally IPO with a pool of capital that's held in a trust (cannot be accessed except for a transaction), and IPO investors receive a "SPAC unit" consisting of 1 share of common stock and a fraction of a warrant (generally 1/3). After a number of days post-IPO, the IPO unit splits and the common stock and the warrant will trade separately. As a common shareholder, you are entitled to:

1) the right to redeem your common stock for pro-rata portion of the trust account (essentially meaning you have no risk of principal loss, and sometimes even with positive returns because the fund generates interest as it sits waiting for a transaction).

2) the right to participate in upside from the transaction due to your warrants.

Here's an example: you buy into a SPAC at IPO, 300 units at $10 apiece (so you invested $3,000). Each unit = 1 share + 1/3 warrant, so you own 300 shares + warrants for 100 shares. (A warrant is like an option but traded like a stock. Warrants provide the owner the right -- but not the obligation -- to purchase one share of the underlying company at a predetermined price per warrant. Warrants generally have a strike price of $11.50 (15% above issuance price). You hold the shares and the warrants post-IPO and post-split. Almost all SPAC Warrants have a five-year term after any merger has been consummated. However, SPAC warrants expire worthless if the SPAC can't close a business combination, and thus are a binary bet that the SPAC will merge with a target company before the date of expiry of the warrants (outlined in it’s terms when issued- typically 2-5 years).

So let’s say the SPAC announces a pending acquisition 12 months later. You are now faced with a choice: redeem your common stock, or participate in the transaction.

Say you don't like the acquisition target at all - you think it's a crappy business and you want no part of it. You redeem your common shares, so you get your initial $3,000 back (likely will be slightly more in reality due to some appreciation over time, or could be slightly less depending on the yield to maturity). You still hold onto your 100 warrants.

The transaction goes through. A few months later, the stock trades up to $15/share - the market has determined that your judgment about the company was wrong. You choose to exercise your 100 warrants, so you receive $3.50/warrant in profit ($15/share - $11.50 strike price) and earn $350 in total profit. If you decided to keep your common shares at the time of the merger, you now have access to those AND your warrants, potentially bringing in some serious upside.

The takeaway: SPACs are unique in that they provide essentially “no downside” as an alternative to cash but could potentially result in a significant upside for shareholders if they make a good acquisition. There have been a lot of run-ups in SPAC-backed companies recently (Nikola, DraftKings, Virgin Galactic, etc.) so there has been some greater interest in the space. Now, SPACs have generated a lot of “genius” interest from having “no downside”, but not all SPACs have made the right acquisitions, and people who held onto their common shares through the SPAC units have lost a good amount.

ALL THIS BEING SAID, SPACs are rapidly evolving and are in a current climate to thrive. I’m really enjoying the show as of now and am interested to see how newer and larger SPACs structure and perform in general. They have a long way to go in order to replace the IPO, but I do think there’s a ton of development left in this new industry and am curious to see how it all plays out.