SPACs — A tale of two brokerages
SPACs or special-purpose acquisition companies are in vogue right now. They are trending among VCs and financiers as a rebranded approach to financing and providing liquidity to a private company. SPACs are also exciting among emerging investors because everyone is talking about them, no one knows what they are, and FOMO is at all-time highs.
SPACs provide certain advantages and present as interesting investment vehicles since they behave almost like separate asset classes. However, to invest properly in a SPAC, we will likely need to set up a second brokerage account.
What are SPACs?
There is a surplus of well-written content explaining the SPAC process. Instead of reinventing the wheel, I’ll point out some great resources here, here, here, and here.
To review quickly, a SPAC, dubbed IPO 2.0, is another way for startups to go public in place of a traditional IPO. Instead, the startup is absorbed or merged into a pre-existing public company, the SPAC, in a de-SPAC-ing process. At the end of the de-SPAC, we have a new publically traded company such as NYSE: SPCE, NASDAQ: NKLA, NASDAQ: DKNG, and soon to be Opendoor.
Are SPACs new?
No. SPACs have been around for a few decades and became unpopular after 2008. The resurgence of interest has been building over the past few years, and the public is just catching on this year.
Some folks are pointing towards COVID-19 as a reason for the resurgence of SPACs—it’s difficult to do a regular IPO roadshow right now when no one is traveling. And even with the coolest of Zoom backgrounds, it’s difficult convincing investors to commit hundreds of millions of dollars virtually. However, I think Uber, Lyft, and WeWork are the early catalysts that got the ball rolling. (Shout-out to Kareem Sabri for his post last year about WeWork’s S-1).
While Uber and Lyft both had disappointing IPOs, WeWork was laughed out of the room by public investors. Airbnb, wanting to avoid WeWork’s embarrassment, completely shelved it’s IPO. Could it be that the public market had lost its appetite for unprofitable startups? If only there were a way for the companies and early investors to buy an insurance policy against turbulent IPO pricing or even the inability to go public at all.
Insurance for startups
As you probably guessed, the insurance policy is a SPAC. Startups can hire someone else to fundraise and IPO on their behalf—remember, a SPAC undergoes its own IPO first as a blank check company lead by a prominent promoter. At the point of formation, no one knows what unicorn the SPAC will merge with; however, we know the person running the show.
- Chamath Palihapitiya, a prominent VC and early employee at Facebook.
- Bill Ackman, billionaire hedgefund manager.
- Reid Hoffman, another prominent VC, and co-founder of LinkedIn.
- Michael Klein, former Citigroup executive.
- Numerous other successful bankers whom we’ve never heard of.
This just an abbreviated list of high-profile SPAC promoters. These folks are all very accomplished in their careers and have a track record of raising money easily. And for the price of $10 per unit, we can entrust our money to them.
What’s the cost of this insurance premium?
A twenty percent promote fee, with additional dilution in the form of warrants, is paid for by the company… but ultimately, the founders and employees in the company are the ones who will foot this bill.
But wait, isn’t this supposed to be cheaper and faster than an IPO?
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.
There will be fees of around 20% of the size of the original SPAC (excluding the PIPE amount), which goes to the SPAC sponsor in the form of equity — this effectively means a blended fee of 5–6% for the company as a percentage of total capital raised, fairly similar to the 5–7% for a traditional IPO. 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.
John Luttig’s breakdown of the fees incurred shows that SPACs currently cost the same as a traditional IPO. Not to mention the warrant kickers issued to both the SPAC investors and the PIPE (Private Investment in Public Equity) investments!
Warrants, similar to options, represent the right but not obligation to buy common stock in a company at a predetermined price, the strike price. Warrants are issued by the company, while options can be created and issued between investors on the open market. Since warrants can be exercised into additional stock, that stock from the warrants is dilutive to the existing shareholders. Keep this in mind as warrants will play a big part in our decision later.
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Okay, well, it seems like the company has to pay to play. As a potential SPAC investor, what are the pros and cons?
The risks
SPACs aren’t silver bullets. In fact, they have interesting drawbacks that make them behave like alternative asset classes. Let’s unpack some of them now.
Inefficient pricing
Matt Levine, a very knowledgable resource on SPACs, sums this problem up well.
If you want to overprice an IPO, you have to convince dozens of big investors to overpay, but if you can find one SPAC sponsor to overpay then you can overprice your SPAC merger. An IPO is effectively a Dutch auction; you get bids from dozens of investors and then price the IPO at the price that clears the market, meaning that the whole deal is priced off the lowest buyer’s price. A SPAC merger — any merger — is just a regular auction; you sell your company to whoever will pay the highest price. Of course the universe of merger bidders is smaller than the universe of IPO investors, so the actual clearing price for a SPAC could well be lower, but if you can find one generous outlier it could be higher.
Matt describes the concentration of pricing risk entirely on the promoter. If Bill Ackman falls in love with a startup and ends up pricing the transaction higher than what the public market agrees with, there’s a chance to lose money as a SPAC investor—after the de-SPAC, the share prices may drop below $10. Thus, a large degree of trust is afforded to the promoter, and it’s the job of the investors to scrutinize and discourage non-arms length transactions. For example, LCA’s acquisition of GNOG appears troublesome since Tilman Fertita is acting as the SPAC promoter and executive at the target company GNOG. In short, he’s selling to himself—it did work for Elon Musk with SolarCity.
Extra due diligence
Different SPACs will have different agreements in place, and it’s essential that as emerging investors, we familiarize ourselves with the agreements and read thoroughly. Here’s another from Matt Levine.
And in fact Bill Ackman’s giant SPAC, Pershing Square Tontine Holdings, does not have a 20% sponsor promote; Pershing Square, Ackman’s hedge fund, is buying shares at their public price and some special warrants at, it says, fair value. The 20% commission that SPAC sponsors historically charged for taking companies public may have been driven in part by the small size and generally dodgy nature of SPACS, which meant that it was hard for a sponsor to find a real home-run trade; for Ackman, having a few extra billion dollars to get him a big stake in a company he likes might be reward enough.
To add on to Matt, the Tontine warrants are structured peculiarly. They are only granted to investors who don’t redeem their SPAC units. The number of the warrants are fixed so that as more investors redeem their units, the more warrants each non-redeeming investor receives. As more SPACs compete for the same startups, non-standard terms will arise, and it’s important to understand what we’re investing in.
Opportunity cost
The biggest drawback considered is the opportunity cost. When a SPAC is created and goes through the IPO process, a target cannot be already identified. After the SPAC is formed and the units are sold, the promoter has two years to find an acquisition target. During those two years, the SPAC price stays relatively steady until a target is announced. Upon the announcement of a target, there is still a chance that enough SPAC investors will oppose the deal to kill it. If a deal is not reached at the end of the two years, the money is returned to the SPAC investors. In which case, the net return is essentially 0. At the same time, we could have invested that money in AAPL during those two years and could have secured a sizeable return. Similar to the pricing risk, opportunity cost depends on the effectiveness of the SPAC promoter.
The advantages
On the other hand, there are significant advantages to investing in SPACs. In my opinion, these advantages outweigh the drawbacks.
Access to pre-IPO companies
Without a SPAC, traditional IPOs aren’t available to emerging investors. The company looking to go public will hire investment bankers to build a book. The bankers will call all the institutional money managers they have relationships with and pitch the company and offer them the privilege of buying in at the IPO price. As retail investors, we can only buy on the first day of trading and often only after a big pop or jump from the offered price.
SPACs, on the other hand, provide the average investor the ability to secure a spot in line. Furthermore, the institutional money managers invest alongside with the PIPE. Imagine getting Snowflake at the same price as Warren Buffet!
Limited downside
If a target is not identified or a merger is not approved within two years, all SPAC investors receive their money, roughly $10 per share, back. The only possible loss would come from some management and admin fees over the two years.
If a target is identified, as the SPAC investor, we can decide to vote against the deal if we think the deal is unacceptable or not at arm's length. By doing so, we will be offered the choice to redeem our shares for $10 per share.
Arbitrage
When the units are sold, and the SPAC is funded, the money is placed into a trust. That trust then invests the money and buys mid to long-term US treasury bonds. If the money is returned or we choose to redeem our shares early, we can benefit from an effect called curve roll-down— the inverse relationship between the yield and the bonds' price causes the bonds to increase in value. Essentially we would receive a return after two years that is higher than if we invested in a 2-year US treasury note.
Warrants
With the limited downside so far, we have a very favorable risk profile skewed towards our upside. This can be further compounded by public warrants offered as sweeteners. The warrants are issued bundled with the common stock to form the SPAC units. A typical SPAC unit will have one share of common stock combined with either a whole warrant or a fraction of a warrant (1/2 or 1/3). The warrants usually have a strike price of $11.50 and are priced out-of-the-money.
If the De-SPAC is a success, and the shares prices jump on the open market, we can leverage our warrants and exercise them to buy more common shares to get a larger return. Here’s a quick example. Let’s say we bought 3 SPAC units, and each SPAC unit contains 1/3 of a warrant.
Investment: $30
Equity: 3 Common shares
Warrant: 1 warrant for 1 share of common at $11.50
On the first day of trading, the stock is now trading at $25 per share.
Proceeds without warrant: 3 x $25 = $75
Procceeds with warrant: 4 x $25 − $11.50= $88.50
If we find this exciting, here’s the icing on the cake. Warrants and common shares can be de-coupled from the SPAC unit 52 days after the SPAC is successfully formed and completes the IPO. This means we can buy or sell warrants on the open market! Yes, I see you /r/WSB foaming a little at the mouth. You can indeed YOLO all in on warrants just like you do for TSLA call options.
A quick guide to SPAC share, unit, and warrant tickers:
- SPAC shares are four-letter tickers, e.g., IPOC
- SPAC warrants are ticker plus W, e.g., IPOCW
- SPAC units are ticker plus U, e.g., IPOCU
*Warning* If the target company shares trade above a certain price, usually $18 per share, after the de-SPAC, the company has the ability to redeem the warrants for their nominal value ( $0.01 per warrant). This effectively starts a countdown for warrant holders to come up with the funds to exercise or end up selling the warrants back to the company for next to nothing. Yikes! This means we need a trading platform that handles the exercising of warrants.
Actionable steps
Robinhood currently does not support warrants. In 2017, Robinhood decided to sunset the support for warrants as a feature. In fact, Robinhood also doesn’t support the buying of units either. Understandably, units contain warrants. Warrants are difficult to price, are less popular than options, and confuse first-time investors. However, I feel like this was a big misstep at what is now unfortunate timing. To invest in SPACs and not participate in the upside provided by warrants is quite a handicap. We need something else besides Robinhood.
TDAmeritrade
ThinkorSwim is TDAmeritrade’s commission-free trading platform. They offer a desktop app, mobile app, a web app, and, most importantly, the ability to buy, sell, and exercise warrants. The user interface is not as easy to use as Robinhood, but for now, it’s the one best viable alternative for SPACs.
I’ll be opening my new account on TDAmeritrade and will plan to move my portfolio over slowly at the end of the year due to tax reasons. Honestly, I would really prefer to stay on Robinhood and can’t help but hope that Robinhood will roll out warrants again before too long. Stay tuned for future posts as I will do a bit of a deeper dive on SPACs I am considering.
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