Are the “Roaring Twenties” the beginning of the SPAC “Gilded Age”?
From the most credible US investment firms like TPG or Oaktree, to seasoned tech veterans like Linkedin’s co-founder Reid Hoffman, to more surprising celebrity athletes Shaquille O’neal or Alex Rodriguez, SPAC sponsors are rolling the drums of this new bonanza, frenzy, tulip mania, boom of SPAC IPOs … This long form article aims to walk the reader through the key elements to know about SPACs, a way to take private companies to the public markets, and the main takeaways about their recent resurgence.
We will here explore the basic mechanics of SPACs and the reasons why SPAC IPOs have become so popular in recent months. The SPAC renaissance is rich in many learnings for technology investors like ourselves as it brought to public markets a collection of disruptive technology companies. Interestingly enough, the revival of this alternative IPO route comes at a time where the number of publicly-listed companies is at a 25-year low. Like every market novelty, SPACs come with innovative practices and numerous challenges we will explain.
What is a SPAC?
Transactions by Special Purpose Acquisition Companies, aka SPACs or blank-check companies, are publicly-listed acquisition vehicles through which a sponsor team of investors raises a pool of cash in an IPO and places that cash in a trust, to be used solely to acquire an operating target company. The SPAC is required by its charter to complete a business merger, or “de-SPAC” transaction, typically within 24 months, or liquidate and return the gross proceeds raised in the IPO to the public shareholders.
SPACs have been around for 15 years and now are established as a legitimate alternative to a traditional merger or IPO. In the 1990s, the SPAC had a reputation for taking small, immature companies public for a large fee, leading to high levels of company failure and lackluster stock performance at the expense of investors. Regulations enacted in the 2000s helped to bring SPACs back into the spotlight, but the financial maneuver lost traction following some high-profile failures in 2008. Their renaissance in 2020 is the subject of this article.
To say the least, SPAC IPOs exploded last year to reach 248 deals, resulting in a 320% increase compared to 2019, 2021 is even crazier. Indeed, there has been a staggering $84bn of IPO proceeds raised through 261 SPACs, eclipsing a record 2020, as of mid-March 2021 only. By contrast, only $3bn were raised through a little 13 SPAC IPOs in 2016, five years ago.
How does a SPAC work?
SPACs have a simple model: raise funds, then find a company to merge with. When they announce the merger, shareholders can either accept stock in the new company or redeem their shares at the original price of the offering. If the SPAC is successful in finding a suitable business, then it does a merger with that company. From then on, the SPAC takes on the identity of the business that it’s acquired.
For the targeted company, a SPAC is basically a deconstructed IPO with a short roadshow where you negotiate with just one investor. It’s a quicker and easier alternative to an IPO, corporate M&A process, or private fundraising. To the SPAC investor, it’s a money market fund with an option attached. For the cost of tying up your capital, you have the option to invest in a — yet to be known — company. From the SPAC sponsor’s viewpoint, it’s like running a growth or PE fund that can only make one investment.
The SPAC itself goes through the US Securities and Exchange Commission’s IPO registration process when it first offers its own shares to public investors. Although the merger of the SPAC with the operating company triggers its own SEC disclosure requirements, those are generally less onerous than filing a full S-1 registration statement to do a traditional IPO. The execution of the acquisition takes 4 to 6 months, requiring due diligence and regulatory filings. SPAC investors must then approve the transaction, which is the biggest risk in the de-SPAC process. If they reject the transaction, it means a deal renegotiation or investors get back to the search process. During this process, the SPAC sponsor will coordinate a second group of investors who invest in the company alongside the SPAC via a PIPE (Private Investment in Public Equity).
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 private equity firms. 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 $1.2bn to $1.6bn. The quality and credibility of PIPE investors are crucial to give a second endorsement to the future public company.
The convention is to price SPAC equity at $10 per share, and the shares trade around $10 until an acquisition target is found. Pre-merger SPAC shares may trade at a slight premium if investors are confident in the SPAC sponsor. For instance, Hedosophia II, run by Chamath Palihapitiya, was trading around $13 per share despite still searching for an acquisition target. Since then, it merged with US real estate technology company Opendoor now trading at $27, already delivering a nice return to early SPAC share buyers.
SPAC fees are 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. It’s 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.
Why take a company public via a SPAC?
In a recent note “Public to Private Equity in the United States: A Long-Term Look” economist Michael Mauboussin set a chart with Strengths and Weaknesses of exit routes to the public markets in comparing IPOs, SPACs, and Direct Listings.
Compared to an IPO, a SPAC is much less risky for the company. It signs a deal with one person (the SPAC sponsor) for a fixed amount of money (what’s in the SPAC pool) at a negotiated price, and then both parties sign and announce the deal and it probably gets done. With an IPO, the company announces the deal before negotiating the size or price, and it does not know if anyone will go for it until after it has announced it and started marketing it through a lengthy and energy-consuming roadshow. Hence, SPACs reduce the market volatility inherent in an IPO process and reduce time spent by management on the listing process.
Interestingly enough, the SPAC boom is concomitant to sharp criticism against the IPO process because of the exuberant “IPO pops” in share price happening during the first day of trading. IPO pops draw increased attention in the media and some think it’s a detrimental situation for existing shareholders and employees. Venture capitalist Bill Gurley at Benchmark Capital has heralded a crusade against IPOs in favor of direct listings or SPACs as a preferred route to the public markets.
“The traditional way of going public is systematically broken and is robbing Silicon Valley founders, employees, and investors of billions of dollars each year. This problem is getting worse every year” argues Bill Gurley on his blog. As you can see by the numbers below, asset underpricing at IPO is growing each year. “The average company that has gone public in H1 2020 was underpriced by 31%. This equates to a cost of capital of 31% + 7% (IPO fees) = 38%.”
Gurley is quite vocal against IPO pops: “At this rate, 2020 IPO underpricing will transfer the wealth of $15bn in one-day giveaways to Wall Street investment firms and their clients. Most of these companies are about 20% employee-owned, so that is $3bn right out of employees’ pockets.”
Dragging down the price volatility risk and speeding up the process, are two key features partly explaining why the SPAC renaissance happened during the Covid pandemic. Another reason could be because IPO roadshows are hard to do, and don’t work as well remotely, so there should be a shift towards one-on-one deals rather than one-to-many capital raises.
Why are SPACs enablers of market evangelization about disruptive technology companies?
Rarely has there been a better period for a highly disruptive company to go public through a SPAC. What’s key to understand is SPAC’s ability to disclose company business plans. Traditional IPO prospectus prohibit companies from including financial forecasts. SPACs, on the other hand, have a private due diligence process that allows companies to present financial forecasts. This opens up SPACs to merge with more vision-driven or high-growth earlier stage companies, where the trailing financial profile is not representative of the company’s trajectory.
In a traditional IPO, a company presents its history and a narrative about its future to an underwriter. The underwriter’s equity research team asks questions to management until they feel like they have an in-depth understanding of the business. Analysts will build their own forecast models which serve the purpose of validating the company’s projections. For traditional business models and slower growth companies, all forecasts tend to be pretty similar because the business and market conditions are understood. But, the IPO process can be crippling if understanding a business requires telling a story about a still evolving and highly uncertain future.
In a recent interview, Social Capital’s founder and SPAC promoter Chamath Palihapitiya stated: “Our mission is to create an alternative path to a traditional IPO for disruptive and agile technology companies to achieve their long term objectives and overcome key deterrents to going public.” Palihapitiya sponsored the highly mediatized SPAC of space travel company Virgin Galactic in 2019 which is now worth $7bn of market capitalization although generating $0 in revenue. SPACs historically have targeted companies that would otherwise struggle to IPO in a stable manner via a traditional banking process. In contrast to IPOs, SPACs are empowered to acquire more “exciting” businesses in industries like space exploration, fantasy sports, or electric vehicles that may appeal to a new type of investor.
It’s fair to say excitement around technology stocks has been exacerbated throughout 2020 on the back of two main factors. First, technology stocks screened as a “safe haven” vs. badly hit traditional counterparts struggling with lockdowns and paralyzed economies. Most technology companies have weathered the pandemic well publishing growth rates stronger than ever leading investors to pour capital into Covid-propelled stocks. Second, central banks have flooded the markets with emergency liquidity sending interest rates to an all-time low, thus depreciating bonds and inflating the present value of free cash flows of fastly-growing companies. To give you a sense of the scale of this, almost 20% of the total US dollar in circulation was printed in 2020 by the Federal Reserve that has injected $1.9tr to relieve a coronavirus-ridden economy. In March 2021, another $1.9tr stimulus package went into effect in the US.
Now mix massive liquidity on the market, positive investor sentiment around growth stocks, SPACs being the ideal vehicle to list forward-thinking (sometimes no revenue) startups … and you have the perfect cocktail for a highly volatile environment. To eat the SPAC cake as an investor, you’d better be a tough cookie able to endure massive ups and downs as illustrated below.
Another exciting development tied to SPACs is that venture capitalists have a preponderant role to play here. Indeed, there are natural benefits for VCs to promote SPACs given late-stage VCs’ synergies with their existing portfolio startups and access to the best companies. One can view the SPAC emergence as a great way for venture capital firms to build out an array of products to support companies throughout their entire lifecycle.
For technology investors like ourselves at Gaia Capital, the ongoing SPAC renaissance is an amazing moment to read the investor presentations of the most promising and disruptive startups around the world. It’s great news we have publicly available information about late-stage startups and disruptive models. We can dive into the market they play, we discover the problems they solve and their product use cases, and of course, their financials projected growth. It helps us refine our benchmarks, our competition understanding, and ultimately strengthen our investor knowledge and convictions about specific themes.
To give you concrete examples, here are some recent SPACs that recently caught my attention. I linked to their names their respective investor presentation:
- Matterport: a spatial data company turning buildings into 3D digital twins filled with insights for property managers
- Otonomo: a platform and exchange marketplace for autonomous vehicle data
- Talkspace: a mental health company giving access to a network of certified psychologists through telemedicine
- Skillz: a mobile games platform connecting players in a fun competition through cash prizes
- BlackSky: a micro-satellite imagery and geospatial intelligence company useful for critical infrastructure monitoring
- Latch: a software and hardware company making buildings smarter and easier to live and maintain
Some SPACs will blatantly fail, overpromising but not delivering, others will be category-defining businesses and long-term winners.
As technology investors, we keep a close eye on this new breed of SPAC stocks giving us a glimpse of the future and the pulse of the market about disruptive companies. All the more so that SPACs are coming to Europe after a roaring 2020 in the US. French billionaires Xavier Niel, Bernard Arnault, and François Pinault have endorsed a team of seasoned investors to sponsor SPACs they committed to. For now, European SPACs are scarce with just 19 listed in Europe over the past six years. One can expect a larger number of European SPACs to acquire local scale-ups in the near future. It could be a great argument for a revived IPO market in the Old Continent and a way to offer liquidity to private and public investors rather than relying too much on US or Asian acquirers. For instance, Tailwind International Acquisition is a US-listed SPAC on the hunt for a European technology target to merge with. It’s set up by a team of seasoned French and German operators and its US listing signals that the Nasdaq will likely remain the hotbed of tech-focused European SPACs in the near future.
Not only did SPACs enable previously forbidden technology companies to go public, but they also gave a myriad of retail investors the historic opportunity to invest in forward-thinking companies. Through a SPAC IPO, retail investors do not need the endorsement of an investment bank to invest. Bankers typically build the pre-IPO order books with blue-chip institutional investors or family offices. In that way, SPACs are agents of democratization in the public markets. Their sudden renaissance in 2020 goes in hand with the steep increase in trading volume from retail investors that are now market movers as exemplified by GameStop’s price action in recent months. Year-on-year volumes on equities doubled in 2021 partly fuelled by the retail crowd enabled by free trading apps like Robinhood.
Less known is that SPACs are also a tribune for investment teams to be vocal about their thesis and spread their beliefs and area of expertise. After all, matching the right target company among many with the right sponsor team is no easy thing and marketing techniques from both parties are helpful. I got interested in a SPAC sponsor team led by Hemant Taneja, a former General Catalyst healthcare investor and co-founder of startup Livongo Health (acquired by Teladoc in summer 2020 for $19bn). He formed Health Assurance Acquisition Corp. (“HAAC”) with a distinctive incentivization structure and published “UnHealthcare: A Manifesto for Health Assurance” as a profession of faith in the future of tech-powered health insurance in the US.
The bigger picture: can SPACs reverse the shift from public to private equity exits?
In the 2000s and earlier on, the conventional wisdom for a startup was to IPO after a few quarters of revenue growth. This left massive gains for public investors, Amazon, Apple, Microsoft all saw outsized returns after their IPOs. Young companies today don’t need to raise capital from the public market because they are generally less capital intensive than their predecessors. For example, companies that did an IPO in the 1970s had lower gross margins, operational costs, and R&D expenses than those that went public in the 2000s. They also had higher CAPEX: tangible investment was double that of intangible investment in the mid-1970s, and intangible investment is one-and-a-half times tangible investment more recently. As a consequence, companies need less capital to fund their operations and hence the demand to raise capital through public markets has diminished.
Below is the evolution of the median age of US companies doing an IPO between 1976 and 2019 going from 8 years since inception until the dot-com crash to 12 years over the last two decades.
The stay-private-longer phenomenon peaked with the $100bn Softbank Vision Fund era. The IPO window had shifted massively: conventional wisdom has been to stay private until you simply can’t raise any more private capital, which could get you to a $50bn private valuation in the likes of Uber or WeWork in the heydays. Many VC-backed companies have had ample access to capital, as large venture firms like SoftBank generalized $100m+ rounds to late-stage private companies, deferring the need to go public. One could argue that staying private for too long sheltered some founders and investors from a most-needed public market accountability. WeWork acts as an egregious example of a private capital goose fed startup.
Michael Mauboussin studied the drop of the number of publicly-listed companies in the US that has bottomed over the last 25 years. Mauboussin showed there has been a shift in US equities away from public markets to private markets controlled by buyout and venture capital firms. Mauboussin noted that more than 90% of the stocks that have disappeared since 1996 were those of small and micro-capitalization companies due to acceleration industry concentration and delisting from buyout firms.
As a result, the exit path for venture capitalists has largely drifted away from IPO to M&A as illustrated below.
It’s not that IPO exits are the best way for venture capitalists to show returns on investment and for companies to thrive. It’s more that this imbalance reduces options on the table for companies and their stakeholders to explore alternative routes to their equity story. Getting back to SPACs, this is where they provide an interesting and useful instrument to give more liquidity options for private investors and access to public equity financing for companies. This could be a great development for a healthy European technology ecosystem which is often blamed for lacking such liquidity events and little numbers of technology IPOs.
As I briefly touched base earlier, one can also point that the shift to stay-private-longer companies creates more wealth in the private market and less in the public market. While individuals are ultimately the beneficiary of the private wealth creation through pension funds or endowments that invest in venture capital funds, a normal individual investor is largely shut out from that source of wealth.
The challenges ahead for SPACs
Despite the positives, there are also challenges and concerns regarding SPAC IPOs. From sponsor risk to low-quality companies to supply and demand concerns, SPACs are far from perfect. For a struggling company, a SPAC may provide a temporary lifeline that is faster to access than the public markets.
For example, electric truck company Nikola went public via SPAC in March 2020, despite not earning any revenue in 2019 and lacking a clearly viable truck model. It saw its market cap jump to $29bn (higher than Ford’s) before its CEO resigned and the SEC opened an investigation into the company for fraud. Stories like this could taint the reputation of SPACs in the future, potentially pushing other companies away from the structure. The chart below exhibits the number of billion-dollar listings of zero revenue companies surpassing the dot com bubble era thanks to SPACs.
Legendary Berkshire Hathaway investor Charlie Munger recently gave an interview on the biggest trends in investing he sees and he was a critic of SPACs: “I hate this luring of people into engaging in speculative orgies. Robinhood may call it investing, but that’s all bullshit”, and “I don’t participate [in SPACs] at all, and I think the world would be better off without them”. There’s no denying that SPAC sponsorship is an easy way to get large paychecks for every stakeholder ranging from the investment team launching the SPAC, to board members, lawyers and bankers, and of course entrepreneurs. Overpromising companies and their most likely bumpy equity story may lure inexperienced investors into large investment losses.
To be clear, a SPAC company will eventually be public and subject to the same set of expectations (beating estimates on a quarterly basis) as existing public companies. Investors are paying a premium to get access to high-growth, exciting companies. But it will be interesting to see what happens if (more likely when) some of the SPAC companies miss their forecasts. One can expect that in the next few years we’ll see more than one securities class action lawsuit pop-up that challenges the historical disclosures and forecasts of a poorly performing SPAC-funded operating company. One study showed that, between 2003 and 2013, 58% of companies that merged with SPACs failed, a higher rate than traditional IPOs. Even if companies don’t fail outright, some negative press may have an outsize impact on the SPAC reputation for companies considering this process in the future.
Another concern is that the number of SPACs may outpace the number of companies willing to go public. Legally, the sponsor is not allowed to express interest or discuss a merger with any potential target companies, which means that, while sponsors may have potential companies in mind, they take their SPACs public without knowing the demand for a future SPAC merger. Moreover, SPAC’s popularity among retail investors is a double-edged sword when it comes to gathering sufficient votes from shareholders to agree upon a transaction and the de-SPAC process. Reports show that individual investors account for about 40% of all trading in SPACs, twice the amount for S&P 500 or Russell 2000 stocks. Problem is that voting mechanisms are little understood by novice investors and gathering votes is a real logistic challenge for sponsors. Low shareholder vote turnout already led to derailing a few merger processes, and this is a situation that could occur more often in the future.
On a concluding note, SPAC prevalence is likely to continue through 2021, with a significant number of both SPAC and de-SPAC transactions in the pipeline. Will the 2020s see a goldilocks IPO window? That’s one promise of SPACs. At scale, SPACs should help to shift the IPO window earlier for companies with a more nuanced story. This gives public investors access to great companies early, and unlocks liquidity for early investors, employees, and founders.
