Barron's Streetwise - 23andMe and the SPAC Pullback

Episode Date: June 4, 2021

The genomics company's founder has big ambitions. Plus the bull and bear case for Special Purpose Acquisition Companies. Learn more about your ad choices. Visit megaphone.fm/adchoices

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It was unknown, you know, how many people were actually going to get connected through 23andMe. And now I would say I get a story almost every day. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard, that's Ann Wojcicki, co-founder and CEO of 23andMe. It's in the genealogy business and the genomics business and increasingly the healthcare business. We'll hear more about Anne's ambitions in a moment and about why she chose to go public through a merger with a special purpose acquisition company or SPAC. The SPAC market in general has gone from a frenzy to a slump. Coming up,

we'll hear from a prominent SPAC bull and bear about what comes next. I've never researched my family tree. I suspect I come from a long line of people who just aren't that curious about genealogy. I would like someone to answer for why my last name is spelled H-O-U-G-H but pronounced How. All the famous H-O-U-G-Hs pronounce it Huff, like Julianne Huff, the TV dancer and singer, and Charlie Huff, the former knuckleball pitcher. And all the famous Howes, they spell it H-O-W-E, like hockey great Gordie Howe. I can't rule out the possibility that I come from people who've been pronouncing their own

name wrong for generations. And I'm not sure a saliva test would help get to the bottom of that. And I'm not sure a saliva test would help get to the bottom of that. But these days, genealogy kits can do more than fill in family trees in a hurry, like tell who's predisposed to certain diseases. And all that genetic data put together might hold a key to treating diseases, which has Wall Street's full attention. Wall Street's full attention. Last year, private equity giant Blackstone paid nearly $5 billion, including debt, for the genealogy player with the largest user database, Ancestry.com. And this past February, the company with the second largest user database agreed to a merger. It's the first genealogy player to win FDA approval for offering risk screening for diseases, 23andMe.

I've been an early investor in 23andMe. I even managed to discover that my great, great, great grandmother was from India. Sir Richard Branson, the billionaire daredevil who founded Virgin Group and its space flight startup Virgin Galactic, which was brought public in 2019 in a SPAC deal. Well, he has a SPAC of his own called VG Acquisition. And for its target, VG selected 23andMe. And the two reached a deal that valued 23andMe at $3.5 billion. SPACs, of course, are special purpose acquisition companies, sometimes called blank check companies, and we've talked about them before. They raise money through initial public offerings, often at

$10 a share, with the promise that the proceeds will be used to buy a promising target company to be named later. What's notable about the 23andMe deal is that the announcement came just before the peak of a massive run-up in SPAC launches and share price gains. Two weeks after the 23andMe announcement, a professor named Ivana Nemovska wrote an article in Harvard Business Review arguing the SPAC bubble was about to burst. It was titled, The SPAC Bubble is About to Burst. And pretty much right away, SPAC prices started tumbling. traded fund called Defiance NextGen SPAC-derived ETF, ticker SPAK, which holds shares of companies that went public through SPAC deals, like Virgin Galactic and DraftKings, the online betting company. The ETF went from $34 when the article was published to about $22 at one point last month,

before rebounding a bit to a recent $25. We'll hear more from Ivana, the article author, in a moment. First, let's get the perspective of a company caught up in the SPAC volatility. Everyone should have their genetic information. It's like looking in a mirror. In the early days, people bought 23andMe because it was new and it was interesting and people were curious just about genetics. And I think more and more, especially as people are used to this personalized world in shopping and in TV, your health absolutely should be personalized. That's Anne Wojcicki, the co-founder of 23andMe. Her father, Stanley, was the chairman of the physics department at Stanford University, so Ann and her sisters grew up on campus. One sister, Susan, became the CEO of YouTube,

and another, Janet, became a Fulbright scholar, an epidemiologist, and anthropologist. Want to raise wajiskies of your own? Anne's mother, Esther, an accomplished teacher, wrote a book on the subject. It's called How to Raise Successful People. Not a bad title. I'm working on a parenting book called Get That Out of Your Nose and Wash Your Hands. Anyhow, Anne began her career as a healthcare investment analyst and co-founded 23andMe in 2006. The name 23andMe comes from the 23 pairs of chromosomes found in human cells. And as the name and Anne's background suggests, whereas

Ancestry.com is a genealogy company with potential to expand into health care, 23andMe was started as a healthcare company with a genealogy hook. Here's Anne. 23andMe really started out with this premise that you have a secret code within you. Your genetic code is only four base pairs, and you're connected to all of life. There's this opportunity to understand the code and ancestry is a huge application. Same as health. Health is a huge application. Anne says one thing that's different from when she started is the sheer number of people discovering surprising connections in their family trees. Another change is the level of detail available on where people come from.

trees. Another change is the level of detail available on where people come from. Ann says it's like satellite photos. The information used to be foggy and grainy, and now it's highly detailed. A third change has to do with something called polygenic risk scores. Here's Ann. Looking at all common disease and being able to look at hundreds or thousands of genetic mutations that add up into a score. And that is really a huge transformation for the entire field because you're going to be able to look at every single condition out there, whether it's heart disease or arthritis or macular degeneration and put people on a scale as to where are you relative to risk of everyone else out there. 23andMe can test for predisposition to things like type 2 diabetes and celiac disease, and for mutation linked to risk of breast cancer, and for carrier status for diseases like cystic

fibrosis and sickle cell anemia. We've had Regeneron CEO on this podcast. The company uses genetic information to make drugs. I've toured its genetic research center and it's impressive, but 23andMe says it has around 10 times as many genotyped individuals in its database, 11 million of them, eight and a half million of whom have given permission for their information to be used in drug research. Why do so many customers give permission? Here's Anne. We all get sick and we all have a friend or a family or a colleague who has had a awful health story.

And we all participate in these walks and fundraisers and we can relate. Like we try to help each other on this. And what I find that what we're trying to do here is really tell people that we are actually all going to benefit if we all participate in research. Of course, 23andMe stands to benefit too. Regeneron is a $53 billion company. If 23andMe can put its genetic information to fuller use in drug discovery, maybe it can be worth a lot more too. To that end, the company has a joint venture with GlaxoSmithKline, the British drug maker, to develop treatments for cancer, metabolic disorders, and immune system and neural diseases. There's one program in early clinical trials and others in preclinical research.

If these programs come to market, 23andMe gets a revenue split. And that gets to why Ann felt now is the right time to go public, and this particular SPAC is the right path. As we think about a bigger stage where we can influence the practice of medicine with genetics, as well as really influence drug discovery, we think about access to capital, looking at acquisition opportunities, and really being able to leverage what we've built to have the kind of impact in the world that we want to have. So the SPAC process is really interesting for us. We got lucky to work with the Virgin team.

Richard Branson was an early Series A investor in 23andMe, and we had had a history of the last 10 years of periodically coming to Richard for advice. And they also really know healthcare. One of the defining features of the SPAC process is that it gives companies much more leeway to talk up their prospects. To boast and forecast, in other words. VG Acquisition has a slide deck with bar charts showing 23andMe selling 1.5 million DNA kits this year and then growing that to 2.5 million by 2024. By then, it predicts it will double its number of therapeutic targets, drugs under research, in other words. Maybe the boldest prediction is that 23andMe will attract

nearly 3 million subscribers by 2024. Customers can pay $99 for an Ancestry and Traits kit, or $199 for a kit that adds health information. But there's also a new service for $169 up front plus $29 a year, which provides ongoing reports tailored to each customer's health. Wall Street loves ongoing subscription revenue, so if 23andMe's predictions are right, its investors could profit. But let's remember that much of this is theoretical, and the things might not work out like the slide deck says. One of the features of SPACs is that investors can ask for their $10 a share back before the merger closes. That gives them some downside protection early on. If investors view the transaction as promising, shares can rise above that $10 floor. VG Acquisition, ticker VGAC, it shot up to $15 right after the 23andMe deal was announced. Now that the SPAC market seems to have cooled,

it was recently trading at a penny or two under $10. I asked Anne, does the volatility bother you? She says no. I really think about 23andMe in the long term. There's a huge world. Everyone out there, majority of people, understand that genetics is going to be part of their life and part of their healthcare. And so do I worry about the short-term volatility?

Like, absolutely not. Like, I know our place in history and I know the types of things that we can do and got cut off there she was saying I know the types of things we can do but what happened was as Ann was saying that Charlie her beagle puppy pulled down the ring light that Ann uses for video conferencing and Charlie got scared from the noise and yelped. But don't worry, Charlie's fine. Is she okay?

Okay, Charlie. Are you okay? Yeah, yeah, yeah. Sorry. No dogs were harmed, didn't they? Although one got startled. 23andMe seems happy with its SPAC deal, but what about all the other SPACs out there? It's time to hear from our bull and bear, right after some brief but scintillating stage setting.

Now, in a typical merger, a big company absorbs a smaller company, or two companies of roughly equal size join together. There's also something called a reverse merger, where typically the empty husk of a forgotten company is used for its stock listing. If you inject it with cash and use it to buy a healthy private company, presto, the private company is now publicly traded without going through the cumbersome process of issuing shares to the public itself. A SPAC is similar, only the shell company is set up from the start with the goal of doing a deal, and the management is already in place. SPACs have been around for decades, with a dozen or fewer deals most years,

including some high-profile companies like Burger King in 2012 and Hostess in 2016. The number of deals multiplied as markets turned frothy and meme trading took hold, particularly in 2020 and early 2021. Celebrities got involved in sponsoring SPACs, including basketball big man Shaquille O'Neal. When it's time to make a move, we make a move. When it's time to sit and just try to weigh things out, we sit and weigh things out. But again, I just try to make investment on things that are just, you know, make people happy. One result of all this is that there are hundreds of SPACs that have raised money from the public and now must do deals or else give the money back,

typically if they can't get a deal done within two years. SPAC sponsors can pay millions of dollars to launch SPACs. Their incentive is that when SPACs buy target companies, the sponsors are often rewarded with deeply discounted stock. They can make many times their money, but if the deals don't get done, they have to eat their upfront costs. So in other words, there are hundreds of highly motivated, cash-filled companies shopping for Targets now, at a time when Targets are nervous about the trading volatility they've seen in SPACs, which raises the question of whether SPACs are about to go on an overpaying spree and why investors would want to buy shares of SPACs now. You know, all these headlines that we read,

including myself, if we don't look at the actual facts, one would feel a significant amount of alarm and panic that something is fundamentally wrong. But if you look at the prices, if you buy all SPAC deals at IPO, 10 bucks a share, and you held them through to now, you'd be at $13 on average across the entire cohort if you could afford to buy everything. That's Rajiv Shukla, CEO of Constellation Alpha Holdings, who has done two SPAC deals and is eyeing a third. Rajiv was the global head of mergers and acquisitions for the R&D division of Pfizer, so he focuses on healthcare deals. His first SPAC bought a company called Dermtech, ticker DMTK, which does skin cancer diagnostics based on genomics, and which Rajiv calls the best performing healthcare SPAC deal

of all time. His second SPAC is in the process of buying a company called Humacyte, which Rajiv says can make human organs in a factory, not in a lab. He says it can make blood vessels and a pancreas and a functioning lung. Here's Rajiv on the pancreas. What Humacyde has done is they've created a product that can be delivered through an outpatient procedure, meaning you don't have to go under. It's like going to the dentist or the optometrist. You know, you get a local anesthetic and they implant the pancreas. And now, you know, over time, your diabetes goes away. I should add that this is a development program for a pancreas and that not all development

programs work out. I should also note that if you asked me to point to my own pancreas, I'd need three tries and a margin of error of a liver and a half. In other words, I haven't reviewed Humacyte's technology, and please don't tell people that Jack from Barron's says you can get a new pancreas during next teeth cleaning. I did ask Rajiv how long he thinks it will be before those outpatient pancreases are available, and he said, before we're on Mars. Doesn't sound super soon, but let's see. Anyhow, Rajiv has bought a service for SPAC research. It's called SPAC Research. He tracks past returns and he says that SPACs that have come public in recent years are trading

on average at around $13, which suggests that investors have made good upside. at around $13, which suggests that investors have made good upside. And there's the option of exiting at $10, which provides downside protection. Rajiv views SPACs as a good deal relative to venture capital investing, which isn't available to everyone and which can come with high fees. He says the market got crowded with celebrity SPACs and too many SPACs related to electric vehicles. He thinks there will be a shakeout, but that SPAC sponsors with plenty of experience in capital markets and private equity will continue to be successful. As he puts it, if you're born on rocky terrain, you know how to navigate rocky terrain.

But if you're born on the beach, rocky terrain isn't for you. rocky terrain. But if you're born on the beach, rocky terrain isn't for you. Folks who are from a PE background, who've got those networks with bankers, with capital to source deals, they're not very phased by this because you hunt and compete for transactions anyways in the private markets. Do we look at some of these SPACs that are coming in with less experienced guys with some amount of concern, absolutely. An unsophisticated competitor can be quite a scary competitor because they'll be willing to do whatever it takes to get the deal, which may then flounder subsequently. Rajiv says that if you're buying a SPAC at a significant premium to its IPO price,

be careful that you're not just getting caught up in hype. He says that it's true that sponsors like him can make good money from getting discounted shares, but that they also risk having their equity stakes negotiated downward as part of the terms of the deal they do with a target company, or as part of the specialized financing they receive from outside sources

called private investment in public equity or pipe financing. There's also the reputational risk of a deal flopping. You're only as good as your last deal. So acutely aware of the pressure of performance and very, very keen on ensuring that we keep putting up wins on the board because you're only as good as your last win. You know, keep putting up wins on the board because you're only as good as your last win. To be clear, the returns Rajiv was talking about earlier are for SPACs that haven't yet done their deals. There's a limited history on those.

Another way to measure returns is to look at what happens after SPACs merge with their targets. And those numbers haven't been great, or good, or even just okay. The problem is what happens after they de-SPAC, after they acquire a target. And then the annual returns are minus 15% on average in 2019-2020. That's Ivana Nomovska, a professor at INSEAD, and the author of that article that precisely predicted, or maybe even helped cause, the bursting of the SPAC bubble if it has, in fact, burst for good. Ivana says the flood of SPACs shopping for deals now is a problem. It will allow for pricing of targets that will not necessarily be in the best interest of the smaller shareholders and the non-sponsors. So what we are seeing is, this is anecdotal evidence, but what we are seeing is that a

target can potentially decide to close a deal with a given SPAC in a shorter time frame because it has more negotiation power and that shell company and those sponsors will have less time to also engage in proper due diligence, which inevitably will harm shareholder returns. Ivana says celebrity involvement doesn't necessarily help returns. She didn't mention Shaq, but she did mention former baseball great Alex Rodriguez, whom she says she likes to call the ex-boyfriend of Jennifer Lopez. Ouch. Sorry for that beanball, A-Rod. Take your base. Jennifer Lopez. Ouch. Sorry for that beanball, A-Rod. Take your base. Here's something counterintuitive. The whole appeal of a SPAC deal in the first place for the target company is supposed to be that it's easy and cheap. Ivana says that's a myth. It's

not cheap. When you ask a SPAC target, why did they choose to go public with a SPAC, they would typically say it's faster and more certain. They would also invoke this regulatory arbitrage, the safe harbor, where they can make forward-looking statements without really being legally liable if they are overconfident and overpromising. And another aspect is that some of them think it's cheaper to go public with a SPAC. And the data doesn't seem to support that. So the total cost of a median company going public by a SPAC merger between January 2019 and June 2020 was about 14% of the post-issue market cap, while it was about 4.8% for the traditional IPOs. It's hard to say whether SPACs will have another leg up from here, but Ivana says a regulatory crackdown from the Securities and Exchange Commission is coming. They will impose, in my view, new guidance,

potentially new rules and regulations that will create incentives so that better SPACs take place out there and make more salient to sponsors the risks that come from acting not in the best interest of shareholders. And these will be legal risks, right? So you envision that there will be a SPAC marketplace going forward. It would just be smaller and maybe less volatile, less exciting than the one we've seen in recent years? Yes, absolutely. I think SPACs are here to stay, just like any traditional reverse mergers are here to stay. But they will have to evolve and

adapt to the new environment and the market learning. Thank you, Ivana, Rajiv, and Anne, and thank all of you for listening. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts or Spotify or wherever. If you don't follow me on Twitter, I mean, you're probably showing good judgment. See you next week. I feel like if I had a catchphrase here, I could really punctuate it. Good luck, and don't forget to do your hot diggity due diligence. That's got potential.

I think that's the one.