Motley Fool Hidden Gems Investing - SPACs Revisited

Episode Date: May 21, 2022

Hey, what happened to all of those SPACs going public? Dylan Lewis and Bill Mann look back on the great SPAC boom, when more than $240 billion flowed into blank check companies between 2020 and 2021, and discuss: - The incentives that both created the boom and bust - Rare SPACs that may have a bright future ahead - A potential arbitrage opportunity for investors watching SPACs Stocks mentioned: NKLA, DKNG, LCID, QS, UTZ Additional resource: What Are SPACs in Finance? - https://www.fool.com/investing/how-to-invest/stocks/spac/ Host: Dylan Lewis Guest: Bill Mann, Chamath Palihapitiya Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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do you think right now there are 8,000 publicly traded companies in the United States? So not an apples to oranges comparison. Do you think that there are 600 companies that are ready to go public right now? I'm Chris Hill, and that was Motley Fool senior analyst Bill Mann. You remember the great SPAC boom of 2020 and 2021, right? Dylan Lewis and Bill Mann are taking a second look at what happened when more than $240 billion into blank-check companies over a two-year period. And so far, most of them haven't really done so well. Out of nearly 200 companies that used a SPAC to go public last year, just 11% trade above

their offering price, and some of the most talked-about companies, including Nikola and Virgin Galactic, are down about 90% from their all-time highs. The guys break down the incentives that created the boom, the rare SPACs that are showing showing some promise, and one arbitrage opportunity investors might want to know about. We're checking in on SPACs and trying to pull lessons from the past two years. Bill Mann, thanks for joining me to walk through it all. How are you? I'm doing all right. Perhaps not as good as the recent SPAC classes are doing. You've been

Investing a long time, Bill, you have seen the market through cycles, through crashes, through fads. If you could capture the rollercoaster of SPACs over the past couple years, how would you do it in a sentence or two? Really, how I would do it is to say this, there ain't no such thing as a free lunch. SPACs became spectacularly popular in 2020 and 2021. In 2020, there were $83 billion worth of deals that were launched through new SPACs. In 2021, that number was $161 billion. And you have to ask yourself why a formerly somewhat disreputable way of going public became so hot.

And it's very rare, Dylan, that things like this happen in such volume if it is beneficial to the buyers of these instruments. Now, we've always described SPACs as being a little more than a bank account plus a promise. And what we found in 2022 is that that was exactly the case. So, I could ask you to explain a SPAC, but I think it would be more fun to roll some tape from our interview vault. I want to make sure we lay that context for our listeners. Back in 2020, you spoke with Chamath Palihapitiya, the CEO of Social Capital and the SPAC king. Here was his quick pitch on SPACs. A SPAC is a special purpose acquisition company. So what is it? It's basically a group of people.

The leader of that group of people is called the sponsor. So in my case, it's myself and I have a handful of partners that I consistently work with in these things. And we file an S-1 and go through a traditional IPO process, except that what we are describing in the S-1 is essentially a company that has one asset, just money. It doesn't make a product. It doesn't sell anything. And then the purpose of that vehicle is in the business of finding another company to acquire. And so, you know, whereas Google's S1 would have described a search engine in the business of acquiring users and, you know, providing them relevant information, et cetera, et cetera. Ours is a shell company, a balance sheet of cash, which we then use to go and find a business that

we think is really compelling and interesting. And we can describe that interest on many dimensions. It could be geographical, it could be about a specific vertical, and then we go and we buy that company. When we do that, it's effectively a merger. And so for the company that we acquire, they go public by being acquired by us. And what it does is that it allows them to actually write an S4 document together. And by writing an S4 versus an S1, we are covered under a different body of law, securities law, that's enforced by the SEC. And the major difference is there for the purposes of the viewers and the listeners is essentially that it allows you to talk about the future. And the reason why I think that single thing is such an important

feature for SPACs and why SPACs are a really important part of building a modern portfolio is that in a world of zero rates, I would sort of put out there that everything is about the future and that you need to be really understanding the potential of a company's performance in 2023, 25, 27, 29, 2030 even. And that those future cash flows,

especially for technology companies, are very poorly described by looking at the past. So 2016 through 2019 don't really mean much for 2025's earnings. That's not true for other businesses, but it is very true for tech businesses. And so the S4 process allows Vivek and Andrew, myself, the ability to really understand the business, underwrite the future for many years out, and then have a conversation with people who may potentially be interested in buying it about describing that future performance and then give folks the chance to buy. Bill, as you mentioned, SPACs absolutely

surged in an incredible way. It almost defies hyperbole, the activity that we saw. Chamath was a big part of the reason why. He famously wanted to bring companies public from ticker IPO A to IPO Z, and was behind the debuts of Opendoor, Virgin Galactic, Clover Health, and SoFi. How would you characterize, on your end, the appeal of SPACs? What were your impressions as we saw this activity blossoming? Internally, I had released a document in late 2020 basically saying that there was really no functional difference between coming public through a SPAC and a traditional IPO. What we were just talking about was simply a new wrapper for the same purpose. Also, at the end of the day, we caution people.

It's really, whenever you see something where something becomes as popular as this in any form of finance, you need to be careful. Because SPACs, ultimately, they were a promise that was somewhat unfulfillable. Because as Shamath Palihapitiya said, one of the things that you get to do if you go public merging with a SPAC is you get to use an S-4 form instead of an S-1. Now, that sounds like government Ds, but S-1 forms have a form to them that's really important for investors, and it is this. You can't be too promotional about what your company is. It is a lot of what is, whereas the S-4 is, what do we think this company will be? And there are reasons why you would really appreciate a Form 4 in the hands of someone

who is not promising the moon and the stars. Because, obviously, whenever a company goes public, you're not buying it based on what it is. You're buying it based on whatever you think it will be. Maybe you could go farther to say that's true with any investment. So, a Form S4 seems like a really good idea. But Dylan, what you had instead was five different electric vehicle companies coming public through SPACs, filing S-4s, and saying that they would within five years have $10 billion or more in revenues. That was their projections. That has only happened once ever with any company, and that company was Google. So, what ended up happening with S-Force, and Chamath was right to a degree, but the lack of oversight and the lack of experience that

investors had with SPACs, to me, was a real signpost that there were going to be some abuses coming down the pike. Bill, do you think to some extent that's emblematic of how much we were in a growth-on mindset over the last three to five years? SPACs are generally priced at about $10, not about, exactly $10 per share when they were launched. And so, when you had a SPAC, before it met a dance partner trading above $10 a share, you were literally saying, hey, that's a bank account there, and I would like to buy those dollars in that bank account at two to three times the price that I'm willing to pay. So, I'm willing to pay you $2.50 for each dollar in that bank account. And to me, it just ultimately

became a question of, does that actually make sense? And in the main, the answer was no. Yeah. I can see, though, why seeing these valuations in the private markets, because of how active we've seen the private markets over the last decade, you would look at that and say, I have seen these businesses swell to valuations in the tens of billions of dollars. This vehicle is letting me hopefully get in on businesses that I otherwise wouldn't necessarily be able to and be alongside some pretty well-heeled investors. Right. And it's not the dumbest theory in the world, right? If you're talking about a pre-merger SPAC, you are, in fact, talking about getting in on something before it becomes public. But Dylan,

the challenge became this. The reason why SPACs became popular from the other side of the ledger is that so many insiders watch their companies come public through a traditional IPO, and they would leave lots of money on the table in the form of the IPO pop. You've got a company that comes public at $20 a share, and it immediately, once it hits the open market, moves up to $50 a share. That means that's $30 per share that has been offered of money that is going to someone other than the company itself or the selling insiders. That's, in fact, a problem. It's part of the gamesmanship, if you will, of the IPO process. But that does not mean that a SPAC is necessarily a better way for the outsider to move to the inside. At the same time,

The reason that SPACs were coming along and became popular was that the insiders were trying to prevent the outsiders from ending up with all of the money from the event of going public. So, I'm sure a lot of those outsiders, and we're generally talking here about the retail investors that wound up buying these shares, are not particularly thrilled at the way that this class has performed. They are, in a lot of ways, the growthiest of growth stocks, and we know that that category has been absolutely punished recently. When you look at the growth of this space over the last

couple of years, who were the winners? The insiders who actually took companies public were the winners because they were able to, in some cases, there were some really abusive cases where you would see the promoters bringing, let's just name a number, which sounds both low and high at the same time, $50,000 to the table. And because of the incentive structure that was place on the SPACs, they would end up with millions of shares of a company once the SPAC merged in with a company. It happened over and over and over again. At that point, when you start with $50,000 and you end up with millions of dollars worth of shares, do you care that the stock drops that much? You don't. You have absolutely positively won. The insiders won

in a great deal of the situations. There have been some companies that have done okay post-SPAC. I mean, it's not a segment of the market. I don't even think of it, you used the term asset class earlier, and I would disagree that it's actually an asset class. It's just a strategy. It's a strategy that tended to, to let you up off the mat in this description, It tended to attract growth companies that wanted to go public. But SPACs themselves, you could end up putting anything into that vehicle, and it would have been okay. I'll use Bucket next time.

Thank you! I don't ask for much here, Dylan. I want our nomenclature to be proper. It's a reasonable way to describe it. I just don't happen to think that, I mean, SPACs, you could probably call an asset class before they find a merger partner, because they are, as I described earlier, just bank accounts looking for a home. And actually, those high-level numbers we hit before were referring to those SPACs overall,

not necessarily those who have found dancing partners. And I want to talk about the other side of this. So, we were talking through, okay, the performance of companies that came public this way. and it's been fairly disappointing. Some of that is market conditions, and some of that's just the reality of how forward-looking a lot of those companies were. There's another piece to this, though, where there were SPACs that were created that have not yet found their dancing partner. That means that there's cash that's available in the market here. Bill, what do you make of that? That is so important. There are currently

600 SPACs, more than 600 SPACs, that are looking for companies to buy. And if you think about that, do you think right now, there are 8,000 publicly traded companies in the United States. So, not an apples to oranges comparison. Do you think that there are 600 companies that are ready to go public right now? I mean, the answer is, Yeah, you're shaking your head, which is great radio. Great radio. I know. I didn't want to cut you off there. But yeah, just think about the sheer percentages of that. 600 over 8,000. Right, exactly. 15% of the publicly traded market is currently in the form of SPACs that have not found a merger partner. Now, the reason why that's important is that

SPACs generally are given a two-year period in which to find a merger partner, or one of two things have to happen. Either the members of the SPAC, the owners of the SPAC, have to vote to extend that period of time, or they've got to give the capital back. And when they give the capital back, they give it back at $10 per share. So, there's some interesting opportunities out there right now in arbitrage, where there are SPACs that are coming close to the end of their period that are trading below $10 a share. Again, the efficient market theorist in me says that shouldn't make sense, but there's always the risk that their period of time will be extended to find a merger partner. We've been in a space recently where

growth stocks in the public trade markets have been absolutely walloped. We don't have as much insight into the valuations of private companies. They're not something that gets updated by the minute or by the day. But there's a part of me that thinks, we've seen growth stocks get hit hard. We know that there are some high-growth private companies out there that are probably going to have their valuations reflect what's going on in the public markets at some point. There's some cash here on the sidelines with these SPACs. Does that create an interesting acquisition opportunity? Do you think there's going to be a little bit a bump in activity because of these compressed valuations?

That's definitely possible. You were exactly right. I very artfully dodged the question when you were talking about the private market valuations perhaps being at least an explanatory reason why SPACs became so popular. We are now seeing companies that are having to have down rounds that are still private. I think that you're probably going to be seeing companies that have been valued on a private market basis. Let's be frank about this. Private market valuation is, in some ways, their made-up numbers. That's essentially like you being an 11th grade calculus class and teacher saying, Dylan, how do you think you did? And you're like, I think I got an A, Bill. I think I got an A. I think I got an A. I think my company is worth

$50 billion, even though it doesn't make a penny. So, some of that is, you know, they're creating the own momentum around these private valuations. But with these venture capitalists, they do want an exit event. And there are, as you mentioned, ready buyers in the form of SPAC companies that are looking for merger partners. So, I think maybe you might actually see some more activity. It's not going to be on the same frothy level as when Nikola came public through a SPAC in the middle of 2020, and it was as if the stock price had been shot out of a gun. I mean, it just rocketed higher, even though they had barely any revenues at that point. I do wonder what the quality of businesses would look like that would come public that way. Because

One of the concerns that I had in looking at SPACs in general over the last couple of years was, these are not going through our traditional IPO pipelines. What does that say about the businesses that will be coming public? I think we've seen a range of answers on that over the last couple of years. Yeah. There are two answers there. One is, again, we talked about the SEC form arbitrage, just to be really, really fancy about it. The companies that were able to come out and promised the moon and they didn't have anything. There are really two ways that you can think about going public through a SPAC versus going public through an IPO. There were companies that didn't want to go public through a traditional IPO with, as you described, that period of

time in which the investment bankers come in and actually do analysis to put a valuation on the company. There are other ones that probably couldn't go through a traditional IPO, where the easiest route to the market was going to be, find a single credible SPAC and merge in with it. Next thing you know, you're publicly traded. I think, ultimately, because of the volume of SPACs that were launched in 2020 and 2021, as I mentioned earlier, there are still 600 that are out there that have not consummated Merger Partners, that there was a lot more of the latter, of the type that just used this as an opportunity to go public without having to go through that scrutiny, than there

were high-quality companies that went this route because they thought they would end up with more of the money in the coffers of the company than through a traditional IPO. In researching the show, I thought it was interesting. We tend to look at SPACs and say, this was a two-ish year phenomenon that just happened. If you zoom out a little bit, we saw a growing SPAC activity in the mid-2000s. It was basically ended by the great financial crisis. I'm not saying in any way that SPACs are a leading indicator of downturns or recessions or anything like that, but I do think that there's something interesting there about the activity and the deals you are more likely to see at various points in market cycles.

You said it earlier, and I love that point. Now, the number of SPACs that happened in 2007 was a tiny fraction of what happened in 2020 and 2021. But you're exactly right. When 2008 hit, that activity dried up entirely. Just poof, went away. I wouldn't describe SPAC activity as a leading indicator, but I would pay more attention in the future about what types of companies are coming public this way. Because if they are getting credibility by virtue of going public through a SPAC, it really may be a sign, as you said, that we are in a growth-on and a risk-off environment. Investors are just simply not considering the downside of certain vehicles as much as they should. I think that it is absolutely the case that when companies go

public through a SPAC, your No. 1 question ought to be, why? We've talked about the incentives. I think that's a great lesson there on the why and what is the reason that this company is coming public this way. Are there any other lessons you see with this, Bill? I think, ultimately, whenever you see so much activity in any segment of the market happening all at once, you immediately need to grab your wallet. There was a sense to me in 2020 that the SPAC rise was coming alongside with investors giving way too much credibility to companies that did not yet deserve it. Whenever you see that much activity in a segment of the market that prior to that had not seen

that much interest, you really have to be a little bit cautious that maybe the ultimate goal is to separate you from your money, not giving you an opportunity to invest in this new, new thing. So that we're not ending on a total downer. do want to see if there's some shining light here, Bill, for us. At core, the idea with SPACs is we are looking for futuristic businesses that, especially in Chamath's case, are exploring where the world is going, exploring solutions for where the world's heading and some of the major problems facing it. That's something that we as Foolish investors can very easily get behind. We're looking for those five, 10-year roadmaps for companies. This is a space that has been hit hard,

but are there businesses that came public by way of SPAC that you still think people should be paying attention to and shouldn't be writing off just because the category has had a hard time? Certainly. I would say that maybe at the top of the list is actually Lucid, which is an electric vehicle company. They've just come out with their first ultra-luxury cars. And that SPAC has actually done quite well. QuantumScape is another one. It's a battery company with electric vehicle potential. Utz. You know Utz. Let's go from the consumer package good company. Yes, the best potato chips on earth. That was a SPAC. It came public through a SPAC. So, there are plenty that are out there. Yes, because I don't want us to be super dour at this

point, I do think that it really is important to mention, again, that SPACs are just a method to go public. It's not so much that they are illegal, immoral, or fattening, or bad to your health. It's just simply when so many happened at once, and there was so much interest at the same time, it almost could not have ended any other way than the way it ended, with a bunch of SPACs finding marginal companies and other SPACs not finding companies to merge with at all. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

I'm Chris Hill. Thanks for listening. We'll see you tomorrow.