The Breakdown - SPACs 101: A Bubble, the Future or Both?

Episode Date: July 28, 2020

Special purpose acquisition companies have been around since the 1990s, but have seen a significant uptick in popularity in recent years. Companies like Virgin Galactic, Draft Kings and Nikola have changed SPAC’s reputation from a tool for second- and third-tier private equity shops to win fees to a legitimate alternative to initial public offerings. In 2020, SPACs have made up roughly 40% of the IPO market. Recently, chatter around SPACs reached a fever pitch with the listing of Bill Ackman’s Pershing Square Tontine Holdings - the largest-ever SPAC.  In this episode, NLW breaks down: What a SPAC is Standard SPAC terms  Why the traditional IPO process has generated growing discontent, especially from Silicon Valley The benefits of SPACs for companies and investors The downsides of SPACs for companies and investors  A number of reasons explaining why SPAC popularity is surging now How Robinhood retail traders are creating an important bridge buyer for SPACs Why Ackman’s Tontine Holdings SPAC could change how we think about SPACs in the future  Are SPACs a bubble? Cited resources: SPAC Man Begins - Alex Danco SPACs as a Call Option on Hype - Bryne Hobart SPACs: the most ludicrous bubble we’ll ever see… why not $IAC? - Yet Another Value Blog Return of the SPAC - John Street Capital 

the speed of SPACs make them a better fit for the narrative trade. Hobart again says this. He said, the standards for SPACs are lower, so that any time there's a well-hyped trend or the possibility of one, a SPAC is the right vehicle for a quick IPO. Nicola is not a coincidence. MP Materials, for example, is a trade war play. They're the only U.S. producer of rare earths,

and China has used rare earth embargoes as a policy tool in the past. So now is a great time to offer the market a pure play. on domestic rare earths. When I read that, what I see is narrative and meme warfare in the markets and the SPAC being a tool that is quick enough to actually enable that. Welcome back to The Breakdown, an everyday analysis breaking down the most important stories in Bitcoin, Crypto, and Beyond. This episode is sponsored by BitStamp and Crypto.com. The breakdown is produced and distributed by Coin. Desk.

And now, here's your host, NLW. What's going on, guys? It is Monday, July 27th, and today we are talking SPAC, special purpose acquisition companies. We're not doing a brief today because I'm actually recording this on Sunday. I won't be available in the morning to record tomorrow, so hopefully nothing too crazy happens and you're not like, why aren't you talking about that? Bitcoin was up at 10K this morning when I woke up, so it was a good Sunday.

but let's talk about our main feature SPACs. Today's episode is going to get into what they are, where they came from, why they're on everyone's radar right now, and what the pros and cons are, and maybe what happens next. For anyone paying attention to markets last week, you definitely heard about Bill Ackman's Pershing Square Taunteen Holding SPAC. It went public last week and was the largest ever SPAC to do so. But first of all, what is a special purpose acquisition?

company. It's also known as a blank check company, and it is effectively an alternative to the IPO process. Going public traditionally involves a company getting an investment bank involved, doing a long, laborious roadshow, doing a lot of cumbersome diligence, and ultimately having an initial listing with the price determined by that investment bank, which hopefully gets them that much vaunted pop on the first day as people rush in to get a piece of the company. A SPAC is effectively a different way to get a company public. The way that it works in simple is this. Some well-known money manager or promoter starts a public shell company effectively

that does nothing except exist for the purpose of going out and merging with some other company. That promoter then recruits investors to the shell company on the promise of a future merger. Investors buy shares at some flat rate like $10 a share and also get warrants for more shares. The promoter then goes out and finds a private company that they want to merge with, effectively taking that private company public when they do so. Investors can either vote to approve the deal or they can take their money off the table and basically vote with their feet. In other words, in most SPACs, if you're an early investor, you don't necessarily have to stick around if you don't like the company that the promoter ends up deciding to merge with.

You can get your money out. And so in that way, it sort of becomes almost like an option on a future deal. If the deal does go through, the promoter or manager then gets 20% equity interest in the company for doing the work. So this is a pretty significant fee. They end up with 20% of the future company, and usually they've only put in a very small percentage of the money to cover the actual fees associated with closing the deal. Usually in these SPACs, there is a time limit to how long the promoter has to get the deal done, which might be something like two years. Now, SPACs are not new. The first SPACs happened in the mid-90s. There was another wave of them that happened in the early 2000s ahead of the great financial crisis. And frankly, SPACs have not enjoyed a

particularly good reputation in the past. They've been a second-tier type of vehicle for second-tier type of funds who are just trying to benefit from those hefty management fees in some ways. Or at least that was the perception. They have, however, been on a 10-year trend to return to prominence that has really accelerated in the last few years. Alex Danko, who was formerly of Social Capital, explained how a few years ago, Chimath Palahapatia, who was obviously the founder and chairman of Social Capital, sat down his firm three years ago and told them about this structure,

the SPAC, that he was going to use to do new interesting things. Notable companies that have subsequently gone public through this type of vehicle include Virgin Galactic, which came from Chimoth, draft kings, and more recently, Nicola, which has had a lot of buzz around the same sort of energy type of play that Tesla has benefited from as well. So what are the motivations to use a SPAC when there is this IPO instrument that's much more common historically that's available to them? Well, there are a lot of issues with IPOs. They're laborious. They're super time consuming. They can take more than a year. There are price

considerations, which are increasingly a focus of Silicon Valley who tends not to believe that banks are pricing things correctly. And in some ways, more or there's just a general misalignment with the investment banks who are in charge of taking companies public. I want to read a section from Alex Danko's recent newsletter about exactly this topic, which I think does a good job of explaining that. On the day of the IPO, you show up at the New York Stock Exchange, you ring the bell, and your stock starts trading. And most of the time, the stock will open quite a bit higher than the price you sold it for via the bank. This is called the pop, and it's really the core part of why businesses grumble about IPOs. They feel like they've left money on the table.

Of course, there's a sensible reason why you actually should expect a pop to happen. The initial investors are taking on risk by buying a brand new, not yet priced stock. So, on average, they should get paid for taking that risk. Banks recognize this, and that's why they price their IPOs accordingly. They want the pop to happen because it keeps their clients happy in coming back for more IPOs. Sometimes stocks don't pop, though. From time to time, with Uber last year, for instance, the stock will slide right from

the opening bell if, for whatever reason, the bank misjudge the public buying appetite. The bank's job is to help stabilize this, and they do it via something called a green shoe. The way a green shoe works is that the bank actually commits to sell more shares than the company issues. In other words, it oversells the offering and therefore is effectively short the stock on day one. In order to cover that short, the bank also gets for free an offsetting number of call options to buy more stock from the company at the IPO price. This is a heads-eye win-tales-you-lose kind of deal. If the stock pops on day one as it normally does, then the bank covers its short position by simply exercising its free option to buy more stock at the IPO price.

So the bank makes money on the difference and the company grumbles because it had to cough up even more shares at below market value. If the stock slides, on the other hand, then the bank can buy up shares on the open market. Either way, the green shoe is nearly risk-free for the bank, and the company foots the bill either way without actually seeing any direct benefit. Why am I telling you this? Because it's a window into an important lesson about IPOs. The company might hire the bank, but the bank doesn't really work for the company. The bank works for the ecosystem. The bank's job is sort of to make the company happy, but really it's to make sure that its IPO goes predictably and boringly and let everyone take their profits.

Banks don't just care about this IPO, they care about getting IPO business generally. Alex then makes a really interesting argument where he says, on the one hand, this is a good thing in general. It helps people avoid the tragedy of the commons, right? If banks only cared about maximizing the revenue for their business IP. their business IPO clients, then they might do things which would not be in the interest of the markets as a whole, which could sour people to future IPOs, etc., etc. On the other hand, he also notes that it creates an incentive for companies to want to work around this system. Enter

SPACs. So let's talk about the benefits of a SPAC in a couple different dimensions. For the company who's actually going public in this way, you have one certainty. So you're negotiating one time with that SPAC buyer. You have a price, there's no roadshow in the same way, so there's a lot more certainty to it. There's also an issue of speed. Bryn Hobart called it the Vegas wedding chapel of liquidity events, which is a great way to describe it. It happens much faster than the average IPO would. There is the potential of a brand halo around the promoter. In other words, if you have the right promoter who's leading the SPAC merger with your company, it might drive the valuation up compared to what it would otherwise be. And here's a really big one. Once the deal is done,

the new owner theoretically starts working for you rather than say an investment bank who's really just a consultant. So in other words, if Chimoth is the one who's running the SPAC that merges with your company, he might stay on as the executive chairman. And if you want Chimoth or someone like him, whoever's involved in the SPAC that's merging with your company, to be involved in a bigger way, this is actually a net win. So you may be negotiating with that person at the beginning before the deal gets done, but then ultimately they're on your team. That's very different, again, from one of these big investment banks who's just on to the next IPO. Now, another thing worth noting from a company perspective is that there are some benefits to SPACs over just direct

listings. In a direct listing, which has also had kind of a moment over the last year or so, you can't raise any money in a direct listing. You just start trading. You also can't get any of that momentum from the pop, and sometimes both that money raise as well as the momentum are kind of the whole point of trying to go public. Now, what about the benefits of a SPAC structure for the investors themselves? Well, the biggest one is this idea of quote-unquote free optionality. I want to read an excerpt from a blog by yet another value blog, which says this. The bullcase here is pretty simple. As an investor, buying a SPAC unit is free optionality. If you like the deal, you can vote to approve it. If you don't like the deal, you can just redeem your stock and get

your cash back. Or, if the market likes the deal, you can sell your stock for a premium to cash. In fact, it works out a little better than that. When you redeem your stock, you are giving your cash back and get to keep the warrant. If enough shareholders vote against the deal, that warrant would be worthless. But if other shareholders approve the deal, you've got all your cashback plus interest and effectively gotten the warrant for free. I get investing in pre-deal SPACs. In fact, I think doing so to get a free look at a deal slash see what the warrant is worth is a really interesting strategy. Now, we'll come back to that same blog post, and I will obviously link it in the show notes, but it is ultimately called SPACs the most ludicrous bubble will ever see. So you can get an

idea of where they land ultimately, but this idea of free optionality is appealing. But let's switch then to the critique. For the company, the terms can be sort of a rip-off. Ultimately, the promoter is, of course, trying to get terms for the merger at lower than what the market will bear. They want the company to be worth more in the market's eye than they got the deal for. This is especially amplified by this 20% promotion fee. Danko again writes, in theory, that fee is charged to the investors of the SPAC, not the target business.

In practice, that fee gets passed back to the negotiated price with the target. The net result is that instead of going public and feeling ripped off by your investment bank for having sold them shares too cheaply, instead you just directly give the sponsor something like 1% of your business as a tribute offering and go straight to being public.

So that's on the company side. It's also that 20% fee makes it very expensive for the investor. yet another value blog writes again, basically you need to assume the founders bought a company for more than a 20% discount for investors to even break even on the deal. The key issue here is this 20% promotion fee, which effectively is a huge tax on the value of the company. So if you are an investor in the long term of that spec, you have to think that the deal that they got is at least at a similar discount to what the market will eventually price the stock at to break even and then hopefully go up from there. There's also critique around this idea of a winner's curse. In other words,

the idea that acquisitions destroy value unless one of three conditions are met. The first condition would be that synergy happens. In other words, the acquiring company or the mergers create something so much more valuable than either one on its own that actual value is enabled. So this is a whole greater than the sum of its parts type argument. The second is that there's some sort of proprietary deal flow, right? So this wasn't going to come to market unless this particular actor brought it to market. The third is having the ability to see the future. So this is obviously alpha in some ways. But effectively it comes down to assuming or believing that a manager, a promoter has a savvy enough sense of the future that they're going to get a better deal than someone

else could and the stock's going to be worth more than it otherwise would. In some people's estimation, it's very hard to see how SPACs apply to this. And I think, especially on that third one, ultimately, if these get more and more popular, you can't assume alpha in every case. Even if some fund managers or some promoters, the Chimots of the world, you genuinely believe have the capacity for generating alpha, you have to assume that as more people crowd into this trade, that's just not going to be the case anymore. BitStamp is the original global cryptocurrency exchange. Since 2011, BitStamp has been the preferred exchange for serious traders and investors, trusted by over 4 million customers, including top financial institutions.

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There are also some really serious incentive issues that are worth noting, which is particularly around the incentive of promoters to get a deal, even a bad one, as the clock runs out on their, call it two years that they have to make something happen. Imagine that you're one of these promoters, well, as that clock runs down, maybe you went after a deal that ended up falling through and you just don't have enough time left. If you get wind of some company that's relatively speaking similar to what your investors are expecting, because presumably you didn't sell people on your SPAC by telling them nothing about what type of company you wanted to go acquire. Perhaps it was a domain that you wanted to focus on. Perhaps it was

something about the economic characteristics of the company that you wanted to acquire. In any case, let's say that you haven't been able to pull it off and you've got just a few months left, and then you get wind of some company that roughly fits those criteria that is coming to market. You have an incentive to bid higher, in fact, maybe even significantly higher than the rest of the market, because you're on an artificial timeline, artificial at least relative to that company, and what's the right price for that company that you want to merge with, because you're just trying to get your 20%, ultimately, you want to be able to present a deal that people can say yes to.

And so your incentive, again, is to bid more than other people. So this adds an even heightened layer to the fact that there's already this 20% discount, effectively in the value of the company for people who are in the SPAC because of the fees that the promoters ultimately get. So what really has people confused right now in some ways is that many of the spacks out there are trading at premiums to cash value. So given all of these critiques, all of these concerns, it's not just that people are taking this deal optionality point of view. It's that people are actively trading these SPACs because remember, this is a publicly traded instrument, they're trading these SPACs at higher than the cash value of the shares going into it.

Whatever you happen to think about all of these critiques, there is no denying how big a force in the market SPACs have become. In 2020, 48 SPACs have raised $17.1 billion, representing 40% of the total 2020 IPO market. This is more than any other individual sector. Seeking Alpha put together a list of SPAC milestones from this year, in fact. They wrote, the largest SPAC ever to go public, the largest announced SPAC merger, the largest ever SPAC IPO of common shares, the best first a pop for a SPAC, the most SPAC proceeds raised in a single year, the biggest quarter ever by proceeds, on pace for a record-breaking year by deal count, more companies choosing SPAC listings over IPOs. So again, keep in mind, we have five months to go and we've already had a record year

for SPAC proceeds raised. This of course brings up the question of why is this happening now? Well, there's a lot of different answers that people have levied. One has to do with improved sponsors and improved economics. On the improved sponsors front, we started right away with Chamath, right? Chimoth is a hugely recognized name. Some people call him this generation's Warren Buffett, so the fact that this is a strategy that he's been actively involved with is notable. But then you have other folks like Bill Foley, Bill Ackman, Chinchoo, names that are respected, they are absolutely top-tier managers, not the sort of second and third-tier bucket shops that were doing these sort of deals before the great financial crisis. When it comes to this idea of improved economics, we'll come back to

that in a minute because it has a lot to do with why people are so excited about this Bill Ackman deal this last week. Historical precedent. The fact that Draft Kings, Nicola, and Virgin Galactic have all performed so well in this has sort of wiped the stain of some of those earlier versions of this away. So now the standard thing is happening. When people see something work, they want to do more of that thing, right? On top of this, there is a Silicon Valley IPO revolt, where Silicon Valley is at war in some ways with investment banks that they believe have just been mishandling that relationship. And so they've been looking for alternatives for this reason. It was reported earlier that Airbnb was considering a direct listing. And as we've talked about,

there are a lot of benefits of a SPAC structure over a direct listing. There's a question of valuation arbitrage. And this is a really interesting idea and something that I want to actually just read a passage from John Street Capital on because I think it sums it up so well. If there's anything 2018 and 2019 showed us, it was that many late stage private companies got ahead of where they would be in public markets from evaluation perspective, with companies like Uber and Lyft failing to reach the high scene privately, and of course, the WeWork Tobacle never getting out of the door. Direct consumer brands like Casper getting cut by more than half. Compare those to something like Nicola, which is trading at 13 billion market cap

with zero in sales. For late-stage companies that might have issues growing into their valuation, e-g. Coinbase, SPAC becomes a way to, quote, bail out late-stage investors while not hurting earlier stage-staged-common shareholders. Due to the time period in which it takes to float to normalize and a true short market to mature, companies may have 9 to 12 months to start to execute prior to having a true two-sided marketplace. So the point here is that we've seen late-stage valuations so high in private equity and venture capital that when those companies are getting to market,

the markets are rejecting those valuations. SPACs may offer those companies a way to go public while effectively buying more time to make those valuations make sense. A couple more reasons why this might be happening now, there is just a lack of public companies and more money chasing them. There were fewer companies listed publicly in 2016 than there were in 1976, so this obviously creates just a demand issue.

Speaking of demand, there's a ton of money on the sidelines not allocated right now in private equity, which makes these structures potentially have a more ready home. COVID-19, in addition, has made road shows impossible. Now, I don't think that this is a huge determining factor, given that there was this sort of 10-year trajectory around SPACs, but it certainly might have helped accelerate things. There's also, of course, because it's 2020, a Robin Hood dimension to this. There's the phase that they call a hybrid phase that is post-deal announcement and before closure, where this thing is still trading, right?

And that's the point at which a lot of the early investors, which are PE firms, want to get out before it goes to the fundamental investors who are interested in buying on the basis of the actual deal, the actual merger, the actual company that this will end up being. Robin Hood retail investors have provided a new buyer where there was no natural buyer in that phase. They're more willing to bet on narrative before the fundamentals phase hits, and so that's actually helping create a better mechanism or just some grease in the wheels, right? It's creating liquidity at this really essential stage. I think, as I've said before, that part of what makes Robin Hood so relevant right now

is that we have ever more narrative-driven markets. And there's a lot of reasons for this. But one of them is that Robin Hood investors are willing to play the narrative game more aggressively. And in the context of the media landscape that we have, that's actually working to their benefit. They push into a trend, they pile into a trend. That trend becomes even bigger news. People watch that news and FOMO in, and all of a sudden they're piling in becomes self-fulfilling prophecy. We've seen this play out over and over and over again.

Well, the speed of SPACs make them a better thing. fit for the narrative trade. Hobart again says this. He said, the standards for SPACs are lower, so that any time there's a well-hyped trend or the possibility of one, a SPAC is the right vehicle for a quick IPO. Nikola is not a coincidence. MP Materials, for example, is a trade war play. They're the only U.S. producer of rare earths, and China has used rare earth embargoes as a policy tool in the past. So now is a great time to offer the market a pure play on domestic rare earths. When I read that, what I see is narrative and meme warfare in the markets and the SPAC being a tool that is quick enough to actually enable that. What comes next? Well, as I

mentioned at the top, Bill Ackman's Pershing Square Taunteen Holdings went public last week. It raised $4.0 billion. It has committed another $1 to $3 billion from its own funds. And it traded at plus 6.5% on day one. Now, what makes this quote-unquote unicorn SPAC different is that one, it was the biggest ever SPAC raised with $4 billion and a commitment to put another $1 to $3 billion more in. It was looking to do things in a slightly different way in terms of ownership, rather than owning a company outright or owning a majority stake. It wanted a minority stake of 20 to 30% in a private company unicorn with a $10 billion plus valuation. Pershing has a huge, huge brand. They're They've crushed the S&P 500 over the last 16 years, like 771% growth to 224% growth.

So that's obviously a big indicator as well. But the key thing really is that they are totally upending the fee structure. They don't have the same 20% promoter fee. In fact, they've done away with that entirely. The whole idea here is that they only make money when others make money who are investing with them. And that's created a much bigger interest around this. In fact, so much so that I think you could see.

see it impact the way that other SPACs in the future are traded and created. So the question is, is this a bubble? And there are a lot of opinions on that. You have yet another value blog, who I quoted earlier, who said, I don't think there's ever been a bubble where investors got excited to buy into an asset class with a history of failure that combined buying assets for absolutely top dollar with management teams incentivized to get a deal done at any price. And while some have held up Nicola as a great example of the success of sports,

that same blog pointed out that this is exactly the issue of those warped incentives to overbid. They said, quote, it seems that the recent way to overcome this issue of price is for a SPAC to buy a speculative tech or consumer-focused company that no other financial or strategic buyer would touch, but that could be easily hyped to the masses. Again, Nicholas serves as the perfect example here, a basically pre-revenue startup in a notoriously difficult industry. Maybe the company could have found some VC backers, but no strategic company was going to buy them for anywhere close to what they'd SPAC for, and obviously no private equity company could make a deal work. By being essentially the only buyer into a company that could be hyped with a

crazy growth story, the current SPACs currently seem to be able to waive away the conflict of interest in 20% management take by pointing to massive growth opportunities. Who cares that you're paying 20% of the deal with management now? Don't you want 80% of this potentially massive pie? The other issue that coincides with this for people is that you have both this overbidding plus the Robin Hood crowd coming in in this pre-deal rumor phase before the fundamentals buyers who want to know about the company to be purchased. There's also an interesting dimension with crypto companies. In his piece, Alex Danco talks about how over at social capital they spent a bunch of time thinking about whether there was a way to get a SPAC public before the crypto bubble burst in

2017. Just yesterday, Barry Silbert wrote, SPAC pitches coming my way from every direction. He thinks we're going to have some publicly traded crypto companies this year, and the John Street Capital blog that I also referenced earlier also talked about this. In a section about fintech spacks they'd like to see, they wrote about Coinbase and said this, Tiger led a $300 million series E round in October of 18 at an $8 billion valuation. Rumor has it they did $700 million in revenue in 2018 and $500 million in 2019, which is nowhere close to justifying an $8 billion valuation, as those were most likely off the 2017 peak. Given increasing competition across every business line, it's tough to see the institutional

long-only community getting excited about Coinbase. But if space, gambling, and EV have become trends the Robin Hood Mafia wants to back, you'd have to imagine crypto would fall into that bucket as well. Could be the most eloquent exit, and Chamath is familiar with the key players. So really interesting to see that there may be a crypto dimension of this later this year. But here's the really interesting thing to think about as well, is how would this bubble play out if indeed it is a bubble? Well, really what it comes down to is this. If spacks are successful, it will create more spacks. More spacks then mean more competition for the best deals,

which drives prices higher and higher still for increasingly out-there deals. That influx of cash could ultimately price out other buyers like PE and even other synergy acquirers until the only game is which spack are you going to go public with. In other words, it could get weird, but frankly this could take a little while to play out, So until then, I hope you have a better understanding than you did going into this episode. Let me know what questions you still have on SPACs and I'll try to have them covered. I'll see if I can bring in someone, maybe one of the people that I referenced,

who wrote about this to talk about this more if you're interested. But I hope that you guys had a great weekend. And until tomorrow, be safe. Take care of each other. Peace.