Will the SPAC frenzy also hit European capital markets?

Nothing in this article should be taken as investment advice.

The old new kid on the block

There is a new rage on Wall Street: going public with so-called Special Purpose Acquisition Companies (SPACs). SPACs are listed shell companies that are meant to merge with a real business, a strategy known as a reverse merger. Due to the simplicity of the SPAC — an entity that only holds cash on the balance sheet and has no real activities — the IPO process is much simpler than for a real business. SPACs are increasingly popular under tech CEOs and VCs, as quite a few of them seem unhappy with the traditional IPO process.

SPACs themselves are not new and have been around for decades, also in Europe. They have a somewhat dodgy reputation as they were used mostly by companies for whom the IPO option is not available (read: investment banks do not see a large enough appetite for their shares). SPACs are created by sponsors, often former business executives or investors who also want to provide their expertise to the acquired business. With more reputable sponsors entering the space, the good old SPAC is dusted off and given new allure.

Pitchbook estimates the combined purchasing power of SPACs that are currently out hunting at around $20 billion. The SPAC of hedge fund manager Bill Ackman represents 25–30% of that. With his $5–7 billion mega SPAC he aims to merge with a private unicorn (Airbnb is said to have rejected the invitation to dance).

In addition to the $20 billion in dry powder, SPAC managers have in their toolbox the option to facilitate a ‘private investment in public equity’ (PIPE). A PIPE is a private placement with accredited (institutional) investors that is subject to lighter regulation requirements than for an IPO. This method can be used to raise additional capital. Once complete, the issuer files a resale registration statement with the SEC to add the shares to the float (i.e. they become publicly listed and can be traded).

Last year, it was the direct listing that emerged as the hottest alternative to the IPO and now there is the SPAC. What is driving SPACs’ popularity?

Drivers of the surge of SPACs

An often cited reason for the rise of SPACs is the feeling that the IPO process is rotten, however, I actually believe that circumstantial factors play a bigger role here. But let’s first look at what the IPO bashing is all about.

Big part of the IPO criticism is about first-day “pops”: surges in share price on day 1 that suggests that the IPO was underpriced and money was left on the table. These pops give investors that were part of the ‘book’ (investors who ‘pre-ordered’ the stock) an opportunity to make very attractive and quick returns on the first trading days (if they decide to sell). These pre-ordering investors are typically long-term clients of the investment banks, and critics argue that shares are purposely underpriced, that way almost guaranteeing attractive returns. The underlying force at play is an asymmetry in relationships: for the investment bank the IPO with this particular company is a one-off, whereas the relationship with the people buying the shares is long-term. The argument goes that the investment bank has an incentive to give more weight to its long-term clients.

But in the end, it is the management team of the company that has to OK the IPO price. Some executives know there’s going to be a pop, but decide to stick with what they consider a more realistic valuation. They reason that when it is time to present next quarter’s results, it is impossible to meet inflated expectations. There is reason to believe there is ‘irrational exuberance’ in the market, with investors (or gamblers?) ignoring company fundamentals and betting that they can sell at an even higher price tomorrow.

Although I do agree that the IPO process needs innovation, I think a more important driver of the surge of SPACs is the volatility in public markets. Volatility creates a harsh environment for companies looking to raise fresh capital through a lengthy IPO process. SPACs — also referred to as blank check companies — can move much faster. No lengthy roadshows, but targeted conversations with the SPAC managers who you know are actively looking to buy.[1]

Finally, there is the ever-present factor of opportunism. Some SPAC sponsors may expect that an ongoing pandemic will drive down valuations of private companies, creating attractive investment opportunities.

Are SPACs a good or a bad thing?

The rise of SPACs is driven by the current environment of high volatility, opportunism and thirst for innovation of the path for going public. The fact that there is a new rediscovered path for private companies to take, in addition to the IPO and direct listing is, I think, a positive thing. Plus, the current trend of (tech) companies staying private longer is undesirable. By staying private, their stock is out of reach for retail investors and other public market investors. If SPACs mean more tech companies go public, I applaud that.

But SPACs have flaws as well. For one, they are not cheap and with an average cost at around 20% of the proceeds arguably more expensive than IPOs (although new players vowed to make the SPAC option more cost efficient).

Then there is the issue of price discovery. Demand drives up the price. In an IPO process demand is tested and possibly created with the help of investment bankers at a large group of investors during the roadshow. If there are more investors who want to buy a large number of shares (demand outstrips supply), the higher the price the issuer can ask. With SPACs you’re negotiating with one potential buyer (or max a handful if you’re negotiating with multiple SPACs). As a result, SPACs provide limited price discovery and are not a guaranteed solution for the first-day “pop” issue that is central in the IPO critics’ argument. For illustration, the share price of DraftKings’ climbed 274% since it listed through the merger with a SPAC in April this year (based on closing price 9/8/2020).

SPACs are not the holy grail, but for companies in a hurry or complex equity story they may be an attractive pathway.

For companies that do not need to raise fresh capital, the direct listing is probably a better option (Slack and Spotify listed this way, Palantir may also walk this path).

For companies with a good equity story and time on their side, the traditional IPO, even with its flaws, may still be the better option, given the factor of price discovery. In todays volatile markets, however, IPOs are subject to more uncertainty than SPACs.

Will the SPAC frenzy also hit European capital markets?

The majority of recent SPACs involved American companies, including tech firms like DraftKings, Nikola, and QuantumScape. But there is also activity in Europe, for example the SPAC merger of UK-based spaceflight firm Virgin Galactic in 2019.

My expectation for Europe is that SPACs will become more common in this period of high expected volatility, but that we will not see the same degree of SPAC-hype play out as in the US. The US has a huge inventory of private tech companies with lofty valuations, and when the crisis hits financial markets, they may come available at more attractive valuations.

Europe today, unfortunately, lacks the products at display to choose from, much like the shop owner who had to close due to a pandemic-driven lock-down.

Notes

[1] Direct listings are not an option as they cannot be used to raise new capital but only for providing liquidity to existing shareholders (this may change under new regulation).

You can find this and other stories on my website www.thalein.com.

Sources

• Pitchbook. The 2020 SPAC Frenzy. September 1, 2020.
• The Economist. Buttonwood: The SPAC hack. August 1, 2020.
• a16z. In defense of the IPO. September 2, 2020.