SPAC SPAC SPAC!

There have been a lot of SPACs, special purpose acquisition companies, recently. What has been going on? 

The WSJ covered them in a recent article, showing both SPAC IPO volume spiking and taking over a significant portion of total IPOs.

It is not a coincidence that the launch of these funds has accelerated in recent times. It is based on a distinct aspect of the market: Public company investors are valuing private companies at significantly higher multiples than both private company investors and private company management teams. And perhaps more importantly, with a pandemic shutting down large portions of the economy but government stimulus propping up other areas, private company executives and investors are unsure how much longer this valuation differential will exist.

The difference in valuation leads to the perception that there is a lot of money on the table. And people are rushing to get their piece.

It is important to understand that there are eventually three distinct parties to SPACs, each of whom benefit in different ways.

1. SPAC sponsors: The people who raise and deploy the SPAC. Sometimes, this group is broken up into two distinct types of people:

A. The money people: These are the people who have money and connections to the types of investors who might be interested in deploying capital into a SPAC type vehicle. They also have the operational experience to do the work to get the special purpose vehicle public and conduct the due diligence of the acquisition target (Note: In some deals it appears that there were not anyone specializing in DD associated with the SPAC sponsor team). From the perspective of the money people, a SPAC is yet another way to do their job of finding deals to get done.

The risk reward is significant, they typically put up above $3M and usually below $10M dollars to cover the cost of running the SPAC. In return, they can end up with a value equivalent to 20% of what they are able to raise. So $5M in capital that successfully finds a deal for a $200M SPAC can turn into $50M in wealth, which nets them a $45M return minus the upside they might need to pay out to the credibility people. And this calculation is before the company they find is bid up by the public markets.

B. The credibility people: These are the people who have accomplished enough in their careers that LPs feel like there is someone important putting their reputation on the line for them. From the perspective of the credibility people, a SPAC is a way to monetize their current reputation in return for relatively small amounts of work compared to the money involved but with the downside of significant regulatory exposure and minor reputational exposure. They will also often put up some capital, but have even more upside than the money people (Their additional upside would come out from the share of the money people).

In many cases, such as with Bill Ackman's or any other hedge fund's SPAC, it doesn't make sense to differentiate between the two groups because the money and credibility come from the exact same people. In other cases, the credibility people are distinct. They are people who built their reputation in their industry, whether that industry is Hollywood, automobiles, government, sports, or Silicon Valley. From the perspective of outsiders looking at the value differential between public and private companies, we should expect many money people will be courting Silicon Valley people to lend themselves the additional credibility to both raise the capital and win the right deal.

Both the money people and the credibility people are staking some capital and their reputations in return for significant immediate upside in the 20% of sponsor equity they usually structure into the deal for themselves. They have additional warrants on the upside if the stock price outperforms.

How much of their reputation the sponsors are putting at stake is an interesting question. For the money people, they are risking important business relationships if they put people into SPACs that go nowhere. Meanwhile, the SPAC investors hope that a lot more is at stake for the credibility people than is usually the case. In the real world, ex-speaker Paul Ryan and legendary baseball general manager Billy Beane will not have their legacies ruined if their respective SPACs go sideways. They have a huge monetary incentive to make things work, but the only thing really at risk if their respective SPACs do not work is their ability to make money with SPACs.

2. SPAC Investors

In times before SPACs were popular, the type of people who would be SPAC investors were an enigma. They were the types of people who allowed themselves to be pitched by people who had a very particular dream for their blank check company and who bought into that dream and the team enough to come along for the ride. It was never that risky, as SPAC shareholders could sell their shares on the open market or reject deals and get their money back. But there was a significant opportunity cost to letting their money sit in a SPAC for up to two years and there was no reason to expect that the SPAC sponsor would find a company that the market would value enough for the investor's warrants to matter. And maybe even worse, it was weird.

But today it is more obvious why a SPAC should work. SPACs are the new IPO and IPOs are hot. There is enough upside for the company to get a higher valuation and for the public markets to bid up the price even more. So many SPAC investors have been getting the equivalent of ridiculous IPO pops when their companies get announced. The people who come in before the SPAC is publicly traded also get warrants, long term call options they can keep even if they sell their stock, when they invest in the initial deal and a large enough pop means that these warrants quickly become quite valuable. The pre-launch SPAC investor can get both initial upside, protected downside, and longtail upside. And when other parts of the market seem risky, SPACs seem like an almost safe way of taking part of a portfolio to cash, forfeiting money they might earn with near zero interest rates in return for some valuable optionality.

There is a type of SPAC investor that sponsors need to watch out for: The greenmailers. Greenmail used to refer to investors who threatened a hostile takeover but would leave a company alone in return for a payout. But it is a term that works well for any legal financial blackmail. Today’s SPAC greenmailers are those who buy into SPACs with the intention of voting against the deal unless some of the sponsor upside is shared with them. Bill Ackman structured his SPAC so more of the warrants went to people who actually stayed in the deal as it de-SPACs to try to deal with these tactics. But if you see a deal announced and the stock is trading below the $10 price, understand that there could be some behind the scenes greenmail going on as some more opportunistic investors demand some of the sponsor’s share of equity in order to get their vote to approve the deal.

3. Target Companies

A SPAC solves a lot of problems for a company. It raises capital and generates liquidity for the private company on terms they want at what should be a higher valuation than they were getting in the private markets. And it does so relatively quickly, with a minimum of hassle. With so many SPACs competing for deals, target companies can choose whether to optimize for amount of capital raised, valuation, control, or affiliation with some of the people involved in the SPAC whose help they might want or who might just be fun to hang out with. 

The main downside is that unless the SPAC sponsors arrange for significant additional investment via PIPE (private investment in public equity) from outside their SPAC, it's uncertain if the company will really get the capital they need and the fees are really high compared to an IPO. It's on the order of 20% for a SPAC vs 7% for an IPO. The other downside is that due to the way that SPACs are structured, the investors have a public up or down vote on whether they want to do the deal.

I have not seen a notable no vote in this market. Like politicians from the Tammany Hall of old, the SPAC sponsors are not going to have an election if they do not already know they are going to win. There might be whispered conversations, and the closest we might see to a public rejection would come as rumors of the company name hits the market and the SPAC in question’s share price doesn’t move up in anticipation of the deal. The sponsors would then know it was not a good move and would probably not force a shareholder vote. But if it came to a vote and shareholders decided to shoot down the deal, it would be a much more damaging public rejection than one in which a company’s underwriters quietly pushed back the timing on an IPO.

And a minimum of hassle is always great, but for some companies it is better than others. Nikola surely benefited from a lack of scrutiny, although it’s important to note that given the lockup time period that insiders have they still need to keep their company from being exposed as a fraud long enough to sell their equity. In the case of Nikola it’s unlikely to be able to hold up. But Nikola is perhaps an exception, a company that primarily consisted of smoke, mirrors, optimistic business deals, and hope.

Types of Targets

There are a few characteristics of companies that make them good targets, and the more of these attributes a company has, the more attractive it is to SPAC sponsors:

1. The most attractive feature of a SPAC target might be a company that is known to be IPO ready, But they also make difficult targets as not only does the sponsor have to win the deal against other SPACs, but against the lower-cost IPO option.

2. Companies with metrics where private valuations are significantly below the public market comparable.

Related: Companies in the same space as another public company that is getting a high valuation.

3. Companies with a promise of a future version of the company unrelated to near-term cash flows. Every company is based on future cash flow expectations, but usually the best evidence of that future cash flow is what is happening to a company’s financials today. This is why investors are concerned with earnings reports, as they hint at the direction the business is going. But there are some companies who are not yet making a substantial amount of money and earnings reports mean very little.

For SPAC sponsors, they do not want to risk real world events bringing bad news that lowers the price of their stock before they are allowed to sell their shares. Thus, the further out in time that investors are expecting to see real results, the better. Draftkings, a sports betting stock while major sporting events were expected to be shut down for the duration of the pandemic, is a great example of a company insulated from any potential bad news before the lockup period expires.

4. Hype. If investors are not getting excited about something, there is less of a chance that they will buy the stock at a significant premium to its private valuation. Hype is what the SPAC sponsors are trusted to find, and what can create the outsize return for their investors. In a $100 million dollar SPAC, the sponsors are splitting about $25 million in upside if they can push through a transaction they make their money. But if they latch on to an idea that the market values at a 4x premium, their upside becomes substantially higher.

The hype is helped by the lack of a quiet period that traditional companies going IPO are required to observe. Instead of no stories about the company from the company's point of view, we get the SPAC sponsors and the company hyping their story to the masses. 

The Future of SPAC

Are SPACs the replacement to IPOs that some tech investors have long hoped for? How long will we be inundated with SPACs? The answer to these questions depend primarily on how long public market companies trade at significant premiums to private companies. The model doesn't broadly work without the IPO-like pop that some tech investors have focused on to what some may say is an unhealthy degree, and given how discounts in high finance can turn something low status and thus destroy hype, it is unlikely that the 20% take from SPAC sponsors will be cut to be competitive with the 7% fees charged for IPOs.

If fees do get cut, it will be because someone has decided that they can to be to IPOs what Michael Milken was to corporate bank loans: Their biggest enemy. It's worth remember that Milken made a fortune introducing companies to the option for lower cost junk bonds, but his enemies eventually found a way to throw him in jail, effectively for the crime of taking their business. A systematic low-cost SPAC machine would likely be targeted by both numerous nuisance shareholder lawsuits and a future New York Attorney General.

While a public market crash could take most of the air out of the SPAC balloon, there is also the risk that too many people become involved because they are only focused on the IPO style pop when deals are announced. In Hong Kong, normal IPOs are now trading down on the day when they started the day over 1000 times oversubscribed. If all the investors are there for the pop and none are there for the long term, the pop goes away too.

If more SPACs turn into Nikola, which is still somehow trading above the SPAC’s $10 initial price but which option markets give a high probability of falling significantly, then we might see excitement in the sector cool.

But until then, the excitement over SPACs will only heat up. People are even launching funds of SPACs, one with more fees on top as well as potential leverage. What could go wrong?


I would like to thank the people who read drafts of this and helped me clarify my thoughts, but I will refrain from doing so lest I implicate them with the errors that I added in afterwards.