SPAC nuances
In my previous post, I touched on the general thesis for investing in a SPAC, and what criteria questions an investor should ask before choosing a SPAC to allocate capital. I recommend reading it before diving into this one, as it includes technical details and nuances, which will be easier to grasp after reading an introduction to basic notion of investing in SPACs.
After we’ve done diligence on the sponsor’s background, past performance, and expertise, the next thing one should do is look at the details of a SPAC offering. Understanding the process of SPACing a company can be challenging, I’ll try explaining some of the nuances from a high-level point of view, and dive into the important details from there.
Understanding the internals mechanisms of a SPAC offering is crucial, as it contains a few non-obvious neuances. As we’ll learn, the risk profile of a retail investor pouring money into a SPAC stock is different than the one of the sponsor, or the PIPE investors. Doing the deep-dive into the unsexy details of the SPAC phenomenon has made me more cautious but also smarter when assessing similar investment opportunities. The more I dug into it, the more I realized a SPAC isn’t really introducing us with real innovation, but rather hacking the existing IPO model into something more scalable. Despite some of the benefits a SPAC brings to it’s target company, I remained debating myself with the question of — Is a SPAC superior to an IPO/DPO in all cases?
The Offering
A SPAC offering is nothing but a regular IPO event, investors can choose to subscribe. In most cases, other hedge funds and PE firms choose to invest in an offering of a SPAC sponsor. For the sponsor, it takes time to prepare for the IPO. In the SPAC’s case, there’s less accounting work to do, comparing to a traditional IPO, as the company has no revenue, profits, and other math to report when filling. The SPAC has to choose an underwriter bank to compile the offering, and off we go!
Typically, a SPAC offering includes two kinds of shares. The SPAC Unit Share consists of a class-A/B share and a warrant. The ordinary share gives the holder the right to participate in governance, vote on merger proposals, and other actions related to the SPAC operation. Each Unit is usually priced at $10 and entitles the holder to claim a chunk of a warrant(usually one-third, or one-fourth)to be excersiced at a higher premium, usually priced at $11.50 a share. The warrant are given to incentivize the investor to hold the share and get rewarded with more “free-shares” when the share’ price appreciates. In some cases, the offering includes a ‘Right’, additionally to the shares and warrants, which turns into 1/10 of a share at the time of the merger at no-cost! In the beginning, it’s only possible to buy the SPAC’s Unit-shares, and later on, the regular shares and warrants split, and trade separately as the SPAC gets closer to the merger event. In the cases I’ve interacted, only full-warrants are exercisable.
*It’s important to note there are some exceptions with pricing and shares’ structure.
The ‘Shtik’ with SPACs
Investors purchasing a SPAC share, have the right to redeem it by the time the merger is complete. In that case, they will get the $10/share back + trust’ interest(the SPAC’s money is held in an interest compounding trust while the sponsor is looking for a company to merge), and keep the warrant they were privileged to when they purchased the units. What it means for investors, is that they have all the upside but no downside until the SPAC has merged with another company. The share has gone below the $10 value? not the public investor’s problem. She can still redeem 100% of her money back at any time against the $10/share price she paid. Then, she can still keep the warrant and hope the share’s value will arise above $11.50, to take risk-free profits.
As we’ll learn later, shares redemption introduces a challenge to the sponsor and the other investors as the SPAC gets closer to the merger event. The redemption option marks the first point of divergence between the sponsor’s risk and the investor’s, as the sponsor carries the risk of the SPAC costs and operations. If everyone’s abandoning the ship, he’s left alone.
Dilution
Just like any other cap-table, the SPAC’s will suffer from dilution with time. What it means for the investor, is that the $10/share(more or less) they pay when investing — will be diluted on the backend, as the SPAC has its own costs of operation. The reality, as a recent SPAC research paper shows, is the public investor’s money is only worth 50 cents of equity on every dollar put into the SPAC, post-merger. The underwritering fee, Sponsor’s promote, warrants and redemptions account for eating the investor’s money, before it touches any gold. In this game, much like in Venture Capital, it’s important to pay attention who’s there for the fees, and who’s there to do the work.
Underwriting fees
If we look at the way SPACs are formed, there’s no real innovation in the IPO itself, but rather a different way to structure the way shares of a private company will become liquid. Some might call it a subsidized, pre-baked IPO.
The SPAC sponsor is IPOing his own company, that will merge with another private company after going public. Here, the private company will be saving the IPO fees it’ll pay had it gone through a traditional IPO process directly with an underwriter. The SPAC sponsor subsidizes the IPO fees upfront and typically pays a 5.5% fee to the underwriter. A somewhat similar amount a regular company pays when it files to go public. In that regard, a SPAC isn’t really cheaper than the regular IPO or direct listing. The advantage is for the company that will merge with the SPAC, as it saves the underwriter fees. The underwriter fees typically dilute the shares’ value from day-1. So a $10 share will be really worth around $9.5 from the beginning. It is pointed out clearly in an S-1 fillings.
The Sponsor’s Promote
The SPAC sponsor typically holds 25% of the shares pre-merger, which dilute to 20% at the time of the merger, while providing just 4–5% of the capital. It means 20% of the SPAC are essentially shares with no capital behind them. The other investors are ones paying — they basically buy the sponsor free shares. In exchange, the sponsor does the work of finding a target company to merge.
This concept is somewhat similar to the 2% fee (2%/year* 10-year=20%) LPs pay in Venture Capital, only here it’s paid for a max of 2 years vs. 10 years of work in venture capital. It may be viewed as cheaper considering the fact the sponsor does not take any carry on the SPAC. The reason the net-promote fee might be higher than 20% at the time of the merger, is that a sponsor usually buys more shares in the SPAC during the additional financing round called ‘PIPE’(Private investment in public enterprise) when the merger is announced. In the PIPE, more dilution is introduced, in case the other investors are added to the cap-table to inject missing capital, caused by shareholder redemptions. Oftentimes, the SPAC sponsor is asked to cancel some of their own shares, as they get additional promote from other investors in the PIPE. In that case, the median sponsor-promote from the cohort measured in the research totaled 31%, which was translated to 7.7% of post-merger equity.
This is the second point of divergence between the risk the SPAC sponsor takes, and the public investor. The SPAC sponsor is effectively getting shares for significantly less capital than the public investor has paid. To the sponsor, it’s more difficult to lose money on the investment, even if the SPAC shares go below the initial $10/share price. That is reflected in the table below:
An interesting example for a sponsor who chose not to take a sponsor to promote is Bill Ackman with his SPAC via Pershing Square Capital. In that case, the sponsor will invest in warrants that are not exercisable or saleable until three-years post-merger. They packed in a way so the sponsor can effectively make money only if other investors. I suspect more “attractive” SPAC offerings will continue to take place as the SPAC market gains popularity, and sponsors have to find ways to differentiate from the rest. Incentive alignment matters, particularly in SPACs where investors quickly start to realize it’s a sophisticated game and not a free-lunch.
The sponsor’s promote is an important point to understand before investing in a SPAC, as it accounts for a significant expense that will have to be covered by a meaningful surplus. When you buy shares intending to hold through the merger, you start with a hole, caused by fees and sponsor’s promote, that needs to be covered.
Warrants
Warrants are the main incentive mechanism in a SPAC, as its given for free. As explained, a SPAC shareholder is entitled to a chunk of a warrant for each share she holds, for free. The warrant only becomes meaningful if the share’s price goes above $11.50, the warrant’s strike price. In such a case, the shareholder will be getting a more risk-free return on his capital, and increase his holding in the SPAC. That also means more money goes to the SPAC’s balance sheet and the sponsor.
Not only! Since investors can redeem their shares at any time, before the merger — there can be a situation where an investor claimed some of his shares back but is still holding the warrants and rights. Effectively, it means a SPAC investor can buy a share, return it tomorrow and keep a free chunk of a warrant. That outlines the clear asymmetry aspect to investing in a SPAC even more, as there’s no real downside for the investment, before the merger.
During the recent market volatility, I started thinking SPACs may be a good place for investors to put their capital in uncertain times. Instead of liquidating to cash or moving to gold, why not earning a risk-free interest, and get free warrants, in a risk-free SPAC stock?
The dilution aspect in the warrants is pretty straightforward, as more shares get exercised, are added to the cap table and are diluting it. It gets problematic for the sponsor and the other investors when redemptions get in the picture. As fewer shares exist because of redemptions, it means there are more warrants per share. Since warrants aren’t given away 1 to 1 for each share, thus dilution is introduced. The bottom line is that because of fewer shares = fewer shareholders have to bury the SPAC costs.
Last Man Standing
Dilution in SPACs is created by three main factors; the fees, sponsor’ promote and warrants. Each one of them has the potential to make it harder for the public investor to generate a return on their investment. The trick is that this dilution doesn’t really show up in the stock price. An investor can buy at $10 and sell at $10 or more, and essentially carry no risk of losing a dime of their money, before the business combination happens.
In many cases, SPAC investors can have a profitable ride before the merger as they sell at a higher price and move on. The investor won’t suffer from any dilution until the capital is injected and the merger is complete. The beauty of the game, it’s a tradable investment in a half-private, half-public asset. Accordingly, some call it, “private equity with an exit option”. This results in a game where a SPAC’s costs structure only affect the long-term shareholders.
Share redemptions in a SPAC are the main pain point in this process, both for the public investors and the sponsor. As a public investor buying a SPAC share, redemptions mean some of your fellows simply decide to abandon the ship in the middle of the sea, leaving you to deal with what’ll happen next on your own. The sponsor has to deal with the share redemptions, which can be significant in some cases. A SPAC research paper that helped to provide a context in this piece, outlines that on average, over 70% of SPAC investors redeem their shares before the merger.
The solution to redemptions is the ‘PIPE’ mentioned earlier. In that case, private investors are getting calls from the sponsor, to come and help them get the missing capital back to the balance sheet. In some cases, the sponsor might simply invest more of their own money and help complete the capital needed for the investment. In any case, this introduces new dilution to the cap table, as the PIPE investors buy the shares at an attractive discount on the IPO price, well below the $10/share. That is meant to incentivize them to hold the shares through the merger announcement which comes together with the PIPE, and the business combination completion later on. It’s important to note, a PIPE investment can also come as additional financing to the SPAC’s, to provide more capitalization via external funds.
The results of this game is that the last man standing is the one who proves to have the most conviction in the investment, while the rest come along to get risk-free profits and leave. Not to imply it’s wrong, but the way a SPAC vehicle is designed makes it almost inevitable for swing-traders to grab “easy” profits, and walk away before the merger. The result can be an inflated SPAC share prices, caused by speculation and actions of short-term traders.
In today’s market, it’s not uncommon to see SPAC shares trade at the $11+/share price shortly after the IPO. What it means for retail investors, is that they might be effectively paying as much as twice the amount the sponsor and the PIPE investors do. If I think about it for a second, it’s not very different from the way a bank prices shares on the lower side of the spectrum, to make sure his friends will have their IPO investment profitable. The difference here is that IPO pricing is public, and what the SPAC investors pay isn’t getting enough attention in most cases. I don’t try to imply this mechanism is broken, just to outline the fact SPACs aren’t 100% clean from the defects of the system.
Retail investor buying a SPAC share?
Taking all the measures in a SPAC offering into account, the thing that will matter the most to the investor, is his converted SPAC share’ value, post-merger. The goal is to put $10 into a SPAC share, and get one worth (more than) $10 back post business-combination. It’s not going to happen in all cases, as it depends on dilution, redemptions and the deal the SPAC negotiates with the target company. Investing in a SPAC can have a few possible outcomes, like the following:
- In the best scenario, there’s minimal dilution, investors love the stock and a good deal gets through. The retail investor bought 1 share at $10, and will get 1 share of the target company worth $10 or more.
- The SPAC suffered dilution and/or high redemptions, so there’s less money left to make the investment in the target comapny. The target company looks at the deal solely from the financing perspective, and agrees on a 1 to 1 share conversion. The retail investor will get the same amount of shares converted, only valued at less than $10/share. A bad outcome!
- The SPAC suffered high dilution and/or redemptions, and the there’s less money to deliver to the target company. The agreement is a 1.5 to 1 SPAC share conversion rate upon the merger. The target comapny values the sponsor and is willing to give more shares on their behalf to have the shareholders happy and make the deal happen. The retail investor will get more shares valued at less than $10/share. A fine outcome!
To stay ahead of the curve, a smart investor will choose an intelligent criteria to choose a SPAC sponsor to invest. Then, dig in the filling to look for potential significances for dilution.
A few questions can be asked upon looking at a typical S-1 filling of a SPAC:
- What’s the Sponsor’s take? does he have any incentive to hold the shares beyond the short-term? can he sell his stock/warrant at any time? Think about that from the risk perspective, and remember the Sponsor is less likely to lose money on the shares he will have(getting a lower price per share, paid by the public investors).
- What’s the warrants pool size relative to the class-A/B shares? Warrants mean dilution as we’ve learned, and size of the pool matters. It’s more attractive to have more warrants given per share, but also more dilutive. Some SPACs give 1/2 a warrant per share, other give 1/3, 1/4 and so on.
- Is there a lockup on the warrants? oftentimes warrants may be excersised post-merger. In most cases, warrants and ordinary shares will split before the merger. Warrants validity affects incentives alignment. It’s important to pay attention as you should want to know when you’ll get your free-calls!
- How/when will your Unit convert into ordinary shares+warrants?
In most cases, Units will become convertible shortly after the IPO. That can be done upon request via your broker(It’s not a cheap commission as I learned). It matters how will it convert too — Ususally, only full-warrants are given away upon Unit conversion. If one can gets 1/4 of a warrant on every single share, he/she will have to convert an amount of units that is divided by 4, otherwise some warrants will be left on the table.
SPACs — A look forward
SPACs are here to stay, mostly because of retail’s appetite for more public technology companies. We can see it being translated well to the SPACs’ stock prices, and excitement for the surprise that’s gonna come out of the box with the next SPAC — I can see it becoming addictive! As we’re still in the early stages of the SPAC trend lifecycle(before most blank checks have found their tragets) it’s difficult to understand the return dynamics and the continuity of most players in the space.
Stewart Butterfield gave an answer I liked when he was asked for his opinion on SPACs by Harry Stebbings. As someone who’d gone through the process of taking a company public last year, Stewart mentioned SPACs aren’t nessecarily better than an IPO or a Direct listing. In his opinion SPACs aren’t superior to an IPO or a direct listing, but it depend on the situation, whether the company is looking to raise more capital, or just to liquidate shares into the public market(via a direct listing). I tend to agree with that approach, as it’s important to note some of the SPAC benefits on surface aren’t meaningful in practice for all the cases of companies going public. For example, if additional capital isn’t needed.
Desktop Metal co-founder, went through the process SPACing his company via the Trine acquisition SPAC, and shared from his experience(jump to minute 46) a SPAC isn’t nessecarily an easier process for the target company to go through, if including the PIPE financing stage which adds an IPO-like roadshow to the timeline. On the other side, forming the SPAC vehicle can take 3–6 months which is significantly shorter than a traditional IPO. If we put the two together, the full process can easily take 12 months, which is close to the time horizon of a traditional IPO. Launching a SPAC isn’t an easy gig, not for the investor or the company on the other side, as it can take a lot of meetings, negotiating and last minute decisions, beyond raising the capital. Some will unfortunately get to realize it later into the cycle, and maybe ruin the party. So far, we’re still in the point where the DJ plays the music, and everybody’s dancing.
While we’re far from a clean, 100% effective, easy process for companies to become public, SPACs appear to be the closest thing to purity.
In one of this recent memos, Howard Marks wrote the following:
In the real world, things generally fluctuate between “pretty good” and “not so hot”, In the world of investing, perception always swings from “flawless” to “hopeless”.
The challenge in 2020 is to figure out was is justified and what isn’t.
SPACs are no different. I like to remember things are never as good as they seem and never as bad on the other side. The same thinking should be applied to SPACs. Doing a proper diligence process on the SPAC sponsor, asking fundamental questions about their past performance, expertise and approach, and reading the S-1 should be a common standard for evaluating a SPAC vehicle. Going through this process uncovers some interesting nuances about the flawless SPACs everyone is going crazy about, and help us filter the meaning from the noise.
