SPACs — Not a free lunch

So far, almost $60 billion has flown into about 160 SPACs (Special Purpose Acquisition Companies) in 2020. All of those are looking or had looked for other companies to take public via a merger/acquisition. It means that 160 viable companies will also have to exit, for these SPACs to succeed with their intentions.

SPACs are relatively new to us, as public investors. The first SPAC that drew attention to this “old-new” innovation was the merger between Virgin Galactic and Chamath’s $IPOA SPAC at the end of 2019. That deal has opened the door for more investors to raise money via this vehicle. In terms of the SPAC cycle, the SPAC sponsor typically has about 24 months to find a company to merge/acquire. So far, we’ve seen mergers happening much earlier in a SPAC’s lifespan(Chamath’s $IPOB has merged with Opendoor within less than 6 months post-IPO). This is atypical, and there will surely be SPACs that will end up finding their target closer to 12–24 months post IPO.

While SPACs seem to introduce innovation and appear as superior to other mechanisms for going public, this method is still far from perfection. I’d like to dig into the strategy behind buying into SPAC shares and uncover the small details investors should notice, as they hide from plain sight.

Easy to raise, hard to deploy

The fundamental notion of investing in a SPAC is to buy something you know nothing about, besides who’s going to buy it for you. It’s kind of like letting someone else buy you an item you want with your credit card. You’ll have to trust them to purchase something valuable for the money spent.

The recent “SPAC-boom” cohort is still at the beginning of its lifecycle, where buyers come up with the money to buy the item but are yet to find one. Most players are focused on forming investment vehicles and raising money in a hot market(low risk-free rate -> everything else is high). In this market, raising money is almost too easy.

The reality in the past months has been that retail investors trade these SPACs like hot buns(it’s important to mention retail investors aren’t the first investors in the SPAC) and new ones continue to pop up. The music is playing and everyone’s dancing. The missing piece that is yet to come is the answer to the question of whether most SPACs will produce meaningful returns to their investors.

Somewhere between VC and PE (or, “the poor man’s PE”)

As with other categories in investing, I think the SPAC will end up looking not so different from VC returns. Very few SPACs will generate most of the returns in the category, and the rest will have to go through the process of merging with what’s left(unattractive companies) or return the money to the SPAC’s money to the investors(in SPAC, the sponsor has to accept redemption calls from shareholders at any point post-IPO).

If you think about it, for a second — SPACs may not be so different from what’s currently happening in VC. The amount of unicorns that are born each year is unmatched by the faster-growing sum of capital chasing them. The more SPACs being formed, the more competition there is to find the most attractive company to take public via a merger.

The thesis behind forming these SPACs, according to Chamath — the new king of SPACs(according to CNBC), is telling us that the market is ready for more public companies. An effective way to do that is to take companies public via the SPAC which introduces benefits of speed and transparency. These benefits appear to be straightforward but aren’t always meaningful in practice, as we’ll learn later.

This thesis has yet to discover the right pace and ratio between the amount of SPACs and companies who are ready to go public. That is completely normal for a new invention. We have to remember that and realize we are just starting to discover how this system works. Time will tell, but my hunch and others say most SPAC sponsors will discover that the work of merging with a plausible company is way harder than raising the capital. I don’t think those forming the SPACs are fully blind to it, but retail may be — as there are more facts to uncover behind the SPAC model.

Learning to evaluate SPACs

I may be wrong with evaluating the current pace of SPACs, implying there are currently too many SPACs chasing growth at this point. Still, my baseline thought process is setting a healthy standard for evaluating SPACs to invest in. That can help the investor offset unbalanced periods, and get his money closer to the right fund managers, in any market condition.

I think it should’ve been the case that SPAC stock tickers would be the sponsors’ manager name. Investing in SPACs is no different than investing in venture capital as an LP, where choosing the GP is the core component of future success. Much like in the private markets, the SPAC investor gives money to a fund manager to go find a good deal for him. Investing in a SPAC = Investing in a money manager.

In that comparison, the difference between VC and SPAC is that there’s no hedging with the latter. Each SPAC “fund” equals one deal. The way SPAC returns play out results in a harsh, transparent fundraising environment for the next SPACs to be raised by that entity. That is unlike VC, where a typical fund’s lifecycle is 5–20x longer. There, it’s easier to outline your successes, wipe the losses under the rag, and raise more funds along the way while collecting fees.

Some of the same investing principles for LPs in VC can be borrowed to look at SPAC sponsors and get a better idea for their potential performance. Some of the most fundamental questions a SPAC investor can ask himself are:

1. How much Skin-in-the-game the SPAC manager is putting at risk?
   The answer to this question can easily tell if the SPAC manager is willing to take risks on his/her own, next to other people’s money. A reasonable SPAC manager should put a sizable amount of his own capital at risk. With that, I mean that the SPAC sponsor will put capital of his/her own, next to the 20–25% chunk of free shares they get as a payment for the work they’re doing. It’s important to remember there’s no perfect risk alignment between the entity forming the SPAC and its investors. As an outside investor, you’re carrying more risk.
2. What operational expertise(in the late/public stage) the manager can offer companies? the answer will determine the quality of the manager from the merged company’s perspective. It’s crucial because a high-quality company should find the SPAC sponsor attractive from a strategic standpoint in order to choose them. If the sponsor cannot offer any value-adding qualities to the company as a shareholder, it’s just plain money.
3. What history the SPAC manager has as a capital allocator? as an investor in a SPAC, you want to know your capital is in hands that know how to manage risk. In the growth stage, it’s challenging to be precise, and mistakes can be made(like WeWork). Being familiar with your SPAC manager’s previous investing experience can help you understand the quality and style of their work. As we’ll learn, there’re SPAC sponsors who start the process, to realize they don’t know how to manage a cap table and make costly mistakes. Besides managing investments, it’s imperative for the sponsor to design the right incentive alignment between the SPAC partners and it’s investors.
4. In which sector the investor is looking to find a company?
   As an investor, you want to know to which sector your money will eventually go via the SPAC vehicle. One of the benefits of a SPAC is the ability to delegate your capital to investors who can do better work than you. For example, instead of picking a company in the healthcare sector to invest in, I rather choose a healthcare-oriented SPAC manager to pick one for me. In my opinion, this is one of the biggest advantages of SPAC — you can effectively invest together with a credible investor of your choice. As one may call it — “A poor man’s private equity”.

After we’ve answered those questions, and may or may not found the SPAC sponsor credible, the next thing a SPAC investor should be doing is digging into the details of the SPAC IPO offering. On the surface, the SPAC mechanism appears very straightforward but contains a lot of details to clarify.

In the next part(soon to be published), we’ll learn about the technical details of the SPAC offering and uncover some misalignments between the SPAC investors. I suspect too many investors aren’t yet aware of how SPACs work in practice, and what it means to hold a SPAC share. To help the community learn and develop an opinionated approach to investing in SPACs, I’ll be writing more about the subject over the next while. Stay tuned.