SPACs

When a private company wants to go public, they have only a few options. Up until the last few years, most believed that they had one option. The IPO, or initial public offering, has been by far the most popular way to go public. IPO’s are well advertised, with company founders ringing the bell on NYSE and news outlets talking about the IPO pop. They are suspenseful and dramatic, so everyone loves them.

Actually that’s not really true. Founders and shareholders don’t enjoy them that much for a few reasons. How an IPO works is you hire an investment bank (or a few) to help you build pitch decks and hit the road to meet massive asset managers like Fidelity to try to sell investors on your company’s stock. This is called a road show. By the end of it these asset managers will give the investment bank an idea of how much of it they want and at what price. The investment bank takes this info and says to company that they recommend a certain price to go public. Company takes advice, the IPO price is made public, large asset managers subscribe to the new issue if they want, and then the bank and the subscribers can start selling shares to the rest of the market.

So why do companies not like this? Few reasons: 1) Investment banks typically charge about 7% of the total IPO price so they are expensive. 2) There’s often an IPO “pop” where the issue was underpriced and it begins trading in the market 20% or 50% higher than what the company sold the shares for, which means the company missed out on a ton of capital for the company. 3) If you are a company that wants to go public, you first have to announce that you are going public before even knowing a ballpark amount of what your shares will be worth, so this uncertainty is scary.

So what are the other options? One that has become more popular over past two years is a direct listing. Spotify made some noise last year by going this route. How this works is simple on the surface but there are certainly technicalities. Basically the current shareholders put in limit sell orders for their shares at prices they think they are worth, prospective buyers put in limit buy orders for what they think they are worth. The markets open, the stock exchanges match buyers with sellers, shares start trading, and boom, you’re public! This matching process occurs every single morning for every single stock, so it’s a process that exchanges have down pat. There are way less fees going this route so founders like that. So why do companies not like this? 1) It hasn’t solved the problem of not really knowing what price you’re going to get, and 2) Companies can’t raise money doing it this way, they can only sell existing shares, so it’s more of a capitulation event for current shareholders. IPO’s actually create new shares which are sold for capital that the company can use for growing operations. Direct listings can’t do this.

The third option is a Special Purpose Acquisition Company, or a SPAC. A SPAC is what’s known as a blank-cheque company. Essentially what happens is a person (usually a famous investor or venture capitalist) creates a company where they sell shares that have warrants in them (kind of like a call option to buy more shares). The company’s purpose is to go out and acquire a company. If you are a private company that wants to go public, you can work out a deal to be acquired by the SPAC and then boom, you’re public! Private companies like this because it solves for the uncertainty problem. You work out a price before you go public, rather than go public and find out price later. To be fair, you are probably still selling equity below fair market value like you are in an IPO, but at least you know exactly how much you are getting screwed. Another reason why companies like this is because once the deal is worked out, the SPAC founder works with you. They can lend their operations expertise to help make your company even better.

For these reasons, SPACs have been extremely popular this year. SPAC’s have raised cover $50B this year, multiples more than last year already. While SPACs have been around for decades, they have historically only made up a small percentage of new listings. This year is different, as SPACs are starting to take meaningful market share away from IPO’s.

One question you might have is why would anyone invest in a SPAC when you don’t really know what you’re buying? The reason is because of their optionality. The way SPAC works is that the funds invested in it are kept in US treasuries while the SPAC founder finds and negotiates a deal. If they aren’t successful, SPACs are wound up and the investor gets their money back with interest. SPAC owners can even get their money back if they don’t like the proposed acquisition. This means that it has the downside of a treasury bond and the upside of a venture capital company (thanks to the warrants). This is an appealing risk reward! As long as you buy a SPAC at or below NAV and never be forced to sell it (margin called), there’s not really a way to lose money.

This has made SPAC arbitrage a popular trade for many hedge funds. SPACs trade in the market so price can be above or below NAV depending on who is doing buying and selling. If you know the NAV, you can just buy a SPAC whenever it trades below NAV and sell it whenever it trades above. Moreover, if the warrants start to become worth anything due to a potential acquisition, you can sell those. While you don’t earn a ton doing this, if you lever it a couple times it makes for a pretty good trade.

There are two major risks to doing this. One is liquidity. There are many riskless trades on paper (like the future basis trade we talked about last week) that become risky if you are a forced seller because of leverage and liquidity, so it’s important you don’t go crazy with the leverage. The second is market risk of the warrants. If the warrants explode in value, all of the sudden you do have downside risk if the warrant decrease in value, so many managers will typically sell the warrants as soon as they are worth more than nothing. This removes upside but it removes downside as well. That’s what arbitrage is all about.