De-Masking the SPAC
Tech SPACs crushed all records in the first quarter of 2021, completing 182 IPOs with $60B raised and announcing another 73 acquisitions with an aggregate deal value of $201B. These IPO numbers are not annualized, and for good reason, because they will never be repeated again in a single quarter. Completed SPAC IPOs dropped to 28 in Q2 and announced deals fell to 43. Wall Street did what Wall Street does and went overboard, and PIPE investors responded in April by temporarily shutting their purses before slowly cracking them open again in June and July. They are no longer saying yes to everything (as I do with my 2 year old granddaughter, Emma) and have grown far more skeptical and selective on what SPACs they deem worthy of de-SPACing. June and July are on track for an annualized rate of 240 SPAC IPOs and 240 acquisitions, which would amount to a whopping $72B in IPO proceeds and $432B in annualized M&A value, equal to 2/3 of an entire year of typical Tech M&A deal flow.
How plausible is it that, overnight, this old Wall Street product repackaged can supercharge the IPO and M&A market by nearly two-fold? The U.S. government’s near-zero interest rates and massive deficit spending, coupled with insatiable appetite for PE returns, has pushed trillions upon trillions into equities. Sponsors are making an immediate 5x return on their money for literally just closing the deal. The investment banks (yes, my art and trade) put up their best quarter ever in Q2 fueled by SPACs. Those are some powerful forces driving a phenomenon that, in and of itself, does not legitimize the quality of these investments.
The SPACs announced in 2020, with far less competition, have delivered 23 of the 27 best performing closed deals. On the good news front, those top 27 closed SPACs are up a median of 53% since IPO. So in the early days of the SPAC revival, we had better priced and possibly better quality companies. The last 40 SPACs to close are down a median of 8%, driving home the concern of overheated competition and low deal quality.
The fundamental thesis behind SPACs makes a lot of sense: savvy deal makers raise public funds to buy a private company like DraftKings at a discount to the market, unlocking enormous value for both the private and public company shareholders. So let’s back up the truck and do as many SPACs as possible, right? Here is why that strategy is not working as planned:
- Private companies with loads of bidders at the table do not want to sell at a discount, particularly to an unproven SPAC which may require six months to close. For this reason, prices for SPAC acquisitions have been rising from mid-single digit multiples on revenue in the first half of 2020 to over 14x revenues in 2Q 2021. All the juice is being squeezed out of these private companies in the drive to get a deal done. The median return to IPO investors on the 81 completed SPACs in 2020 and 2021 is -1%. Completed SPACs have woefully underperformed the IPO Index and S&P 500, which are up 62% and 41% respectively since June 1, 2020.
- Many of these completed SPACs are pre-revenue concept plays or second tier companies that could not go public in a traditional IPO… Ouch! Not to be too harsh, but that is the truth. There is nothing stopping these companies from doing a traditional IPO if they meet the requirements – the IPO door is wide open. DraftKings is an exception on two fronts; its performance took off after it SPACed, and had all of these SPACs been around back in 4Q 2019 when DraftKings negotiated its deal, it would have sold for a much higher value at the time. Among the completed and announced SPACs, there are many good companies, but it is definitely a 2020 success story with declining returns ever since, and a mixed bag overall.
- Sponsor incentives are still too far out of line with other stakeholders’ for creating long term value. Sponsors put in their risk capital at roughly $1.50 for each $10 share they receive, so when a standard $300 million SPAC IPO closes a deal, excluding the value of warrants and before any stock appreciation, the sponsor has a $50 million profit. Contrast that to a true PE investor who does all of their searching and due diligence knowing that they will need to build the company over 3-5 years before realizing that type of a pay day. PEs are incentivized to find companies with great long-term prospects at a reasonable price, while SPAC sponsors are incentivized to close the deal. If SPAC sponsors were to tie their entire promote to earn outs at higher stock prices post closing, there would be fewer and far better SPAC deals closing.
- The old taint has once again overtaken Mr. SPAC. It is much harder today to convince a high-quality private company to go public by way of SPAC. If you read the business descriptions and review the financials of any ten newly announced SPACs, you are not going to be very impressed.
In June, there were 20 SPAC acquisitions at $30B in enterprise value. Annualized, that amounts to $360B, an enormous capital markets new public listing and M&A product category. Banks and sponsors are making lots of money, and sellers who are generally not taking out any cash are getting sky-high public listing valuations that no strategic would pay. So who loses out in this case? If the stock goes up, everybody does well, but if the stock goes down, the recent PIPE investors get hurt dollar for dollar, and the selling company’s shareholders start getting hurt when the price falls far enough to where they could have transacted on a private market driven valuation. As an M&A advisor, it does not hurt to have all these public companies coming to market searching for targets to backfill their bloated valuations. For traditional IPO investors, SPACs are pushing up their IPO pricings. The banks, sponsors, and sky-high paper valuations will keep SPACs IPOing and announcing deals until a market correction or predictable underperformance ushers them out. While there is some chance that self discipline and healthier sponsor incentives will bring about a more sustainable SPAC ecosystem, I am not betting on it!
So, what would be a well-executed SPAC in today’s market? A solid tech company with strong long-term fundamentals, ready to be a public company, but a little early or not quite sexy enough for Goldman and Morgan in a traditional IPO. The company has IPO aspirations and would like to engage in acquisition sooner than later. In other words, it’s a solid company that can predictably perform well over the long-term with a substantial revenue base, e.g. over $75M. That said, you need to execute the acquisition and de-SPACing, unlike all the other SPACs getting done lately. The new PIPE investors should be coming in with at least 50% of the proceeds of the IPO investors with no sharing of the promote or the warrants. You want a PIPE investor that is a pure third party advocate of the company and the deal with meaningful skin in the game. The acquisition has to be priced at a level that is going to give the new PIPE investors a pop in the market, just like an IPO. Sponsors should get their risk capital back as free shares, so that their capital is returned to them in shares for successfully getting the deal done. The entire promote should be locked up for a minimum of one year, after which half of the promote can be sold if the stock trades above $10 for 60 days, and the other half can be freed up if the stock trades over $12.50 for 60 days, with no early acceleration on the one year requirement. The sponsor should not make a profit on their risk capital, time, and effort until the company stock price exceeds its original $10 acquisition price. If you want PE-quality companies and returns, then you need the incentive structure to be closer to a traditional PE deal. A SPAC deal ecosystem as described above could make for a vibrant, sustainable pubic marketplace for both solid but not perfect larger companies, as well as fast-growing but young early companies.