The future of SPACs
2021 was a crazy year for SPACs. There have been over 500 SPACs raising over $100 billion of capital. In 2010 there were just two. They haven’t yet replaced IPOs — there were 2388 in 2021 — but they are now a force to be reckoned with.
People are asking a lot of questions and opining about whether SPACs are here to stay, whether they are a good thing, and so on. But, assuming SPACs do survive, there has been basically no discussion about what the long-term equilibrium looks like.
A quick process review: IPOs vs SPACs
An IPO is a highly complex, regulated dance. It actually starts more than a year before the IPO itself, usually involving hiring an experienced CFO, formalizing one’s books, and socializing with investors. The company then files with the SEC and hires a bank, called an underwriter, for a very hefty fee. The company then goes on a “roadshow” where they pitch their stock nonstop to large institutions who will buy large blocks of shares just as the shares list on the exchange. Those shares are what retail investors trade on the market. There are many complex dynamics here that I will ignore.1
The SPAC process is rather different.
It starts with an IPO exactly like described above. The difference, though, is that the company that goes public isn’t a real company at all. It is a pool of money that sits in an escrow account for two years that will go out and acquire shares in a private company that, unlike the SPAC, is a real, operating company. The investors in the SPAC don’t know which company it is ahead of time, hence the nickname “blank check company.” The SPAC and target will then go through a reverse merger, bringing the real company public, a process called a de-SPAC, where the owner of the SPAC, called the sponsor, often joins the board of the newly merged company.
SPAC history and the narrative mirage
SPACs were created in the 1990s by GKN Securities as a modern version of a blind-pool offering, but the heyday of SPACs was the Dotcom Boom. They were speculative vehicles with negative adverse selection towards companies without the financials to withstand the IPO process. In other words, during the Dotcom Boom, the “S” in SPAC stood for “shit.” Only the worst companies chose to SPAC. Not surprisingly, SPACs collapsed with the Dotcom Bust. In 2010, only 2 SPACs came to market at all.
The rebirth of SPACs began not with Chamath Palihapitiya but with Bill Gurley, the legendary partner at Benchmark. Companies are rediscovering that going public has benefits too, so interest is increasing. But Gurley noticed that IPO pops are huge, exceeding 20% in the first day of trading.2 IPOs are fundraising mechanisms that bring in real cash for companies, so that means that companies that IPO with a pop are theoretically leaving money on the table — that is, that underwriters gave preferred pricing to their insiders to the company’s detriment. Gurley is today principally a proponent of direct listings, which is an like an IPO but with no bankers.3 He got so upset he even held a conference in San Francisco on direct listings. He has made real progress.
While Gurley was working on the direct listing, two key players were working in parallel on an alternative approach. Diamond Eagles, a highly respected finance team, and Chamath, founder of Social Capital and podcast “bestie,” tried to fill this gap in an unorthodox way: instead of reforming the IPO process, they sidestepped it by reviving the SPAC. Research has shown that financial instruments diffuse through use, which grants acceptance and legitimacy. They showed that in action — they did not just talk about SPACs. They created them. And using their network, they were able to bring highly desirable companies public — Virgin Galactic for Chamath, and Draft Kings for Diamond Eagles. The result is a SPAC boom not seen in 40 years. In 2020, over 50% of IPOs were for SPACs. The bad reputation of SPACs turned out to be somewhat of a narrative mirage. It turned out SPACs had professionalized in the interim. Big companies like Burger King went public via SPAC and reputable firms like Pershing Square and TCG have been backing SPACs for years.
The surge of companies is a response to supply and demand. There used to be over 8000 public companies; now, despite more retail demand than ever, there are fewer than 4000. The main reasons are regulation and private capital. Sarbanes-Oxley increased the cost of being a public company4 in exchange for benefits in reducing fraud, giving public markets a bad reputation compounded by a perception of short-sightedness. At the same time, venture capital funding increased by a factor of 5 since 2010, so companies could stay private longer. This also means there are way more unicorns who could plausibly go public, and indeed in yesteryear would have already gone public years ago. But IPOs are expensive, so a lower-cost approach was natural to evolve to meet public market demand.
Today, SPACs are not garbage. While there are certainly questionable companies that have gone public, especially in the electric car space like Lordstown Motors and Nikola Motors, some of the companies that have SPAC’d are hot companies, including Opendoor, Aspiration, Nextdoor, Hippo, Bird, and others. SPAC share prices have underperformed overall, but some have done quite well.
The fundamental dynamics
There is only one truly fundamental difference between SPACs and IPOs. That difference is an inversion of liquidity on the supply and demand side. The upshot to this is that, in the long run, IPOs and SPACs will select for different types of companies differing primarily by stage.
In the IPO process, recall that companies wishing to go public pursue underwriters to go public. These investment banks act as funnels, managing the process and linking companies to institutional investors. The companies are the demand side and the banks are the supply side. There are far more companies that want to IPO than banks and good bankers, giving significant leverage to the banks. The SPAC process is the reverse. There are lots of SPACs who need a company to take public in a two year window. But there are still not quite so many companies that want to go public. Here, the SPACs are on the demand side, and once again there is much less supply than demand.
There are lots of other things that make the SPAC process different — S-4 filings that are less rigorous than S-1s, forward looking statements, redemption issues that incent celebrity sponsors, differences in diligence standards, complex warrant and PIPE economics, and much more — but the vast majority of these things have to do with the regulatory dynamics and growing pains.5 They are not fundamental to the SPAC market because the SEC could change it overnight. That inversion of supply and demand is the core market chacteristic of SPACs. Some fear this dynamic, saying that it creates inherent negative adverse selection, which the SPAC industry could not survive long-term. This might turn out to be true, but perhaps a more interesting question is: what does a stable equilibrium look like where the SPAC industry does endure?
At a stable equilibrium, a SPAC probably has to be costlier than an IPO or direct listing to incentivize the creation of enough SPACs. They certainly are today. The costs are opaque and not necessarily cheaper than IPOs, especially when accounting for dilution. They also don’t solve the “pop” problem. The average PIPE performance in 2020 was 46%, which was more than double the 2020 IPO pop! To some extent this makes sense. SPACs are riskier and many of them won’t find a target. There are also significant costs in maintaining a management team and board for the SPAC itself, marketing the deal to maintain redemptions, and more. What this does mean is that SPACs can’t be the cheap IPO replacement, so they have to serve another purpose to survive.
There is only one way to maintain an equilibrium with higher SPAC costs, inverted supply and demand, and sufficiently positive selection to make SPACs sustainable. The answer is: selection not on quality but on stage.
Which companies want to go public, are high-quality enough to sustain an industry, will care about which sponsors are on their board, don’t feel ready to go through the gauntlet of the IPO process despite likely lower costs, and can generate great returns? They are crossover companies that want to go public 1–3 years before they are ready to actually crossover.
SPACs would then look a lot like growth equity. They will have higher variance and volatility than IPOs, but may have higher average returns over time. Diligence will continue to improve now that the initial frenzy is over. And just like with growth equity, being able to promise a great board member can help win a deal — so sponsors like ReInvent, founded by Mark Pincus and Reid Hoffman, will probably get better deals than Whoever SPAC Capital Partners IX. In the long run, SPACs aren’t competing with IPOs — they’re competing with private crossover rounds.
This would also require a change in the incentives of SPAC managers, who can still make money even if the de-SPAC’ed stock prices sink. This is the reason people fear negative adverse selection: if sponsors are incentivized to consummate a deal, even if the deal will do poorly, then bad companies will got to SPACs to get a quick deal. For SPACs to avoid this, quality teams need to bring quality companies public and the market needs to not tolerate economics that make SPAC sponsors money regardless of stock performance in time to avoid tarnishing all SPACs.
If this is true, the long run of SPACs is bright, but not an IPO replacement. If this isn’t true, then one of these assumptions about the long-term dynamics is wrong — or there is no stable equilibrium and SPACs will once again be relegated to obscurity and scams. But it seems reasonable to think the market will find a way. After all, we need more public companies.
You can also see why direct listings don’t occur (at least right now) unless you already have a big brand. Much of the IPO process involves socializing a company with investors, so unless you’re already famous the direct listing deprives your company of that significant benefit. This might change in the future, but for now it is a real constraint.
Until recently, direct listings could not be used to raise primary capital, though this changed mid-2021.
One paper found that SOX even increased the cost of being a private company!
For one example, right now there is an oversupply of SPACs and high redemption rates, so they are overfunding their trusts. The result is that many fixed income investors are participating and redeeming as a matter of course. This is probably not a sustainable dynamic and will work itself out. It also means that this is not a fundamental dynamic of a stable equilibrium.