The ABCDEFs of SPACs

After sharing some thoughts on Special Purpose Acquisition Companies (SPACs) internally to the Blackbird team, we took the discussion public for our first Clubhouse session. Like all other future-oriented investments, most technology SPACs are likely to fail but the specific features of their formation and their suitability for long range projects that can raise 7+ years of financial runway makes me optimistic that they will be a net benefit to society (if not to the twitchy investors who roll the dice on them!). Read on to find out more.

What is a SPAC?

A SPAC is like a late stage round of financing that turns the investee into a public company. They are formed in four basic steps:

1. A group of people - this could be a private equity firm, a group of celebrities, technology investors or VCs - agree to form a SPAC and raise $200-300M (or sometimes up to billions) from retail and institutional investors
2. The SPAC then finds a company to invest in/acquire.
3. Once they’ve found a company, the SPAC then finds a group of other investors to join the acquisition (called a PIPE, or private investment in a public entity), which usually doubles or more the $200-300M in funding the SPAC has.
4. The final consummation involves a vote of the original SPAC unit holders, who approve the transaction or ask for their original money back.

But why are so many SPACs being formed?

“Show me the incentive and I’ll show you the outcome” - Charlie Munger

The above steps appear straightforward - even boring - and do not explain why there were more SPAC dollars raised in the first quarter of this year than there were in total for last year (and 2020 was 10x bigger than all other years combined).

The magic of a SPACs is in the set of incentives for each of the participants involved, with each step making complete sense in isolation but in aggregate, leading to an outcome that has probably spun out of control and led to an overdose of capital.

Here are the players in the game:

Promoters: The 2-5 person team that forms the SPAC gets 20% of the SPAC for a nominal cash amount. This figure is taken from the PE/venture world where the investors get 20% of the profits.

But you’ll notice that the promoters get 20% of the whole fund, not just the profits, which means that if it doesn’t work out, they still get tens of millions of dollars (and if it does work out, they will get hundreds of millions of dollars).

SPAC Investors: Reading above, you might think the people who agree to invest in SPACs are retail investors ripe for a fleecing. But instead, they are some of the most sophisticated hedge fund investors or other institutional investors.

Why? Rather than hold cash themselves which currently have no yield, it is appealing to place this cash in SPACs instead. Because the SPAC must hold the initial cash on trust account in US treasuries until the final vote at the end of the process, there is a layer of protection from bad actors.

In addition, original investors get a warrant for every 3-5 shares they purchase. Many hedge funds have immediately sold their shares in the SPAC (often for more than the $10 they purchased them, even though very little has happened) and kept on to the free warrants (the right to buy shares in the future for the original $10 price) and then made even more money once the final merger has been consummated (and the stock price is much more than $10).

PIPE Investors: Institutional investors like Blackrock, Fidelity and Wellington don’t get the benefit of these free warrant shares, so why would they turn up? Because at the time they are making a decision, they have two important pieces of information: knowing the actual company will be that they are investing in, but perhaps most important in the short term, what the share price of the SPAC is.

You see, they also invest at $10/share but almost all SPACs are trading materially higher by the time the merger is being announced, and they are essentially being offered a huge discount to the current share price. They can hold for the long term, but they can also bank the gains in the short term and get a huge bonus in their next compensation review.

Bankers: Someone needs to serve alcohol at the party and investment banks advising on SPACs are having a field day.

Despite the initial narrative of SPACs being a superior alternative because the traditional IPO process was too costly, SPACs have turned out to be the opposite and bankers are minting money. Typically, they will earn about $50M all up in fees from the initial raising of the SPAC, helping arrange the PIPE investment and advising on the M&A combination. A small team of 10 people or so at banks like Deutsche Bank, Credit Suisse and Citibank probably did tens of SPACs each per month in Q1.

SPACs still make me incredibly optimistic for society

Just like all technology (and capital is a form of technology), SPACs can be used for good or bad, and just like venture capital, a lot of the decisions will seem unpopular at the time and the majority will fail.

But the perspective of SPACs being crazy and the majority of them failing ultimately misses the forest for the trees; there will be a small subset of companies that will succeed in a spectacular way. If we focus on the types of frontier technology companies that are getting funded now (like local space company Rocket Lab’s recent announcement of going public via a SPAC) things get really fascinating. These companies are raising the equivalent of a Series C, D, E, F all at once.

Particularly for companies in these harder technical pursuits like space, quantum computing and autonomous vehicles, this takes all the financing risk off the table and gives them the runway to achieve all of their technical milestones. By removing the hamster wheel of raising multiple rounds every 12-18 months, these super premium frontier technology companies can focus on achieving their mission with the certainty of having seven years to make it happen.

I suspect at the end of those seven years we’ll find generational companies in those kinds of areas. The share price might be a rollercoaster but from a societal point of view, I believe it will end up being a net positive - and in a few cases, we’ll see businesses that would not have existed except for the great SPAC boom we are living through.

This content was originally shared as part our Blackbird Variety Hour on Clubhouse. Join us at 8pm AEST every Monday to tune into more ideas and debate from our team!