SPAC to the Future
Going Public in the 21st Century
For over four hundred years, private companies have tapped the public equity markets for additional capital and liquidity. It is believed that Dutch East India Company offered ownership shares to the public in early 1602, making it the world’s first publicly traded company. In the United States, The Bank of North America was the first to offer shares to the public in 1781, just a few years ahead of the founding of the New York Stock Exchange (NYSE). For much of the past century, the process of offering ownership shares of a private company to the public has been conducted through an initial public offering or IPO. More recently, two alternatives have emerged, private companies merging with Special Purpose Acquisition Companies (SPACs) and direct listings. In this quarter’s commentary we’ll take a closer look at all three approaches to accessing the public markets and what the differences mean for companies going public and the investors who participate.
Going Public; Old School
Historically, the most common way companies accessed the public equity markets was through the IPO process. Management teams at private companies have different motivations for becoming publicly traded, but chief among them are liquidity for early investors and access to additional capital funding. IPO’s, however, are a time consuming and cumbersome process regulated by the Securities Act of 1933. After deciding to pursue a public listing, a company will select an investment bank to orchestrate the whole process. The investment bank will form a syndicate with other investment banks to negotiate the size and pricing of the offering. The
investment bank, together with lawyers, will assist in writing a preliminary prospectus detailing the company’s operations, financial history, management team, and risk considerations. Importantly, in a traditional IPO, company management teams are forbidden from making forward projections, but the investment bank can offer their forecasts. It is then up to the syndicate to market the proposed offering to their clients to judge demand and price levels. Prior to the pandemic, this marketing effort typically included a roadshow with bankers and management teams visiting large institutional investors. The roadshow allows management teams to meet with prospective shareholders and build a list of investors most likely to remain long-term holders of the company’s stock.
After all the due diligence has been completed, comes listing day. The syndicate and the company have agreed to an offering price and the number of shares to be offered. The syndicate then allocates the shares to interested clients (mostly large and institutional). The exchanges will then assess additional demand from participants who were allocated shares, as well as those who were not, including the general public. Ultimately, an opening price is determined, sometimes quite a bit higher than the offering price, known as a “pop.” This is a risk to selling shareholders; did the syndicate misjudge demand and underprice the offering, thereby “leaving money on the table.” According to data from Jay Ritter of the University of Florida, in the decade ending 1999, the average first day return for an IPO was 14.8%. From 2001-2020, the average first day return was 16.7%. During the 1999-2000 dot.com bubble, however, the average first day return was 64.6%. The past two years have also produced above average first-day returns, prompting some to wonder if today’s market is getting a little frothy.
Bursting onto the investment scene the past few years have been SPACs. Also known as “blank check companies,” SPACs have emerged as a popular alternative to the traditional IPO. Ironically, though, SPACs must first go through the IPO process themselves. Last year, there were over 240 SPAC IPOs compared to 165 operating company IPOs. SPACs also accounted for just over half of the approximately $150 billion raised through IPOs in 2020. So, what are SPACs going to do with nearly $100 billion in fresh funding raised in the last three years? First, the basics. For this conversation we’ll stick to a broader, conceptual description of SPACs.
A SPAC begins its journey when a sponsor decides to raise money to purchase a private company. It literally starts as an idea. Sponsors need credibility or at least a story to attract capital. That’s why SPACs are increasingly being sponsored by well-known investors or even celebrities. Some sponsors may have a specific target in mind or will target a specific industry, such as electric vehicles. Next, the proposed SPAC will go through an abbreviated IPO process, due to the lack of any operating history.
Once the IPO is completed, the SPAC will place the proceeds raised into a trust and invest in treasury securities as the clock starts on the search for a merger target, normally set between 18-24 months. SPACs are typically priced at $10 per unit, with each unit consisting of one common share and a fractional warrant (option) to buy a proportional share later. But, like traditional IPOs, SPACs can also have a “pop,” sometimes based simply on the notoriety of the sponsor. At any time up to a merger completion or at the end of the defined period, SPAC shareholders can return their units for $10 plus interest.
Some private companies may find SPACs advantageous for a few reasons. First, merging into a SPAC means no preliminary prospectus or roadshow. Next, the transaction price is negotiated up front, not leaving to chance bankers under-valuing the company and “leaving money on the table.” Also, as a public company, the SPAC can make forecasts of future results for the combined company. For investors, the performance of SPACs has a relatively short sample period, but a recent analysis by Goldman Sachs suggests that investors of SPACs pre-merger fared better than those who invested post-merger. Further, pre-merger investors who buy at the offering price will have an essentially risk-free rate of return owing to the ability to put their shares back to the SPAC.
A word of caution; SPACs are far more complicated and nuanced than described here. In early March, the Securities and Exchange Commission (SEC) issued an advisory highlighting SPAC risks to individual investors, including a warning about investing in SPACs simply based on a sponsor’s celebrity status. Additionally, there are now more SPACs outstanding than the average annual rate of IPOs over the past ten years, meaning some SPACs will not complete a merger, or worse, be forced to compromise on the value or quality of a target just to get a deal done.
A second alternative to a traditional IPO is a direct listing. In a direct listing a company will sell shares directly to the public without the underwriting and marketing support of an investment bank syndicate. This makes a direct listing a less expensive alternative to a traditional IPO. Direct listings have been limited in the past due, in part, to the prohibition of issuing new shares to raise capital. Last December, the SEC approved an NYSE rule change to allow companies to raise capital in a direct listing. To complete the process, the exchange facilitates an opening auction to determine the offering price. It remains to be seen if this rule change entices more companies to forgo a traditional IPO and list directly. An added benefit to the issuing company is that a direct listing does not include a “lock-up” period on insider share sales, unlike a traditional IPO.
No Free Lunch
Hot IPOs with big ‘’pops” and celebrity backed SPACs get lots of attention from the media, but that doesn’t guarantee investment success. Generally, companies coming to the public markets are smaller, not profitable, have shorter operating histories, need capital, and likely will need additional capital later. Further, early investors may be looking for an exit. The traditional IPO process provides the most exhaustive due diligence on a prospective public company. Yet, many studies have shown that IPOs generally underperform in the years following a listing. Importantly, most of these studies measure returns from the first day closing price NOT the offering price. This matters since most individual investors are not allocated shares at the offering price and initiate their positions after the opening price. For example, a study by Dimensional Fund Advisors tracked over 6,000 IPOs from 1992-2018 and found that as a group they trailed the Russell 2000 index by over two-percentage points on an annual basis when measured from the first day closing price. SPACs and direct listings have much shorter histories and smaller sample sets to measure performance and should be approached cautiously.
Investing in new issues is tough. Individual investors are unlikely to get an IPO’s offering price and SPACs can have deal terms preferable to the sponsor, often to the detriment of the public. Like any investment, an objective analysis of as much available information as possible can help protect investors from emotion and hype.
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