value and opportunity

I have covered the current SPAC Mania already in a post in June on Nikola, but since then SPACs only seem to gather more steam.

VC legend Bill Gurley (Banchmark Capital, Uber) has released an interesting post on the three main venues for a company to go public: A “classic” IPO, a simple listing and finally the SPAC.

I’ll try to summarize his post:

• he argues that the IPO process is “broken” and rigged by the I-Banks. His proof is that on average, IPO’s are “Popping”  ~20% on the first day of trading which means that this difference, multiplied by the number of shares placed, is “stolen” from the previous owners (i.e. himself as a VC)
• on top of that, companies have to pay IPO fees
• The reason is that banks prefer special clients and do not really match demand and supply
• as direct listings (Spotify) do not allow to raise large amounts of money, reverse mergers with SPACs are preferable
• He argues that SPACs have “lower cost of capital” than IPOs but doesn’t give any examples. His main “proof” here is that there are so many SPACs now and that companies can negotiate really hard.
• and of course the way to public markets is a lot faster for a SPAC

Bill Gurley is clearly not an idiot as he most likely is now a billionaire following some very impressive investment successes (Uber) with Benchmark capital. However I do think that his arguments have some serious flaws.

Mistake number 1:

The stocks that get traded at the “pop Price” are only a small fraction of the placed stocks in total. Often, maybe 2-5% of the share placed are traded at the first day. So the theoretical  “damage” is much smaller than he calculated.

Mistake number 2:

It is actually not a secret that over 1,2 and 3 year periods, IPOs on average are really bad investments, under performing the market significantly. Some studies on this can be found here, here or here. So combining this with mistake number 1, the “damage” is much lower or even non-existent. Or the “stealing” is done from those investors how buy at the pop price and hold the shares.

Funnily enough, Bill Gurley’s most successful investment Uber is a good example for an under performing IPO: Issued at USD 45 per share, the stock dropped 7% on the fist day of trading. With 8 bn USD issued,one could argue that Gurley and other shareholders stole more than 500 mn USD from IPO investors. But I guess he would consider it “bad luck”.

Mistake number 3:

A classic IPO is basically a combination of 2 transactions:

• a block trade either based on newly issued shares or existing shares or a combination of both
• and a parallel listing at a stock exchange (i.e. filing al required papers etc.)

Now anyone with some experience in block trades knows that depending on the stock, the size of the block and market liquidity, that you can either try to sell a block directly into the market, which with today’s market infrastructure (“Flash boys”) will kill almost certainly any share price or you can ask an I-Bank to place the block which is usually done at a discount.

The same applies for almost every capital increase which is done at a discount in order to motivate investors to take up the additional share. So a certain “discount” is nothing special. I would say depending on the situation, a normal block trade or a capital increase is usually done at discounts between 3-10% to the market price plus fees.

So assuming that you can place a huge block of shares during an IPO at no discount to “fair” value is pretty naive in my opinion. I also think that the discount needs to be higher than for a normal block trade or capital increase, as there is no previous liquid market price, which means that there should be some kind of a risk premium. There is no small amount of IPOs that tanked from the beginning and investors will require a premium for this kind of tail risk. So the aprt of any “Pop” is nothing else than a typical dicount for the underlying block trade plus a risk premium.

Mistake number 4:

In his post, Gurley states the following:

The key reason VCs never sell in a traditional IPO is because they all know the game is rigged (the under pricing), and do not want to sell at such a steep discount. As we find new doors to the public market that have truer/fairer pricing, you will see an increased willingness to participate.

Well, I guess that is maybe his opinion but not shared by IPO investors. Why ? Because a VC with a longer term investment in a company is the ultimate insider: As long as a company is private and a VC is on the board, he/she will have access to each and every piece of information. This information is much more granular and comprehensive than anything that gets reported in the IPO filing or thereafter and a VC at the time of an IPO has a huge information advantage vs. any potential new investor.

For any new investor, the selling out of an “Insider” would be a huge red flag and therefore IPOs always require a “lock-up” period for insiders (management, VCs) where they are not allowed to sell shares, assuming that after some time the information advantage disappears.

The attractiveness of SPACs:

To be honest, I don’t buy a single argument of Gurley “pro SPAC”, especially as he doesn’t substantiate it with numbers.

What I see as problematic for SPACs are the following issues:

a) Gurley describes that the current environment is super competitive. This means that many SPACs are desperate to do any deal in order not to have to send the money back and having done work for nothing over 1-2 years

b) The fact that only one team (the SPAC management) looks at the target company for a short amount of time also means that the Due Diligence is a lot shallower than that for an IPO. During an IPO, at least an investment bank has to do some due diligence and different teams form different investors will look at the business and ask questions. Although this process is far from perfect, at least cases like WeWork could be prevented. But overall the “quality control” in a SPAC sponsored reverse listings is a lot lower

c) Finally, in my opinion, the SPACs attract different kind of investors than traditional IPOs. I would put a lot of operators around SPACs into the “grey area” of the capital market, which you often see in Penny stocks. A lot of theses guys know how to “Pump and dump” a stock especially with retail investors.

These 3 points in my opinion ensure that SPACs will mostly attract companies with a lower quality that otherwise would have struggled to attract capital and where the alternative might have been a trade sale with a much bigger discount (or bankruptcy).

For investors who buy into a SPAC after a merger, the news is pretty bad: SPACs have historically under-performed, both, the stock market and IPOs by a very wide margin. There is no lack of studies on the topic and the results are always unbelievably bad (see for instance here).

Of course there is the occasional successful SPAC (Restaurant Brands etc.), but as we say in German “Die Ausnahme bestätigt die Regel” (The exception validates the rule).

Is it different this time ?

The current market environment is characterized in my opinion as a new “digital craze”. Listed tech companies are very expensive and investors need more supply. However there is only a certain amount of “top level” tech companies available and many of these don’t need to go public because there is so much money in private markets these days.

As a result, SPACs allow the promoters to list and sell second tier tech companies to speculative investors at very high prices  who want to make a quick buck.

I am willing to bet that the 2020 vintage of SPAC will most likely set a new record for under performance over a longer period of time, although now one can predict in the short run what will happen.

Interestingly, A16Z came out with a similar post on IPOs which explains nicely some dynamics in more detail how and why “pops” occur during IPOs, but I agree with them almost 100%: There are clearly some issues to be improved in the IPO process, but SPACs are just not a better alternative, unless for very specific situations.

For any fundamental investor the lesson is clear: As most IPOs are not good long term investments, It is even more clear that the current SPAC boom creates a lot of long term under performing stocks. For people investing on the short side, it will become interesting at some point in time although the timing factor is always difficult.

From my gut feeling I would say if we see the first SPACs popping up again in Germany, we might be relatively close to the top.

But to answer the question from the title: No, I don’t think that it is different this time with regard to SPACs. Yes, there might be an occasional winner but the large majority of SPACs will be crap businesses sold at premium prices to unsuspecting trend following investors. But in the mean time the promoters will make a lot of money for themselves. IPOs via SPACS do give an advantage to sellers in the short run, but everyone else is losing.

I think the whole discussion also shows the amount of greed that is now rampant in Silicon Valley and the VC sphere, It will be interesting to see how long demand keeps up with the increasing supply, especially when more and more crappy firms become public.