AUTHOR

GIACOMO GUALTIERI

giacomo.gualtieri@edhec.com

The Private Capital Market

During the last months, at the most macro level, we have seen private capital grow exponentially because it is patient capital. Managers in private capital can manage through cycles, without worrying too much of quarterly earnings or new market trends and this has become extremely valuable in uncertain times like this. They can think about the long term of these companies where they invest because the typical holding period for a business goes up to 7/8 years, therefore they do not approach a business short-minded. The long term perspective is certainly to the benefit of most companies given that today we’re seeing a huge market volatility. CEOs and management teams from target firms have said to actually need this sort of shield from market volatility. This is why in the recent years we’ve seen an increasing trend of private companies that could go public but in fact they don’t. For example, software companies are increasingly reaching $10 billion in value without going public as the following graph suggest:

Source: McKinsey & Company – Grow fast or die slow: Why unicorns are staying private

A strong contribution to the spread of private capital comes from the institutionalisation of alternative asset managers. Most of these market experts operate in multiple business line. They often have a credit division, invest in real estate, are equipped with insurance strategies and beyond. The magnitude of scope of these operators has broadened over the last years. They also manage funds that beside investing in private capital may also be specialised in funds of funds activity or turnaround (DIP – Debtor in Possession) financing.

The Covid-19 pandemic and the economic aftermath has obviously impacted the private equity business. However their response is for example very different from what we saw with 2007 financial crisis. 10 years ago the private equity market reacted quite defensively to the crisis, fund managers were not looking outwardly but they decided to focus on preserving their existing portfolio of businesses. These firms learned from that experience and during the crisis we’re living today they changed their response. First of all they acted quickly in support of companies they own and they acted effectively in keep looking for new opportunities. They obviously benefitted from fiscal and monetary policies which is another lesson they learned from the previous financial crisis. Another material difference is represented by the behavior of the limited partners (LP). During the financial crisis the LPs were not looking to deploy capital, but protecting the money they had on the ground. Conversely what we’ve seen in the current environment is that LPs are encouraging fund managers to invest and they want to find deals in the first place. Thanks to the asset managers institutionalization and the push from LPs, PEs have approached this crisis in a totally different spirit than before.

Deal activity for PEs is incredibly robust, and since the first lockdown period last spring there’s been a rebound in the investment grade market. This flood through the public equity market where banks raised several PIPEs (Private Investment in Public Equity) for companies in need of support in more challenging industries. Subsequently there’s been a rebound in the leveraged loans market and an incredibly active IPO market. ECM activity was 75% higher in June 2019 over last year. Finally for businesses in popular and trending sector whether it is fintech, software, pet care and other segments in healthcare market there’s been a great amount of M&A deals during this summer period.

On the other side, sellers have been very clever in taking advantage of all the tools in their toolchest, whether it is selling the whole company, a partial sale, a pre-IPO capital raise (also known as cross-over raise), a full IPO or the newly solution represented by SPACs. SPACs accounted for 45% of the IPO new issue volume in 2020, which is incredible. The question arises spontaneously: what exactly is a SPAC?

What a SPAC is and how it works

A Special Purpose Acquisition Vehicle (SPAC) is a public shell company that exist for a single purpose: finding a private company and taking it into market quickly. In order to take a company public a SPAC will merge with the private firm taking on its name. This new merged firm gets a spot on the exchange and a new ticker. In other words the SPAC is a pool of capital that is used to purchase a stake in a company. Once the deal closes, investors who own shares in the SPAC now own a piece in the new entity and the founders of the SPAC get a large part of it too often at a very good price. SPACs raise money through an initial public offering that sells shares and warrants in a bundled unit usually at $10. SPACs have 12 to 24 months to identify and complete an acquisition. Early investors in SPACs buy units, which are usually comprised of one share of common stock and a fraction of a warrant to purchase more stock at a later date. Warrants are considered a sweetener, providing investors with the possibility of additional compensation for their cash, though, they expire worthless if a SPAC fails to close an acquisition. In fact there are two available scenarios for the investors:

  • If an acquisition is completed, warrant holders can buy more shares by turning in their warrants and typically putting up $11.50 per share at some point in the future, an enticing proposition for those who believe that shares of the resulting company from a SPAC merger will rise substantially after going public.
  • If investors of the SPAC dislike a planned purchase, they get to sell their shares but keep the warrants. That gives them the possibility of an upside even in transactions they opt out of, if a merger goes better than they expected. That combination is seen as making SPACs a safe bet especially during turbulent markets. Once the business combination is completed, the acquisition target becomes a public company.

These empty shell companies are primary owned by veteran corporate leaders, and big investors like PE firms, and usually only a small amount of shares is available to the public. A SPAC ideally gives you the opportunity to invest in a good management team or a good entrepreneur who will increase the value of the investment. But obviously the investment incorporate business and market risk and if things turn out bad the stock will go down. From this point of view, SPACs, are just like a blank check, where the uncertainty plays a big role. In fact SPACs are often known as blank check companies, the name says it all. 

To better understand the magnitude of this new trend we can have a look at the following data:

Source: McKinsey & Company – SPAC Insider

As we can see the number of SPACs has hugely increased in 2020, and the trend seems only at the beginning given the high number of Blank Check companies still actively looking for the right target to take public.

Some recent examples

Some of the most known examples of SPACs are summarised in the following table:

Source: personal elaboration

An example not provided in the table because not done yet is represented by Pershing Square Tontine which is looking at employee-owned and family-controlled businesses as potential targets for a merger. The hedge fund manager Bill Ackman gave new hints at which companies he may target with his record-breaking blank-check firm. Pershing Square Tontine made waves in the rapidly growing SPAC space with its July debut. The firm raised $4 billion with its IPO, a record for such investment vehicles. If Bill Ackman’s SPAC succeed in getting a large multi-billion private company and taking it public, it will be the best proof of concept yet for the SPACs idea. Airbnb was reportedly approached by Bill Ackman’s SPAC, but the company ultimately decided against this route, instead filing a traditional IPO for December 2020, therefore the hunt continues for Pershing Square Tontine.

Another soon to be listed firm through a SPAC is Clover Health, an insurtech company for Medicare Advantage plans. The company will become publicly traded through a merger with special purpose acquisition company Social Capital Hedosophia Holdings Corp. III. The two companies will combine through a mix of cash financing and stock, according to the announcement. The deal rates Clover at an enterprise value of about $3.7 billion and is expected to bring in $1.2 billion of gross proceeds. The founder of Social Capital, Chamath Palihapitiya is probably the most influential SPAC booster. Besides this huge operation just described he has created the SPAC that bought Virgin Galactic and also the SPAC that bought Opendoor. Now, Palihapitiya, a former Facebook executive, has three more SPACs in the works.

SPAC’s Pros and Cons compared to a traditional IPO

SPACs have really changed since the early days in the 1980s where precursor of today’s companies where called blind pools. These had a shady reputation tied to penny stock frauds. In the decade since, new laws and regulations helped add credibility and favour investors confidence. Now as SPACs gain momentum new blue chip institutions and veteran investment banks are buying in. For instance Goldman Sachs never used to underwrite SPACs IPOs but it started to do so a few years ago. NYSE is also now listing a lot of SPACs while for a long time it did not.

The process to go public is different from IPO where the company works with underwriters and investment banks. The process in traditional IPO can take months and the firm during the whole process has to stay quiet in promoting its shares until they start trading. This is where SPACs have a big advantage. With a SPAC companies can talk about themselves and promote themselves to investors. Growing mainstream acceptance of SPAC helped fuel this year boom. But it was also the Coronavirus pandemic. This is because during volatile markets a company’s valuation can crash overnight but with a SPAC there’s more certainty of execution, you know early on in the process you will get the deal done while IPOs might derail at every moment due to market volatility.

To summarise those are the main advantages compared to traditional IPO:

  • Shorter timeline to listing
  • Less uncertainty in terms of the price (it’s a privately negotiated acquisition with a set price)
  • Lower transaction costs
  • The target firm that wants to go public has to negotiate with only one party instead of a series of institutional investors (no roadshow needed)

SPACs however also have several downsides arising mostly from the relationship with the target company. In fact SPACs may entice companies that need cash fast and that have worse financials than typical IPOs, leading to worse results for investors. When the SPAC gets listed, initial investors are betting on the sponsor, not on the target given that often takes months before finding the right one. In fact today there may even be too many SPACs and not enough companies to acquire which could lead to a crash in the SPAC trend.

Moreover SPACs are sort of a prerogative for certain qualified investors. Those vehicles built mainly by PE houses are often not easily available to retail investors. The latter see all the risk and little of the reward of SPACs, they don’t get to redeem their shares if they don’t like the merger and they don’t get the warrants to buy more share in the future.

SPACs funds are getting larger so the size of SPAC deals is expected to grow as well. Still uncertainty arises on the fact that companies going public through SPACs are not getting as much scrutiny as companies do through IPOs. A good example is Nikola who went public through a SPAC and was later accused of fraud. The company’s shares tumbled after a short seller called the company an “intricate fraud built on dozens of lies”.

With traditional IPOs investors may have more time to check the firm, get to know it and scrutinise it for fraud before it goes public. SEC is now examining how blank check companies disclose their ownership and how compensation is tied to acquisitions.

To summarise these are the main downsides to SPACs:

  • Expenses for target company (costly loss of equity given sponsor share percentage)
  • Sponsors quality
  • Less scrutiny from investors and market authority
  • Target company quality and availability
  • High risk for retail investors

Conclusion

Investors say SPAC deals are here to stay while critics argue the blank check boom is just that, a trend that isn’t destined to last. SPAC economics are becoming more friendly for companies that are considering merging with SPACs and more friendly for investors that invest in this blank check company.

When the shoeshine boy starts sharing stock tips, it is time to get out of equities; or so Joseph Kennedy Sr is said to have remarked as he exited the market ahead of the 1929 crash. 

So what should investors do when college students start promoting SPACs? This week it emerged that University of Pennsylvania students have created a so-called “Penn Spac” club to celebrate these new equity vehicles.

The boom cycle seems emphasized also by European countries. In fact SPACs were originally used exclusively in US but now many European stock exchanges are trying to lure SPACs to the old continent. As we said, some PE houses are raising several SPACs at the same time and now a fund that has jokingly been dubbed a “SPAC of SPACs” has just emerged. We all have clear in mind the last credit boom where collateralised debt obligations, backed by tranches of loans, were so hot that financiers started creating CDOs backed by tranches of CDOs, known as CDO squareds. Before it all ended in the 2008 financial crisis, some financiers reportedly launched a CDO cubed. If a SPAC cubed actually materialises, we should pay attention to its evolution, to say the least.

The outlook itself in terms of SPAC issuance is probably going to be very busy in the following months, across the street there’s a very large pipeline of incredibly high quality sponsors that are lined up to issue SPACs and invest those capitals. Moreover asset managers are sitting on mountains of cash that they need to invest — and are terrified that they cannot find decent returns now that the US Federal Reserve has signalled that rates will stay rock-bottom low until at least the end of 2023. It would be nice to think this reflects a newfound passion for democratic capitalism and retail investors. I suspect that a more likely explanation would be that financiers and founders are getting nervous that the current market boom is going to fade.

That does not mean SPACs are going to crash tomorrow. But if they do eventually, some investors will get hurt — although there thankfully may be fewer systemic implications than with CDOs.

In terms of will this successful trend continue my point is that with this change in the quality of the sponsors that are out there I do think that we’re going to see a continued strong case of business combination with SPACs primarily because companies are more and more evaluating this option. Furthermore there’s a backlog of companies that have been waiting to get access to the public market and SPACs are one of those tools that could bring them out there which will help continue the pace we’ve seen in business combinations so far. However in the long term the outcome seems unclear. A strong regulation of this market however seems necessary, and the legislators should move fast, before it’s too late.

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