The New Game is On – Traditional IPOs vs. Blank Cheque Companies (SPACS)

Ringing the bell at the New York Stock Exchange used to be a rite of passage for American chief executives. It signaled that the company had reached an important moment in its development, when it would ask the public to back its future and invest in its shares.

One of the largest listings of this year, however, did something different. The chief executive of Palantir, a data analytics company, did not show up for the opening bell and nor did he offer any new shares to the public on listing.

Palantir’s market debut as a direct listing, in which no new shares in the company are created or sold, rather than through a more conventional initial public offering (IPO), deserves attention in our opinion for two reasons. It caps a recent dash for the public markets by technology companies that holds echoes of the dotcom boom of two decades ago, and stands in stark contrast to the prevailing economic uncertainty. More worrying in our opinion is the fact that the company’s debut highlights a shift in low businesses are approaching public markets. An increasing number of executives are sidestepping the traditional IPO, which has been the preferred route to market for the past few decades, in favor of alternatives with in our opinion potential downsides for retail investors.

SoftBank boss Masayoshi Son claims visionary status, having less to do with short-term investor concerns. Recently, he has been rebuilding his credibility by taking a break from speculative investments and selling down assets.

But the Japanese tech group’s Vision Fund could undo some of that effort. The fund reportedly plans to launch a “blank-cheque” company to gain external funding. No wonder, market offerings of these have more than doubled. Moreover, the Vision Fund has struggled to raise money for a second vehicle. But the US tech rally boosted the fund’s gains by 2.8 billion USD, perhaps inspiring his confidence.

Mr. Son, who has argued SoftBank suffers from a conglomerate discount, may approve for different reasons. A special purpose acquisition company (Spac) gives investors direct access to the target companies.That would avoid any financial drag from its mobile telecoms unit and Arm subsidiaries to be sold Nvidia. The risks these Spac takeovers carry is that companies with less than decent prospects can gain a quick listing. SoftBank – backed house – selling site Opendoor Labs, which plans to go public through a merger with a blank-cheque acquisition company, is just one more example. It has struggled in the pandemic, cutting staff.

Spacs can ease a company’s route to market as they don’t have to comply with the tougher listing rules applied to traditional floats. The rewards, too, are often shewed in favor of the founders. About 40% of this year’s initial public offering volume has come from Spacs. The boom has caught the attention of the US Securities and Exchange Commission (SEC). The regulator recently said it was alert to the rise in cash shells and wanted to make sure there was sufficient transparency about insiders’ pay structures for investors.

Direct listings, too, carry risks. By not issuing new shares to raise capital, company founders are able to retain much tighter control. In the case of Palantir, there are in our opinion genuine concerns over the company’s governance arrangements, which go to even greater lengths to entrench the control of the founders. Despite this, growth-hungry investors still bought the stock once it had listed.

It is no surprise to us that independent – minded tech entrepreneurs prefer a simpler route to market. Critics of traditional IPOs have long complained of expensive and cumbersome processes, and of under-pricing by sponsoring banks. The fees pocketed by investment banks have also come under fire. Although they have fallen, banks still typically earn as much as 7% on the proceeds of a new listing. Such criticisms are in our opinion justified. Privately held companies that would otherwise have explored a traditional IPO have often either opted to stay private or are now among those being drawn to Spacs.

At a time of shrinking equity markets, new alternatives offering a route to market are welcome but not at any price. Supporters of the new crop of Spacs are promising greater transparency. Mr. Son seems oblivious to investor needs. Much of the 160% gain in SoftBank’s share price from a March low reflects approval for its buyback programme and retreat from risky investing. It was also the group’s more sluggish units that cushioned the losses logged from a plunge in the fair value of its Uber and WeWork investments.

Worse, the simplified listing process Spacs offer suggests lower levels of scrutiny.

A SoftBank version, given the group’s history of opaque trades and governance, will exacerbate investor concerns. Indeed, Spac returns have under-performed the broader market, says Goldman Sachs. SoftBank in our opinion has a history of chasing popular themes – sometimes too late.

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 special purpose acquisition companies? Last month it emerged that University of Pennsylvania students have created a so-called ‘Penn-Spac’ club to celebrate these new equity vehicles. For the students, this is probably a smart move – at least if they want to find internships with finance companies that are profiting from this trend. For everyone else, though, it is a worrying sign of froth.

The statistics around Spacs are startling: so far this year 133 Spacs have been floated in the US, raising 51.1 billion USD, nearly four times last year’s volume. A further 67 are waiting in the wings, according to Spac Research.

Meanwhile, the London Stock Exchange is jumping aboard, as it explores how to lure Spacs to the UK, and a fund that has jokingly been dubbed a “Spac of Spacs” has just emerged. Easterly Alternatives is raising 100 million USD vehicle to invest in up to 15 other Spacs. Anyone older than a college kid may well hear echoes of the previous credit boom. Back then, collateralized debt obligations, backed by tranches of loans, were so hot that financiers started creating CDOs backed by tranches of CDOs, known as squared.

Before it all ended in the 2008 financial crisis, some financiers reportedly launched a CDO cubed. If a Spac cubed materializes, keep that in mind.

Inevitably, this mania is also producing investor losses. Nikola, the electric truck-maker that merged with Spac and is now being investigated by US officials, is a case in point. A Financial Times analysis in August showed that the majority of Spacs organized between 2015 and 2019 are trading below the 10 USD standard Spac listing price.

So is this a bubble that is about to pop?

Don’t bet on that happening soon. There are now at least three factors driving investor enthusiasm for Spacs – and all could run for some time.

One of these is obvious: 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 signaled that rates will stay rock-bottom low until at least the end of 2023. Smart financiers have also realized that the Spac route to a public listing is more “efficient” – that is to say, lucrative for them – than a traditional IPO, given the extensive rules around such listings.

A Spac merger lets a company go public quickly. The method can sometimes allow founders or sponsors to sell more of their holdings quicker than an IPO, which may include a lock-up period. A Spac deal can in our opinion be especially attractive for a company struggling to show profits. Spac disclosures put more emphasis on putative future revenues, while IPO prospectuses require audited past financial statements.

Finally, the relative availability of public and private financing is shifting. In the past decade, so much money poured into private companies that it produced huge numbers of billion-dollar privately held companies, which used to be so rare that they were known as “unicorns”. Now the private equity and venture capital players behind that money, along with company executives, want to top public markets too.

It would be nice to think this reflects a new found passion for democratic capitalism and retail investors. We suspect, but cannot prove, that a more likely explanation is that financiers and founders are getting nervous that the current market boom is going to fade. The woes at SoftBank, which was a huge source of private investment, are also cutting into the availability of private funds.

That does not mean that 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.

Members of the Penn Spac club should read their history books, as well as financial engineering manuals, and remember this: the smart money is good at passing risks on to mainstream investors when they want to leave. Spacs are not so “new”.

What would also help, however, is a new approach to traditional IPOs. Some banks are already experimenting with different ways to ensure more realistic pricing. They are also loosening the conditions on lock-ups that restrict when and how employees can sell their shares after the listing. A company’s objectives when coming to market include raising capital to deliver on its strategy, and giving the public a chance to take part in future success. It would in our opinion be a shame if those aims were lost in the current stock market frenzy.

At least this time investors will have had ample warning.