WeSPAC
A Deeper Dive Into the SPAC Market
March 26, 2021
Click here to download the PDF version
DÉJÀ VU: WEWORK IS GOING PUBLIC (AGAIN)
WeWork’s hopes of going public have officially risen from the dead (for now). From a $47 billion valuation in 2019, to the brink of bankruptcy, to a $9 billion proposed SPAC transaction, we have come full circle. An 80% haircut in less than two years seems like a lot, but the business is still probably worth even less than that.
The investor presentation contains aggressive forward-looking projections and, while there is no reference to “Community Adjusted EBITDA” this time, they still describe their product as “Space-as-a-Service” (newspeak for “we rent out office space”). The below excerpts from the presentation seem wildly optimistic given WeWork’s history.
If you gloss over the S-1 from 2019 (when WeWork originally tried to go public) you’ll notice that none of these fanciful forward-looking projections are contained in any regulatory filings. SEC rules do not permit companies to publish such content during the traditional IPO process. Investors must rely on audited financial statements and draw their own conclusions about the company’s future.
But this time WeWork is going public through a SPAC and, luckily for them, this process is not subject to the same regulatory requirements as traditional IPOs. We feel this is a topical time to explore the state of the broader SPAC market in more detail.
SPAC BACKGROUND
We assume most of our readers already know what SPACs are, but we’ll briefly take a step back and describe them for those who don’t. A Special Purpose Acquisition Corporation (SPAC) is basically just a holding company with cash on its balance sheet. The idea is the SPAC sponsors will use proceeds from issuing equity to fund a qualifying transaction at some point in the future. SPAC sponsors entice investors with warrants to provide more upside optionality. These warrants can be split from the unit and can trade separately in the secondary market.
Once a qualifying transaction is announced, shareholders vote on whether the SPAC should proceed with the deal. Shareholders have the option to get their cash value back if they don’t like the proposed transaction. If the SPAC sponsor secures enough “yes” votes, the SPAC entity will merge with the target and undergo a name/ticker change. Shareholders of the original SPAC can hold onto their shares as they are rolled over into shares of the new company.
THE PLAYERS
Sponsors
The supposed rainmakers who make the deal happen. This group of individuals are responsible for finding a target company and negotiating a purchase price. This cohort mainly makes money through a “promote” structure which entitles them to ~20% of the entity post-transaction in the form of shares and warrants. If a deal fails to take place, they are on the hook for investment banking fees and other search costs. A cynical way to view this incentive structure is that it encourages even poor deals to take place. Good deals are better than bad deals. And bad deals are better than no deals. After all, 20% of something is better than walking away with nothing.
PIPE Investors
This group is brought in to push the deal across the finish line after a target company has been identified and deal terms are finalized. Financiers are generally given favourable terms for their participation and are often friends, family members, and/or related parties of the SPAC sponsors.
Pre-Deal Investors / SPAC Arb Funds
Funds that can obtain allocations when SPACs are taken public can lock-in ~15% - 20% returns in a relatively low-risk fashion. Buying the deal for $10 usually comes with one share of common stock plus 1/3 of a warrant attached (referred to as a “unit”). Put differently, this group pays $10 for a $10 put option and receives a free fraction of a warrant for their troubles. Best case scenario, the stock pops when it begins trading publicly and the Arb Fund can strip the warrants and sell the common stock for a gain. Effectively, they receive cash and a free warrant for participating in the primary offering. Not a bad deal. Worst case scenario, they can opt against the deal and receive their $10 cost base back. Potential losses are mainly in the form of opportunity cost during the search process.
Post-Deal Buy-and-Hold Investors
These investors choose to own shares of the new entity after the announced transaction closes. Historically, this group of players experiences the poorest risk-adjusted returns and, in most cases, loses a substantial amount money. If anybody is a sucker at the table here, it’s usually this group.
Broken SPAC Investors
Arb investors that initiate a position with average costs well below the cash value of the SPAC. The idea is to force “no-deal” votes or simply opt to redeem for $10/share in cash. These players have no intention of holding stock through a transaction regardless of whatever potential deal is put forth. As such, this kind of arb investor can potentially pose a big risk to the SPAC sponsor. No matter how good a proposed transaction may be, this group could decide to vote “no-deal” en masse in order to get $10/share back and (almost) guarantee a profitable investment.
Investment Banks
Make money underwriting these deals. Finding investors to buy the deal and filing a largely boilerplate S-1 is an easy way to collect investment banking fees. Plus the deal comes with potential transaction advisory services if the SPAC can find a target.
ADVANTAGES OF GOING PUBLIC VIA A SPAC
SPACs are becoming increasingly mainstream, and some argue this structure is a better way to go public compared to traditional IPOs. The advantages are the speed at which this can take place and the process involves a lighter regulatory burden. SPACs and their qualifying transactions are not subject to the same disclosure requirements or due diligence process and the company has greater flexibility issuing forward-looking projections. Our view is these “advantages” are double edged swords.
SPAC EXPLOSION
The below charts illustrate just how quickly SPAC issuance has exploded over the past two years.
Source: Wolfe Research - March 22, 2021
Source: https://spacinsider.com/stats/
Both sources have slightly different figures but paint the same picture. SPAC business is booming. It is estimated that over 300 SPACs are currently looking to deploy almost $500 billion worth of deals. To put that in perspective, that amount of cash is equivalent to roughly 16% of the Russell 2000 Index, 25% of the S&P 400 Mid Cap Index, and 50% of the S&P Small Cap Index.
SELLER’S MARKET: WHEN DEMAND OUTSTRIPS AVAILABLE SUPPLY
It’s easy to see why the demand for SPACs is off the charts. ZIRP eliminates the opportunity cost of holding shares in SPACs. Sponsors have a chance to potentially make gargantuan amounts of money. Investment banks collect fees for work they can do sleepwalking. PIPE investors can choose to get involved only when a deal looks like a slam-dunk. Theoretically, everybody wins. The question is, though, where does the supply of good deals come from?
The short answer is that the supply of good deals is very limited. A situation in which the demand for deals dwarfs the supply of quality deals virtually guarantees some combination of the following: (1) Overpaying for good deals; (2) Completing poor deals; and (3) Not finding a deal worth pursuing at all.
Given the incentive structure for the sponsors, we believe Option #2 will be much more palatable than Option #3 even though value will ultimately be destroyed. The effect is essentially a transfer of wealth from the buy-and-hold investors to the sponsors with a smaller combined economic pie.
Anecdotally, we have heard situations where private companies are being courted by numerous SPACs simultaneously. Auction dynamics where every bidder is highly incentivized to do a deal by any means necessary suggests the buy-and-hold investor ends up with the lowest possible prospective return.
A FALL FROM GRACE
Suffice it to say, the bloom has come off the SPAC rose. The majority of listed pre-deal SPACs traded at a premium to cash value in January and now almost all of them trade at a discount. We have even seen a few SPACs file amendments with the SEC to remove warrants attached to their IPO filings (LHAA, VAQC, SVFB and SVFC). This suggests the appetite for more SPACs may be dissipating.
This abrupt shift in sentiment can be explained by a few factors. First, the rising interest rates don’t help. But, more importantly, many post-deal SPACs have come under intense scrutiny from short sellers pointing out just how egregious some of these recent transactions have been. Not only has the purchase price been astronomical for companies with zero revenue in some instances, but some even closed transactions without disclosing DOJ inquiries.
Lordstown Motor (Hindenburg Research)
Clover Health (Hindenburg Research)
XL Fleet (Muddy Waters)
Skillz (Wolfpack Research)
Triterras (Phase Two Partners)
EOS Energy (Iceberg Research)
CuriosityStream (The Bear Cave)
Even other SPACs without notable short seller reports have experienced tremendous selling pressure. Chamath Palihapitiya’s SPACs (SPCE, OPEN, and IPOE) are also way down from their respective all-time highs. Once the “money-printing” machine seizes to function smoothly, any potential transactions from here on out are likely to be subject to some additional due diligence.
EXAMPLES OF SPAC SHENANIGANS
Below are some questionable SPAC transactions/business practices that have contributed to curbed investor enthusiasm.
Lordstown Motors
Lordstown Motors (formerly DiamondPeak Holdings Corporation) initially claimed to have pre-sold 100,000 vehicles but only a few weeks later informed the public they don’t actually have any orders (source 1 & 2).
23andMe
VG Acquisition (VGAC), sponsored by Richard Branson, bought DNA-testing company 23andMe for $3.5 billion. The company has been in business since 2006 and has never made money despite raising $850 million over the years. But the real kicker is buried on page 32 of the investor presentation.
The company expects revenues to decline by more than 50% this year compared to FY 2019 and doesn’t expect to hit peak sales again until at least 2025. We have serious doubts about the potential for incremental growth since sales and marketing spend is being reduced and the company laid off 14% of its total staff in January 2020. Surprisingly, the transaction multiple for this business is roughly 16x sales. Another example of TAM insanity.
The investor presentation, in our opinion, was littered with red flags from start to finish. Interestingly enough, notable existing investors (GSK, Genentech, and Alphabet) chose not to put more money into the SPAC on the transaction announcement. At a $3.5 billion valuation, any one of these giants could have easily acquired the business in its entirety and yet they did not, and the company chose the SPAC route. Makes you wonder.
AeroFarms
Spring Valley Acquisition Corp (SV) will buy AeroFarms in a proposed transaction for ~$900 million EV. The vertical farm company has no revenues, negative gross profits, questionable unit economics and, in our opinion, overly promotional forward projections.
We could fill a book with examples of froth in the SPAC space but will stop here. The point is recent transactions have been getting worse as too many sponsors compete for too few deals. Since a bad deal is preferable to no deal, these sponsors will engage in “race to the bottom” behaviour until investors take away the punch bowl.
RISKS TO THE BUY-AND-HOLD INVESTOR
We believe most transactions will ultimately be value destructive over the coming years. Specifically, ultra-competitive auction dynamics that stem from…
too many SPACs chasing too few opportunities will lead to vast overpayments,
incentive structure encourages sponsors to engage in bad deals over no deals,
the lack of motivation to be price disciplined,
inadequate due diligence as sponsors rush to finalize deal terms before competing offers can swoop in and outbid, and
dilution from the warrants outstanding plus the 20% carry owed to the sponsors
…will make it virtually impossible for SPACs as an asset class to outperform the broader market going forward.
RISKS TO THE SPAC SPONSORS
Pre-deal SPACs trading below cash value can present a unique risk to sponsors, especially the weaker ones. Arb investors could accumulate large positions and vote for no-deal outcomes to get a guaranteed $10/share back. It’s hard to know when this trade would begin to pick up steam. Anything below $9.50 will generate a 5% rate of return. Not bad in a ZIRP world and even better if the Fund can make the trade with leverage. We imagine merger-arb hedge funds will be paying close attention to this. Sponsors could conceivably run into a situation where, no matter what deal they put forth, their shareholders will shoot down the deal regardless of what is brought to the table. In such instances, they may become overly dependent on PIPE investors or will scramble to find new shareholders.
SPACS ROLE IN A BUBBLE
The SPAC issuance mania is reminiscent of the dot-com IPO bubble. Investors are prepared to suspend disbelief and disregard poor historical performance. Instead, they rely heavily on projections put forth in investor presentations and hope that potential TAM narratives can buoy equity prices. After all, in a bull market trees can grow to the sky.
We wonder how many recent SPAC targets could actually withstand a traditional IPO process. We feel comfortable estimating more than half could not successfully IPO given more stringent due diligence and the lack of blue-sky forward projections contained in SPAC investor presentations.
Investors’ willingness to pay more than cash value for pre-deal SPACs indicates elevated market sentiment. Interestingly enough, this is beginning to normalize as most pre-deal SPACs now trade at a discount to cash value. Perhaps the proposed WeWork transaction will have trouble closing.
SPAC-TACULAR TIMES WILL LIKELY TURN INTO A SPAC-POCALYPSE
We think SPACs can potentially play an important role in a more normalized market, but poor risk-adjusted returns are practically guaranteed whenever supply/demand dynamics are this out of whack. Sponsors who can source proprietary deal flow based on their network and work experience have historically completed successful SPAC transactions. These individuals are few and far between though.
SPACs as an alternative to the IPO process is possible but disclosure requirements for traditional IPOs clearly exist for a reason. Perhaps the SEC will make regulatory changes to bridge the gap. Either introducing stricter requirements for SPACs or reducing requirements/increasing flexibility for the traditional IPOs process. We will continue to monitor the pre-deal SPAC environment in the event they trade significantly below $10 and the post-deal SPAC market for promising short opportunities. We feel pretty strongly that a graveyard full of broken former SPACs will exist in a few years from now.