Why SPACS are driving the surge in IPOs

With investors assessing the possibility of further US stimulus along with a series of weak economic data global financial markets were mixed last week in return. The US’ S&P 500 Index and Nasdaq Index were down -0.71% and -1.57% respectively. Asian markets performed better with Japan’s Nikkei 225 Index and the Hang Seng Index up +1.69% and +1.56% last week. The Hang Seng Index, due to the bolster from IPO and local technology stocks continues to lead major global stock markets up +12.54% year to date.

AQUMON’s diversified US ETF portfolios were -0.08% (defensive) to -0.66% (aggressive) last week and -0.15% (defensive) to +5.98% (aggressive) year to date. AQUMON’s SmartGlobal HK ETF portfolio, with more regional exposure to Hong Kong/China, was +0.06% (defensive) to +8.88% (aggressive) year to date. The main portfolio laggers last week were both Chinese tech stocks (-3.99%), gold (-2.00%) and emerging market stocks (-1.31%). Most other assets stayed relatively flat to down slightly.

AQUMON’s newly launched SmartStock thematic stock portfolios continued to perform strongly. Last week, the best performer was Chinese Tech Stars (HK stocks) standard portfolio +7.05%, while the worst performer was the Profit Makers (US stocks) standard portfolio at -2.01%. Year to date best performer was Chinese Tech Stars (HK stocks) premium portfolio +20.32% and worst performer was the Profit Makers (US stocks) standard portfolio at -1.66%. 

As we mentioned last week, the “momentum” will continue to be a main driver for financial markets and the key source driving such momentum are initial public offerings (IPOs). IPOs are private companies selling their shares publicly on a stock exchange such as the NASDAQ Index or here locally on the Hang Seng Index. What is so different about IPOs in 2021 versus the years past? In 2021, 76% of all new IPOs in the US are now via Special Purpose Acquisition Companies (SPACs):

Never heard of a SPAC?

The SPAC trend has already arrived in Hong Kong with billionaire Richard Li raising US$900 million (~HK$7.0 billion) within 5 months (with announcement of a 3rd SPAC potentially underway) this has gotten a lot of investors in Hong Kong asking about SPACs. To help investors better understand the risk and rewards of SPAC IPOs this will be our Market Insight topic this week.

What exactly is a Special Purpose Acquisition Company (SPACs)?

Ultimately companies need cash or capital and listing their company on a stock exchange via an initial public offering (IPO), selling off a portion of their company to public investors is one of the most popular routes. A SPAC is a type of IPO.

In simple terms, a SPAC, sometimes known as a “blank check” company, is a shell company that gets listed on a stock exchange first with the intention within a specific time frame (usually 1-2 years but can be up to 3 years) to acquire a private company and help it list on a stock exchange. This timeframe is called the “initial business combination”. If a SPAC is unable to merge with a private company within this time frame then usually they are required to return the funds raised back to those who invested in the SPAC.

The SPAC itself is created by an individual or a team called a “sponsor” who generally is an expert in their industry with the promise to identify, negotiate and finally ‘merge’ successfully with a private company. When the private company merges with a publicly listed SPAC, it in turns becomes listed on a stock exchange as well. This final process is called the “de-SPACing transaction”. 

So a SPAC is essentially the traditional IPO process in reverse. 

How so? In a traditional IPO, a mature enough private company looks to raise capital via getting listed on a stock exchange. The company selects an investment bank to advise them on the IPO process, act as a broker between the company and investors and figure out the pricing for their shares when it finally lists on the stock exchange. Listing on a stock exchange happens at the end and unlike a SPAC at the beginning.

So why are we just hearing about SPACs now? SPACs were created in the 1990s but they’ve had a bit of a checkered past as a way for lower quality companies that couldn’t afford or meet traditional IPO standards (through an investment bank) to list on a stock exchange. After suffering major losses in the 1990s due to the involvement of lower quality sponsors, SPACs fell out of favor with investors.

So what are they so popular now?

The underlying motivation from many retail investors, beyond monetary gains, is a lot similar to the GameStop (GME) saga and it comes down to achieving ‘equality’. In a traditional IPO, the vast majority of the initial shares are allocated to larger institutional or high net worth investors while retail investors receive little to no allocation. Retail investors are now fighting for their right for these IPO shares attracted by the potential jump in pricing after companies list. SPACs can offer a more even playing ground for retail investors.

For private companies themselves there are multiple reasons why they would take a SPAC IPO versus a traditional IPO:

1) Faster speed: To merge with a listed SPAC a private company can get listed in as short as 3-4 months. This is significantly shorter than a traditional IPO which may take 24-36 months in comparison. Why? Because the SPAC IPO (being a shell company) has significantly lower regulatory hurdles to get listed than a traditional IPO of a private company so in a way it’s gotten the heavy lifting out of the way beforehand.

Considering financial markets are so hot now and investor demand for IPOs is high, it makes sense why private companies are pressured to list ASAP (in case markets take a turn for the worse ahead). This is a big reason why SPAC IPOs have been favored over traditional IPOs recently.

2) More certainty: In a traditional IPO, private companies will go into the process relatively ‘blind’ since the investment bank along with its investors will help determine the terms and the potential stock pricing. In a SPAC, private companies can negotiate the terms beforehand giving both its management, employees and shareholders more clarity heading into the IPO. A lot of private companies like this.

For sponsors of the SPAC the biggest motivation is the monetary upside. Normally, terms of the SPAC allow the sponsors to commonly receive 20% of the SPAC shares along with potential equity linked securities (called “warrants”) after the IPO. This is often called the “promote” and can be very lucrative for the sponsor.

Let's do a little math for a smaller sized IPO:

When a SPAC gets listed on a US stock exchange its capital must not be less than 5.1% of the total IPO size. So if you plan to list a US$100 million (~HK$775 million) IPO, as the sponsor you need to first raise an additional US$5.1 million (~HK$39.5 million) by yourself.

If successful, on the day of the IPO there are 10 million shares of stock priced at US$10 (~HK$78) each. Using US$10 for per share is a common practice by SPACs.

The amount of shares reallocated back to the pre-IPO shareholders is always one fourth (25%) of the shares raised so this will result in 2.5 million shares at US$10 which is worth US$25 million (~HK$193.8 million).

The SPAC sponsor now gets 20% of that 2.5 million shares which is 500,000 shares at US$10 and valued at US$5 million (~HK38.8 million).

Furthermore the sponsor also gets fractional share warrants (normally ? , ? or ?) for each dollar they invest which allows them to buy shares at US$11.50 per share (~HK$89) regardless of the share price on the stock exchange at least 30 days after merger. 

So if the sponsor gets a ? share warrant and the price favorably raises 50% from IPO price (so trading at US$15) our sponsor could exercise their warrants at US$5.1million initially invested x ? (since ? share warrant) x US$15 = US$38.3 million (~HK$297.0 million). This along with their US$5 million worth of shares (now worth US$7.5 million since jumped 50%) means for their initial US$5.1 million investment the sponsor yielded US$45.8 million and a US$40.2 million (~HK$311.7 million) profit from the SPAC IPO. Wow!

So qualified (or unqualified) sponsors are very financially motivated to launch a SPAC.

We want to stress at US$100 million this is a very small IPO. Most SPAC IPOs we hear about in the news are normally in the US$300-800 million range in size, so you can do the math.

How have SPAC’s performed?

The range in SPAC performance can be quite varied but more high profile top performing SPACs like DraftKings and Virgin Galactic are returning +674% and +544%.

For investors looking to get into SPAC IPOs beyond direct participation they can also look into SPAC ETFs as well. When looking at the first to market SPAC ETF (Defiance Next Gen SPAC Derived ETF) it is outperforming the S&P 500 by +16.07% year to date:

Does it mean all SPAC perform well? According to a recent Stanford University study after analyzing the 47 SPACs that merged between January 2019 and June 2020 there is a huge discrepancy between high quality (defined in the study as sponsor that is affiliated with a fund listed in Pitchbook with assets under management of at least US$1 billion and a former CEO/officer of a Fortune 500 company) vs non-high quality ones: 

As you can see once looking 12 months out all SPACs were down especially when compared to broad markets like the S&P 500 which was up +23.52% during this period. All SPACs (high quality or not) were all down.

So investors should understand not all SPACs are created equal and should beware that many SPACs underperform broad markets in the medium to long term.

What are the top risks investors should be aware of?

There are 2 types of risk we think inherently and also in the current investment environment inventors should be aware if investing into SPACs:

Sponsor risk: The #1 risk as an investor you should be concerned about is can the management team behind the SPAC (called the ‘sponsor’) actually deliver the returns you are looking for? We have seen a range of high profile sponsors launch SPACs recently, from venture capitalists (i.e.. ex-Facebook executive Chamath Palihapitiya) to athletes (i.e. US ex-baseball player Alex Rodriguez) to politicians (i.e. former US vice president Al Gore). But for many of these teams or individuals may actually not have an experienced track record when it comes to both identifying investment opportunities and/or negotiating contracts with companies they plan to take public via a SPAC IPO. 

Furthermore, with SPACs being much more loosely regulated than a traditional IPO (via an investment bank), reputation risk with SPAC sponsors resulting in fraud is not unheard of. So essentially, an investment in a SPAC becomes an investment in the sponsor which adds another layer of risk versus a traditional IPO. So for investors, doing your due diligence on the sponsor or choosing sponsors who have a good track record (ideally in SPACs but at least in the investment space) is suggested.

Excess cash risk: With an estimated 333 SPACs in the US representing US$104 billion (~HK$806 billion) still ‘chasing’ for an acquisition target company to take public in the next 1-2 years, this poses multiple problems for investors such as:

1) Less upside for investors: It’s basic supply and demand. With the supply of high quality target companies potentially limited while demand rising rapidly (in terms of cash raised by SPACs and the need to find target companies as a result), these high quality private companies can shop around and strike merger deal terms that are more in their favor which translates into less immediate financial upside for investors.

2) Settling for low quality companies: Most SPACs have a limited 1-2 year time window to identify and merge with a target private company. If they are unable to deploy cash before the deadline, sponsors typically return the money to the investors. It is not atypical for ‘non-upstanding’ sponsors to merge with a lower quality company instead when they are faced with the prospects of returning the cash to investors. Although investors are allowed to get their money back if they don’t agree with the merger target, there are certain cases where if investors didn’t vote against the merger that they may not be able to back out of the SPAC deal (so important to read the fine print). Furthermore, as an investor with limited transparency and subject matter knowledge, it can be hard to judge whether a company is low quality or not.

The SPAC trend is already starting in Asia

Although Asia-based SPACs can’t list their target companies in the largest Asian stock markets such as Hong Kong, Singapore or mainland China (still likely need to list in the US), the demand for SPACs IPOs have not gone unnoticed.

Singapore Exchange’s Chief Executive Officer (CEO), Loh Boon Chye, said last week that if markets are supportive, they are looking to make listing on the SGX exchange via SPAC IPOs a reality later this year. There are rumors that the Hong Kong Stock Exchange (HKex) is also looking into SPACs as well but at this point there is nothing official we can report. Given its past experience, it may be difficult to allow empty shell companies to list given the HKex just tightened rules in this area in 2018 after being plagued by a number of ‘backdoor listings’ (via reverse takeovers that are somewhat similar to a SPAC) that ultimately hurt investors. In the short term, Hong Kong stock exchange will likely remain a place of traditional IPOs but given the recent investor demand and jam-packed IPO pipeline, we continue to view the outlook positively. Largely on the back of recent IPOs and fund inflows from mainland China, the Hang Seng Index is currently leading all major global financial markets up +12.54% year to date.

Even though SPACs can’t list in Hong Kong, what is surprising is that Hong Kong is already the largest hotbed of SPAC activity in Asia and is set to be the largest SPAC market (in deal value) outside of the US:

Hong Kong billionaire Richard Li along with US billionaire Peter Thiel (he was the first outside investor into Facebook) launched a SPAC called Bridgetown Holdings back in October. The US$595 million (~HK$4.6 billion) SPAC reportedly targeted a merger with Indonesia e-commerce giant Tokopedia which already touts SoftBank, Google and Singapore Government’s investment arm Temasek Holdings as its private investors. The pair just launched a second SPAC called Bridgetown 2 Holdings, targeting new economy, financial services, and media companies in Southeast Asia and this week there is already news that Mr. Li will launch a 3rd SPAC by himself shortly. This is all in the span of under 5 months.

With the supply of high quality US companies to take public limited, many major SPAC sponsors are reportedly chasing targets in mainland China. With half of the world’s unicorns (a private startup valued at over US$1 billion) located in China along with strong revenue growth and the potential market size the demand is understandable. Chinese investors are also likely closely watching the US SPAC situation and we very well may see a spike in Chinese sponsors launching their own SPACs in the near future.

A final word of advice for investors

If the rise of retail investors under COVID-19 and the recent GameStop saga have taught us anything, it’s that financial markets are at a sizable turning point in terms of change. This change is happening on multiple levels including structural, behavioral and technological in nature. Financial markets, at one point more favored towards institutional investors, now need to quickly accept the inclusion of millions of new retail investors daily. The recent surge in SPACs further highlights this ongoing narrative.

Although we don’t see an immediate ‘bubble’ on the horizon, change is often ‘violent’ and we continue to anticipate this will only increase market volatility (and correct possibility) in 2021. We feel SPAC and/or traditional IPOs will provide momentum to push financial markets to higher levels. We suggest investors don’t forget that momentum can work both ways. With the lure to list at more favorable valuations by companies to sponsors receiving larged sized compensation via SPACs to investors looking for outsized returns, there will be blow-ups coming in the SPAC space for lower quality sponsors and companies. Doing your due diligence beforehand or investing in moderation as an investor is your key to managing your downside risk while keeping your upside return potential alive.

As such, we see no issue for investors to participate in such IPOs but as investors looking for longer term returns, having the majority of your portfolio (>50%) in an ‘anchor’ that is more stable, diversified and liquid is suggested. Investors can look into our SmartGlobal (HK ETFs), SmartGlobal Max (US ETFs) portfolios or even an offering for a completely different 3rd party. The key is protecting and growing your wealth in a consistent manner over the long term. 

If you have any questions, please don’t hesitate to reach out to us at AQUMON. We’re always happy to help. Thank you again for your continued support for AQUMON. Stay safe outside and happy investing!

Ken

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AQUMON is a Hong Kong based award-winning financial technology company. Our mission is to leverage smart technology to make next-generation investment services affordable, transparent and accessible to both institutional clients and the general public. Through its proprietary algorithms and scalable, technical infrastructure, AQUMON’s automated platform empowers anyone to invest and maximise their returns. AQUMON has partnered with more than 100 financial institutions in Hong Kong and beyond, including AIA, CMB Wing Lung Bank, ChinaAMC, and Guangzhou Rural Commercial Bank. Hong Kong University of Science and Technology, the Alibaba Entrepreneurs Fund, affiliate of BOC International Holdings Limited, Zheng He Capital Management and Cyberport are among AQUMON's investors. 

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