SPAC, the New Black
Plus: The Quest for Monopoly, Ant Group, The FAAMNGs of Finance
|Marc Rubinstein||Aug 28|| 9|
Issue #15 of Net Interest and welcome to all new readers. When I launched this newsletter in May, I had a soft target in mind of 5,000 subscribers by the end of August. With a few days to go, we’re at 4,620—so close I can feel it! So if you have a friend or colleague interested in learning more about the finance industry in a digestible way, please invite them to sign up. Let’s make it happen!
SPAC, the New Black
This week’s been a big one for stock market listing announcements. Palantir, Asana, Unity, Snowflake and Ant Group all filed to go public. It’s a major transition, going public, and the process isn’t without its controversy. Bill Gurley, of venture capital firm Benchmark, made his views plain in a blog post earlier in the week:
“The traditional way of going public is systematically broken and is robbing Silicon Valley founders, employees, and investors of billions of dollars each year.”
Bill Gurley has a particular perspective as a Silicon Valley investor. In order to get the perspective of those on the other side of the trade, we at Net Interest got together with Procensus, an opinion sharing community for institutional investors, to conduct a survey. We captured the views of 29 institutional investors who between them run US$2.3 trillion of assets under management. About a quarter of them are hedge funds, the rest are ‘long only’; and about 80% are based in North America, with the rest based in Europe.
But first, some context.
Over the past 25 years the structure of the investing landscape has changed markedly. The number of companies listed on a US exchange has halved since 1996, from around 7,300 to around 3,600 today. At the same time the number of investors chasing those companies has gone up. Concrete numbers are hard to come by but given the decline in fixed costs required to set up a fund, together with the globalisation of markets over that period, the tail of active funds has grown. The assets managed by those funds has certainly gone up: US domestic equity mutual fund assets are up nearly 6x over the period, and long/short hedge fund assets are up over 7x.
There’s a whole host of explanations for the trend. Michael Mauboussin, who compiled the data, discusses them in his report, Public to Private Equity in the United States: A Long-Term Look. One of them is that the stock exchange simply reflects only a part of the iceberg that is corporate America, and that beneath the surface there are lots of private companies. In fact, for every one company owned by public market investors, there are seven owned by private equity or venture capital.
One of the issues with this set-up is that unlike the iceberg, the market for private and public companies is not continuous. There are big differences between the investors in each. Private equity sits in the middle, but when it comes to venture capital and public markets, the differences can be vast. Venture capital investors have traditionally been entrepreneurs who founded and sold their own businesses. Typically, they are optimists. As Mauboussin points out, there is no mechanism for pessimists to express their view in private markets.
I’m simplifying of course, but the way the investors value their companies differs too. Venture capital investors look to the future, and discount back; public market investors start with the present and forecast forward. Venture capital even has its own valuation method, called the venture capital method. In a survey of 900 venture capitalists, 9% said they do not use any financial metrics at all and 44% said they often make investment decisions based on gut.
The IPO process
Every so often the two groups of investors come together, when a private company makes a transition to public markets. Historically this has been through the IPO process. As with any transition, the process can be hard, not least because of the tribal differences between the two groups.
WeWork is the classic recent example. Private markets had bestowed on it a valuation of US$47 billion; public markets were rightly more cautious. Other examples, within financial services, include Funding Circle, Lending Club and OnDeck. Eighteen months of public market exposure was all it took for Funding Circle to unwind all the valuation gains it had made between its series C and series F funding rounds.
These companies are not outliers. In the nine years to September 2019, about a third of companies that went public with valuations in excess of US$1 billion came at prices below their most recent private funding round. Venture capitalists may not find this surprising—the same survey of 900 of them reveals that over 90% think that unicorns are overvalued (including those who have invested in them).
No wonder public market investors are suspicious! But even when they take over the mantle of valuation, the process may not be smooth. Over the long term most IPOs don’t do that well. According to a Goldman Sachs review of nearly 4,500 US IPOs conducted over the past 25 years, the typical IPO lags the market over its first few years as a public company. The Goldman Sachs global strategy paper, published in September 2019, concludes that the typical IPO since 2010 has lagged the market by 10 percentage points during its first year and by 22 percentage points during its first 24 months. Some IPOs do very well – enough to offset the underperformance of the median issuer – but most do not.
All of which brings us to the performance of IPOs on their first day of trading. The Goldman data excludes this because not every investor gets an allocation in the IPO process, but every investor can buy on the first day of trading. It is this process that has Bill Gurley wringing his hands. In particular, he points to the typical first-day stock price ‘pop’ that IPOs typically enjoy as evidence that the process is “systematically broken”.
It’s true that however poorly IPOs go on to perform, they typically do very well on their first day of trading. In the ten years to June 2019, the average first day pop has been 16%. For venture capital backed IPOs, it has been even higher at 21%.
One interpretation is that this represents a transfer of value from “Silicon Valley founders, employees, and investors” to those public market investors who receive an allocation in the IPO process. Over the same ten year period, that transfer has amounted to US$43 billion.
But we now have a topological map of a typical IPO (stress on the typical): valuation starts too high, it’s reduced in the IPO process, it pops on the first day of trading, it underperforms over the next few years. In this model, those who sit at the juncture between the private markets and the public markets are taking the most risk, so they deserve to capture some value.
In particular, public market investors don’t have the same access to information that private market investors have. Securities regulation specifically prohibits companies from providing their new investors with earnings projections. It was something along these lines that prompted Stephen Schwarzman, founder of Blackstone Group, to go into private equity rather than continue along his formative path as a junior securities analyst. When the CEO of a company he was probing refused to answer his questions, he thought:
“Well if he didn’t answer, how in the world can you figure out what to do? I said, I’m not that smart; I need to have all relevant data and he’s the person who has it, so why won’t he give it to me?”
Without access to the breadth of information that private market sellers have, public market buyers need to do a lot of work. According to the survey we conducted with Procensus, individual analysts and portfolio managers do an average of 14 hours direct preparation for an IPO. This involves preparing for meetings with company management, sifting through the prospectus and creating a company model. Some survey respondents said that they also meet with brokerage analysts and use third party research, but these are seen as less helpful resources.
And they do expect a share price pop. On average they expect a pop of 17%. Curiously, this lines up with historical experience in the ten years to July 2019. That could be due to investors having become conditioned by prior experience, or it could be that pricing has been set to meet investor expectations.
Enter the SPAC
People who don’t like the IPO process typically complain about three things. As well as the cost associated with the first day stock price pop and the prohibition on releasing detailed financial projections, there’s the time it takes. From start to finish the whole IPO process can take as long as eighteen months. From a seller’s perspective, a quicker process may be more optimal, particularly in times of heightened uncertainty. WeWork was undone in the time it took preparing for its IPO, and other companies may not want to fall into the same trap.
An alternative structure, which accelerates the time to market, eliminates the pop and allows for the release of detailed financial projections is the SPAC (special purpose acquisition company). And, for all of those reasons, it’s a hot structure right now.
A lot has been written about SPACs over the past month so I won’t reprise it all. In brief, a SPAC is a “blank-check” company formed with the intention of acquiring another company. In a typical structure, a SPAC sponsor raises initial capital by issuing units consisting of one share and some fraction of a warrant.
The sponsor’s job is to identify a target – likely private – and negotiate a purchase. After they’ve done that they come back to shareholders for approval. Because the deal is structured as a merger, full financial projections can be disclosed. Shareholders have the right to hold their shares and see the deal through or to redeem their initial investment at cost plus some accrued interest. If an acquisition isn’t sourced within two years, the capital raised must be returned to investors.
So from the shareholders perspective, a SPAC is an option on an IPO rather than an IPO itself. It provides a way for public market investors to get access to private markets, where a lot more companies reside. Rather than waiting for the private companies to come to them in an IPO, or staffing up new private investing functions like Fidelity and T. Rowe Price have done (both large pre-IPO shareholders of Ant Group), SPACs allow public market investors to send a scout into the world of private companies and take a look around. The SPAC is a bit like the wardrobe as the portal to Narnia, complete with unicorns on the other side.
The target, meanwhile, has the advantage of negotiating with a single counterparty rather than the numerous counterparties they would meet on an IPO roadshow. The downside is that they don’t get to know their shareholders at the time they come to market. Even if they did get to meet underlying shareholders of the SPAC, the SPAC’s shareholder base can turn over during the time between announcement and the completion of a deal—from merger arbitrage traders and hedge funds to longer term fundamental investors.
Perhaps this is a purer representation of how shareholders behave. A lot of finance theory is predicated on shareholders being the same. The rationale for banks building an IPO book is that they can help select the ‘right’ investors for the company. But in a world where holding periods are getting shorter and index funds are getting bigger, such shareholders may not exist. The SPAC structure is shareholder agnostic. Rather than delivering a list of fairly good shareholders, it delivers one really good shareholder (the promoter) and a cast of supportive others.
So far this year, 81 SPAC offerings have been completed in the US, raising proceeds of US$33 billion. In our survey, 55% of investors have invested in a SPAC. When assessing them, they typically look at the track record of the sponsor and their incentives. Investors like to see the SPAC identify a narrowly defined market segment to fish in, a segment where the sponsor has experience and contacts. Many sponsors are becoming serial SPAC enthusiasts, people like Chamath Palihapitiya, Betsy Cohen, Michael Klein. However, investors are less focused on a sponsor’s prior SPAC activity than on their industry focus.
The SPAC sponsor is usually compensated with a promote equal to 20% of the capital raised, although recent deals have seen some variation around this. Bill Ackman’s US$4 billion SPAC introduced a novel structure, leading some to believe SPACs may be getting cheaper. Investors in our survey agree, with 52% of the view that fees are unsustainably high and another 24% of the view that modest fee compression may occur.
Overall the feedback on SPACs is positive. It’s not yet clear whether they are cheaper than IPOs, but from a disclosure perspective and a timing perspective there are clear benefits. Will they usurp IPOs? Our survey isn’t so sure. Some 62% of respondents prefer the IPO route; only 17% prefer SPACs.
Either way there remains a friction between the private markets and the public markets. Most of the investment capital is one side, but most of the companies are on the other. Of course, not all these companies need investment capital, but at some point private capital needs to recycle its funds in order to cultivate a new crop of start-ups. If SPACs can expedite that, there’ll be a lot more of them.
More Net Interest
The Quest for Monopoly
I wrote a guest post for Napkin Math this week on the Quest for Monopoly. The post looks at how the New York Stock Exchange (NYSE) has been able to sustain its monopoly for over two hundred years, even as the nature of its monopoly has shifted.
In the 19th century the New York exchange was not that much larger than Philadelphia, but network effects compounded its slight edge and it went on to dominate US domestic stock trading for a hundred years. Things changed towards the end of the 20th century when technology lowered the barriers to entry and its customers grew more powerful. Once a ragbag of small partnership firms, NYSE’s customers consolidated, giving them a stronger hand in the power relationship they conducted with the exchange. They backed alternative trading platforms and lobbied policymakers to remove NYSE’s privileges. In 2005 they succeeded. Today there are 13 exchanges in the US and around 50 alternative trading venues. NYSE went on to lose half its market share.
But that’s not the end of the story! Peter Thiel once said, “Monopoly is...not a pathology or an exception. Monopoly is the condition of every successful business.” The 2005 rules broke NYSE’s monopoly but they also imposed practices on all the other venues which meant they at least had to plug into the exchange and use its data. NYSE started making money selling its data and its connectivity. As every trader knows, data and trading go together like gas and cars or babysitters and dinners out. Soon NYSE was giving its trading away for free and shoring up its position in data and connectivity. Today it earns some of the highest profit margins in corporate America.
Unsurprisingly, customers aren’t happy. The lobbying has started and the cycle has begun again. Like in other monopoly debates, the struggle descends into a definition of terms. The story provides a fascinating preview of the monopoly struggle faced by other network-driven platforms. You can read the whole thing here.
Ant Group filed its prospectus this week ahead of a listing in which it is expected to raise up to US$30 billion. We wrote about Ant Group in detail in Net Interest a few weeks ago. What’s surprising from the prospectus is how little money they make in payments. Last year 43% of the group’s RMB121 billion of revenue came from digital payments, but a big chunk of that turns round and goes straight back out the door as fees paid to financial institutions. The gross margin in the payments business is only 13% and the ‘take rate’ on payment volumes, net of those fees, is barely a basis point (0.01%).
Rather, the company makes all its money selling other financial services to its payments customer base. It highlights that around three quarters of its payments customers (729 million users) accessed credit, insurance or investment products through its platform in the past year. Here the gross margins are at least 84%. And the take rates are high. In credit, the biggest segment, they’re around 2.7% (of loan balances) and in insurance, the fastest growing segment, they’re around 23% (of premiums).
The payments business has already succeeded in driving huge value to Alibaba by reducing the friction associated with e-commerce. It is now doubling up as an aggregator for financial services, working with hundreds of product companies to distribute their products. This time, the value will stay with Ant.
The FAAMNGs of Finance
I came across a YouTube video of the former Chief Information Officer of Goldman Sachs giving a lecture at Harvard. He talks about how he got to know Eric Schmidt of Google and how, since meeting him, they’d been talking about the similarities in their businesses. He elaborates by describing Google’s business model: “Google produces software services and those software services aggregate the attention of billions of people and then Google sells the attention to advertisers.” His point is that Goldman does the same with risk.
It could be a stretch and the CFO of Google, formerly the CFO of Morgan Stanley, no doubt has a view. But it got me wondering. If Goldman is the Google of finance, and we established last week that Bloomberg is Facebook, who are the other FAAMNGs? All feedback welcome.