The Rundown (4/23/21)
Welcome to The Rundown! Each week we’ll feature a couple talented guest writers to give their thoughts on whatever is happening in the markets right now.
One of our guest writers this week is SquirrelyInvestor. He’ll be sharing his thoughts about how the SPAC market has performed this month and what to expect going forward.
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Understanding the SPAC Market
In the long run, markets are efficient. In the short run, there are massive dislocations in markets caused by structural changes, behavioral effects, and positioning that cause short term inefficiencies. The SPAC market has shown a considerable amount of inefficiency for the past 12 months which has allowed investors to generate tremendous profits on a nearly “risk free” basis (or more accurately, an abnormally high level of profits with exceptionally low levels of risk).
Specifically, investors could buy pre-merger SPACs at, near, or below their $10 NAV levels, and then generate 50%+ profits when those companies announced a pending deal (definitive agreement). The holding periods of these investments would range from weeks to months, leading to annual returns in excess of 100%.
This short run inefficiency no longer exists and will not return in any substantial way. To understand why, you need to understand and examine the circumstances leading up to the past twelve months that created the inefficiency, and the market reaction that has occurred in order to correct this inefficiency.
The “old” SPAC market
Prior to 2020, the SPAC market was a tiny part of the overall equity issuance world. The first reason for this is signaling- SPACs were viewed as a “shady” way of going public. Institutional investors would typically see a company going public via SPAC as damaged goods “If the company was any good, it would do a traditional IPO”- at least that’s the message all of Goldman, Credit Suisse and Morgan Stanley bankers kept parroting. This resulted in SPAC companies being ignored by institutional investors, which makes it hard for a company to attract capital, build an investor and liquidity base, etc. To add insult to injury, bankers write sell-side research (Goldman Sachs initiatives coverage on XYZ Company with $45 price target) as a quid-pro-quo for investment banking business (read: IPO and other issuance fees). If you go public via SPAC, most of the big banks won’t publish research about you, institutional investors will shun you, and you’re going to have a hard time. As a self-fulfilling prophecy, good companies were steered away from SPAC deals, so only a handful of “less good” companies went public via SPAC, and those companies inevitably didn’t perform well on public markets, cementing the past 10 years of data showing “SPAC companies generate poor returns on public markets.”
The “old” SPAC trade
Despite this, there was a bit of a funny “glitch” in the SPAC market. The idea that investors could redeem their shares for the original NAV value, plus accrued interest (held in risk free treasury bills), and also get a free warrant (or partial warrant).
To astute institutional investors, they could buy SPAC IPO units at $10, get a warrant (which they could turn around and sell), and then redeem their $10 share for ~10.40 after two years (assuming 2% interest rates). For these same investors, who regularly hold billions of dollars of treasuries, re-allocating some of their treasury-allocation to SPACs provides a basically strictly-dominant return (with a liquidity trade-off, you can’t sell blocks of pre-DA SPACs very easily).
Large pension funds and other institutional investors had incredibly simple strategies. Blindly buy SPACs at $10, sell the warrant for whatever price you can, redeem the stock for $10 and you’re ahead. What’s interesting is that the “alpha” in this trade came from the liquidity in the warrant and desperately trying to sell it. Consider that for the last decade, many SPAC deals never traded above $11. Not before the DA, not after the DESPAC, literally never. Trying to sell 2 Million warrants at 80 cents each into a market that trades 5000 warrants a day, is a non-trivial problem (especially when there’s four other funds also trying to sell 2M warrants). “What do we do if the stock goes up to $15 or $20 pre-DA” wasn’t a question, because it essentially never happened. That’s also why pre 2020, the average amount of redemptions was around 50% of all capital invested.
Here’s a graph from spacresearch.com that shows deals from 2015-2018 and you can see that only 1 deal was trading above $15.
Okay, to summarize the most important point of this section, it’s the fact that SPAC IPO investors (the ones buying units at $10.00), are interested in selling the warrants whenever they can, at any price, and their primary plan is to hold the stock to the deal and redeem it. Selling the stock before the DA isn’t a major concern of theirs. I stress that this is all pre-2020 (many readers are unaware of the SPAC market before 2020, so this all sounds very unintuitive to them).
DraftKings changed everything
The exact reason why Draftkings went public via SPAC isn’t officially stated (most speculate it’s because they operate in a fuzzy legal area with respect to sports betting and fantasy sports), but ultimately they announced/leaked the deal on Dec 23, 2019. On that date, original SPAC investors laughed all the way to the bank, and they sold as many shares as they could, for a whopping $10.80 representing an 8% return over NAV. This was “a big DA pop” back in those days. On that same first day of trading, 10M shares traded- which at the time was also a ton of shares to trade for a SPAC announcement (in 2021, we regularly see 50M shares trade on the DA day).
What happened in the ensuing weeks, has basically never happened in the history of SPACs. A torrent of retail interest came to buy shares of DKNG pushing the stock price to $18 in the next 5 weeks. The reason for this is that Draftkings was an extremely well-known retail “household” name and offered a pure-play in the fantasy sports/betting business (also note this was pre-covid). Now to be clear, this “torrent of retail interest”, on a relative basis was still tiny compared to what we see in the 2021 SPAC market. But ultimately, there wasn’t a large supply of shares in the market. While some SPAC institutional investors sold aggressively for prices they’d never dreamed of, many simply held out (I posit that holding was less of a strategy, and more of a residual of not caring and not having a plan in place to do anything other than redeem or sell on the deSPAC date).
Draftkings had some luck, but also did everything right…
The COVID tailwind in February/March ultimately helped propel interest in DKNG and the stock climbed. This created a strange situation where institutional investors were suddenly caught significantly under-allocated in a business that they wanted/needed to have as part of their portfolio. A large institution like Fidelity/DE Shaw/Blackrock etc. will typically get “first look” at all companies in the IPO process and sign up for blocks of 2, 5, 10 million shares when the company IPOs. Virtually overnight, a $10 Billion dollar business that was highly sensitive to the COVID/Sports market was public and they needed huge amounts of shares. Buying large blocks of the stock wasn’t feasible on the open market because the float of the stock was still tiny (The SPAC shares were floating, but most insider and early investor, PIPE shares were still locked up). DKNG made the smart move to hire the same investment bankers that they originally circumvented in the IPO process, to do multiple secondary offerings into the market. This allowed the bankers to collect 5% fees on hundreds of millions of dollars of shares (issued by the company and also sold by insiders), and crucially, got DKNG a ton of coverage from sell-side banks initiating price targets. While the company started as a SPAC, they quickly caught up with the “typical institutional flow” of a traditional public company.
Draftkings was crucial for a few reasons. Most importantly, it added legitimacy to the SPAC process, which paved the way for other high-quality companies to feel comfortable with going public via SPAC. In a very close second, DKNG whet the retail appetite for SPACs. Many retail investors started going on the hunt for “the next Draft Kings”, and we saw record amounts of retail interest in SPACs in 2020. To be fair, there was record amounts of retail interest in stock markets overall in 2020 during COVID, but the relative amount of interest (pre and post covid) was dramatically higher in SPACs. If investors are looking for “the next Draft Kings SPAC”, and also looking for “the next Tesla”, the obvious intersection of that ends up being NKLA, HYLN, QS, etc.
More or less any SPAC that announced a deal in 2020 showed massive gains due to a lack of institutional sellers (the passive strategy from pre 2020 days) and immense retail interest concentrated on a very low number of deals.
Where we are today…
In 2021, a dozen new deals are being announced every single week. There simply isn’t enough “retail money” to plow into these deals with significant interest/liquidity to push these stocks up from $10 to $15, $20, $25 like what was happening in late 2020. To make matters more difficult, the nature of the institutional investors has changed as well.
The sleepy, quiet, traditional, SPAC investors of the past decade have been replaced by hedge funds. These hedge funds have seen the “DA Pop” effects and realize they can generate immense returns at nearly risk-free levels, and aggressively buy the SPAC IPO shares with the intention on selling every DA POP indiscriminately.
There’s a reason for this, if a hedge fund can buy a $10 unit (which is virtually risk free), and sell the stock+warrant for $12+ on the DA announcement, they’re generating a 20%+ risk free return. This, with leverage, is far better than generating a 50%, or 75%, or even 100% return that has significantly higher risk (holding the company and hoping enough retail interest comes to push the stock higher).
This is the logical consequence of markets being competitive and efficient. Clever retail investors (r/spacs!) generated abnormal, excess returns for the past 9 months and smart (large) hedge fund money has copied the strategy and crowded out the retail money.
Putting it all together…
Just to recap with simplified numbers, in 2020 there were about 20 SPAC deals, and only about 25-50% of institutional investors aggressively sold their shares on a DA pop. With say, a Billion dollars of retail money (demand) plowing into these deals, we saw the stocks pop to $20+ on a regularly basis (or $100+ in the case of QS).
In 2021, there are nearly 100 SPAC deals (over 3 months), and 75% of institutional investors are hedge funds that are aggressively selling their shares on the DA pop. With these hand-waivey numbers, unless there is 10x the amount of retail demand pouring into the market, we can’t/won’t see the same market pops.
More importantly, (and critically), we shouldn’t be seeing these DA pops and all of this is consistent with what we expect to see from a market becoming smarter and more efficient over time.
But I pick good Management Teams…..
It generally doesn’t matter, because there are so many SPACs chasing a limited number of targets, and the SPAC deal makers don’t bring much to the table other than cash (which is the same regardless of who you deal with). The only reason a SPAC should have a “DA Pop” is because the deal has been mispriced (the company agreed to do the deal at too low of a price). If a CEO wants to do a SPAC deal, they can just run a competitive process (bidding war) and find whoever is willing to give them the highest valuation (which is great for the company, bad for the SPAC shareholders hoping to make a quick buck). This significantly reduces the chance that the deal will be mispriced, which reduces the chance of the DA pop. If a CEO wants to underprice to get a DA pop, they can run a traditional IPO.
To summarize the effects again:
Retail capital chasing DA’s is diluted across many more deals, giving each one less of a DA pop due to fewer people buying DA’s.
Institutional capital is aggressively selling DA’s since it’s an arbitrage trade for them, adding to the supply of shares being sold on the DA.
Deals are priced more competitively since there’s many SPAC sponsors chasing the same deals.
It’s incredibly important to understand that these 3 factors weren’t in play in 2020, and that’s why the trades worked. If you made a ton in 2020, congrats for being smart and early. If you think you can repeat the performance in 2021, I have very bad news for you.
So… what’s next, how do I make money?
I noted above that SPAC deals are competitive and typically will close at the highest valuation. I’ll follow up by saying that I am very confident that the highest valuation is not the correct valuation. In most cases, it will be too high (meaning the stocks will, on average, perform poorly in the future), and in other cases it will be too low (meaning the stocks will do well in the future). Due to the aforementioned liquidity mechanics that I highlighted above, even if it’s a “good deal, at a great valuation.”, the DA pops are being sold indiscriminately by hedge funds creating opportunities for investors to be investing in great companies at great prices. The very mechanics that have closed one market inefficiency (trading the DA pop), has created a new one (investing in great companies that deserve higher prices). That being said, the latter is an investing strategy that is extremely difficult to get right because it literally just resembles standard investing (buy good companies at good valuations). This is very different than “I buy SPACs at NAV and make 50%+ annual returns, this will obviously work forever, and I am a genius.”