Unpacking SPACs

Well, welcome everybody. And thank you for joining us for a conversation on SPACs, Special Purpose Acquisition Companies. And we've been hearing a lot more about SPACs, particularly over the last six months or so as it's become a more popular way to take your company public. And some of the headlines have different views on what you read there, but my favorite that I read a couple of weeks ago, was, "If you don't own a SPAC, you're a nobody." So we're gonna unpack that comment a little bit here. We're gonna talk a little bit about SPACs, give an overview, some of their characteristics. We're gonna talk about the timeline around what that SPAC process looks like, taking a company public. And then we're gonna talk about our view on SPACs here at Dimensional. How do we build that into our portfolio management process in the way we manage SPACs? So, to join me for the conversation today, is Jake Jolly, which is one the coolest name I think I've ever heard. But secondly, he is a portfolio manager on our small cap desk here in Austin. So Jake, great to have you here. Thanks for joining us today. Thanks Mark. Happy to be here. All right. We've been hearing quite a bit more about SPACs recently. They're nothing new, they've been around for quite a while, but they're becoming more popular. And it is interesting that they do have some nuanced characteristics. Yeah, they certainly do. And I think we'll just jump right into it here today. So, this is what last year looked like, right. I think this chart speaks for itself, but we see a massive jump in the number of SPACs that had IPOs last year, upwards of 250, compared to much smaller numbers in the preceding decade. If we look at that in terms of gross proceeds, it was more than $80 billion. So that's just to set the stage. As you already pointed out, these things aren't new, they're newly popular. And then that's really what we saw in 2020. The trend has continued into January of this year. So, that's why we're talking about here today. And there certainly are some interesting aspects of it that we'll be looking to jump into. Well, if you go right to that peak of that triangle there, so that $80 billion, what is that? That's about half the value of the IPOs that we saw in 2020, is that right? That's right. And we haven't seen that historically. About the same amount of money being raised through SPAC IPOs as traditional IPOs. And it was a pretty hot year for traditional IPOs. Which ties into then why we're hearing so much more about them, for sure. But we hear a lot about them. We hear about a SPAC IPO, we hear about a merger, walk us through some of those terms and what that process looks like. Exactly. So I think this is the best way to walk through it and get a concrete understanding of really what SPACs are. So it is an alternative to a traditional IPO as a way to take a private company and make it a public company. The way that that's done, the mechanics of it, is that a SPAC sponsor will raise funds and issue shares that are going to trade on market. And that happens over here. This is a, the SPAC IPO, and this is a real SPAC, but we're just using it for illustrative purposes. So during the SPAC IPO, they will issue shares in the SPAC, typically around $10 per share. The average SPAC has been around $300 million. When that SPAC begins trading on market, it's going to trade basically exactly like you would expect it to trade. It is ... the only asset in the SPAC is cash, so it's gonna trade very similar to cash. And during this period, from the SPAC IPO, the SPAC sponsor will search, will perform due diligence, will assess multiple targets. So you, the SPAC investor, you don't know what target they are going to eventually acquire. You may know what sector they're focusing on, but over this period before they announce, you really don't know what your money is going to be used for. What you see here is that once they announce, we see a lot more price activity. Once it's completed, that's when it officially ... The ticker changes and it starts trading officially like the new combined entity. And that's really how a private company becomes a public company, through merging with this vehicle that's already trading on market. All right. So you highlighted a couple key points there and let's walk through then, some of the benefits of a SPAC. What do we see out there with that? Yeah, I think one of the benefits that you're gonna hear the most about is really that they're faster. Not this period being fast, but the period from the merger announcement to the merger completion. So, private investors or private business owners might see a SPAC and think, "Wow, that seems like it's faster "than a traditional IPO." We negotiate with the SPAC sponsor, we come to an agreement, and we can move forward. Along with that, there might be more greater price certainty in terms of the deal that the private business owner is getting. So less variability potentially than going through a traditional IPO. And lastly, in terms of SPAC investors, so buying in and buying shares of a SPAC, they may feel that they're getting access to companies that they otherwise wouldn't be able to get access to. All right. So those are some of the commentary from a owner of a company and perhaps the SPAC sponsor, if you will. How do we think about some of the considerations from an investor's perspective? That's right. Well, there are always trade offs and there are a few considerations that we really need to highlight here. The first is that as I've already mentioned, you don't know what your money is going to be used for ultimately. If you took part in the SPAC IPO back here, there's a 22 month period in this example, where your money is sitting in a trust, earning the TBL rate, but is not being put to use in other ways. So there's a high opportunity cost there. Additionally, what you see with SPACs is that the SPAC sponsor is greatly incentivized to do a deal, because they stand to have a windfall, they get a large amount of shares in the new merged company. So, they may be incentivized to just do a deal. Not necessarily a great deal, maybe just an okay deal, right? And so that may mean that there's some misalignment between the SPAC investor and the SPAC sponsor in terms of the quality of the deal. And finally, SPACs by their nature, are rather dilutive for a few reasons. Those shares that the SPAC sponsors get, there may be additional financing taking place during this period to make sure that the deal goes through. And then additionally at the SPAC IPO, typically SPAC shares come along with warrants, fractional warrants, that can be exercised at a later date. So all of those things combine to make SPACs rather dilutive, which can impact performance of SPACs. Now, if you're interested in learning more about that, the Harvard Law School Forum on Corporate Governance is a great resource. They have lots of postings about these mechanics, and I definitely recommend checking that out. Well, I'm glad you mentioned that paper. I think it dives into a lot of the mechanics around dilution too, which is a really important point there of that. I liked how you phrased that about trade-offs. Right as investors, there's always going to be trade offs, as we think about these as possible investments. But I've heard you quote some numbers here. Let's go back. If you look at the last two years, calendar years, 2019, 2020, there are about 300 SPACs that were IPO-d, walk us through where they fall out now in their current life on this chart. So if we break it up into really three blocks here, what we see is, of those 300, about 15% policies for the penmanship, about 15% of completed deals, right? If we look at those that have announced, but not yet completed, we see another 20%. So about 35% call it 1/3, have announced deals, are moving forward with deals or just trading on market like common stock. That leaves us with 65% that are out there trading like cash in the market. The SPAC sponsors presumably are out there looking for deals, looking for a good deal. But I think this is one of the major misconceptions if you just read headlines in the journal. Most SPACs that have occurred in the last two years are trading on market like cash. So it's ... I guess you can conflate the SPAC IPO with the traditional IPO, where these companies are coming online and they're immediately trading as the new entity. With a SPAC IPO, it's trading like cash and sometimes for an extended period of time. So the SPAC IPO is really raising cash, and then the merger is where it comes into play and then of course, merger complete. So I liked that overview of that process, but let's get into the investment side of things here then, which is, let's go to that 15 ... Actually, let's go into the 35% there, post-merger announcement. Ultimately, what does performance look like post merger? What do the returns look like from these things once you're actually trading? Yeah. So, the first thing is to note that the data set is rather limited with SPACs. As we saw in that chart at the beginning, there just weren't that many, excuse me, in the last 10 years. 2020 it was really sort of the sea change. Now, the ones that we do look at, what do we see? You basically see what you would expect. We see some that do very well. Those are great deals, those are great companies that everybody's excited to see trading publicly. But at the same time, we see a number do very, very poorly and actually have negative realized returns after completing a merger. So, that is trading below $10 currently. So, there's no obvious trend, it's a small dataset. So what can we say about these things? Well, we can say that after a merger completion, after provisions like lockups roll off, we would expect to see that these names are going to trade consistently with their exposure to the premiums. So generally, what do these look like? They tend to be smaller. They're usually about smaller than $2 billion in market cap when they complete a merger. They tend to be growth or more growth than an average small cap, and they tend to not be profitable. So, keep that in mind when you think about these things, especially when you read the headlines about a big company that's very popular that had an amazing SPAC merger, and now everybody's excited about it. That's ... As all things in finance, the outliers are the things that you often hear about not the averages. Yeah. You hear about the great winners, right? Not the ones that didn't do so well. But I liked how you phrased that, that it really is by chance after the fact some do well, some don't. The premiums are reflected really in their performance there. And that might be a nice introduction then to when you talk about premiums, how do we think about SPACs in what we do here at Dimensional? Where do they come into play as part of our portfolio management process? That's right. And I think our process is very intuitive. So if we go back to the chart here, think of the SPAC IPO. Over the period from the SPAC IPO to the merger announcement, this thing is trading like cash. So what is the return on cash, Mark? It's gotta be close to zero, I would think that. It is approximately zero. And that's not even mentioning the opportunity costs with these names, right? If you are buying into the name here, you are essentially tying up your money. You are not getting the largest of the premiums, the equity market premium. And in this case, that's 22 months of your cash being tied up, not being deployed to other uses. From the merger announcement to the merger complete, there are a lot of things happening. So obviously the deal has come out. There's a lot more activity, a lot more trading in the name. The SPAC investors have the ability to redeem shares at this point, if the deal is not to their liking. The SPAC sponsor may be rounding up additional financing, depending on how many of the investors have redeemed. And maybe more importantly during this period, shareholders are voting on whether the deal's actually gonna go through. So there's a lot of uncertainty back here, but then there's even more uncertainty over here. Because things are changing, it's an evolving situation. Most deals are going to complete and go forward. And that's really where Dimensional starts looking at these things. Because from that point onward, although this is formerly a SPAC, at this point it is a publicly trading operating company, right? So there's a few things that we wanna pay particular attention to when reviewing these names. And I've already mentioned one of them, and that's the lockup provisions. We wanna be assured that the shares, the majority of shares are trading on market, and there isn't some point in time in the future where a lot of shares may come to market. So, you really have to review these on a SPAC by SPAC basis because the terms can be different. There can be different provisions that allow shareholders, excuse me, large shareholders to take their shares to market. The other things that we're looking at are up-to-date audited financials, as well as just our basic trading criteria. So minimum liquidity, operating history, all of the things that we review for all securities that will potentially enter our portfolios. Well, a lot of those things you're describing there, it sounds very consistent with what we do in the way we evaluate traditional IPOs as well. That's right. It's very similar. It's the same care and attention that we pay to all securities that enter the portfolios. Okay. Well, great. Well, let's summarize a couple of key points here that you walked us through there, Jake. And I liked the first part there about what we do here at Dimensional. The way we think about expected returns of SPACs, the idea that ... For most of those SPACs out there, they're still in a cash position. Obviously we have very defined guidelines and what we're trying to accomplish particularly in our equity portfolios, it's for equity, not cash returns. So we definitely take that into account. And then all those other things that you walked through around the lockups are incredibly important. I thought the dilution comment is very, very important. And again, we'll reference the paper there at the Harvard Law School, it's called? The Harvard Law School Forum on Corporate Governance. And the paper is actually called "A Sober Look at SPACs." Okay, great. Thanks for that one. And then I think that last comment there about research into SPACs it's continuing. I think that's really important to us. You just get more data sets around that, you see more of these things happen, we'll have a better understanding of performance around that. But the other things you mentioned there that jumped out to me as well I think is very important, is this idea of, there's some flexibility, perhaps we're an investor on the front end, but like we talked about, everything has trade offs. There's a tremendous amount of uncertainty from that aspect of it and once these things go post merger, you really see it normally by chance, some do well, those you hear about, a lot don't do as well. That's right. Pricing a private business is uncertain business or uncertain activity, right? When we think about how Dimensional is approaching this, the way I think about it, is that we're avoiding a lot of that uncertainty and we're letting the market do its thing and price these securities once they begin trading. So we're really using all of that collective knowledge, and using it to determine, are these securities that we wanna include? Well, it depends on their exposure to the premiums. But the important thing is that we're avoiding that cash like exposure, and we're avoiding a lot of the dilution that happens early on in the process. So I'm gonna go back to the headline I mentioned earlier on here as a way to summarize it. If you don't have a SPAC, you're a nobody. I think you're still a somebody with that, for sure. You can still have a great experience here. But we go back to what gives you the best chance of success over time? It's maintaining that well-diversified portfolio. All right. In case our audience has a tendency to like puns, I know you guys have come up with one, so I'll just give you the last word here on that. Yeah. I had a SPACtacular pun the other day, but I already forgot, so, apologies. So, yeah. Great. Ladies and gentlemen, thank you for joining us today. And you're getting some humor there from the portfolio management desk with a SPACtacular comment. But we do appreciate your time. Hopefully it does give a little bit of context again, as you hear more and more headlines around this idea of SPACs. And from all of us at Dimensional, have a fantastic rest of the day.