SPAC to the future
“Private for longer” has been the bane of many an investor in the past decade. We have written extensively about the structural changes happening in the global equities market, both on the private and public side of things. Arguably, the biggest driver of interest in the private space is very much the lack of opportunities in traditional public markets.
For many public market investors, the rise of PE and VC mega-funds has been an annoyance, to say the very least. The availability of private funding has allowed startups to remain in private hands for much longer than they previously could, ultimately leading to the postponement of their IPOs to a point where much of the “alpha” from their growth trajectories has already been priced in. And by the time they come for their IPOs, all the good stuff has already been extracted by PE investors – at least, that’s what the public markets tell themselves when it came to the high-profile (yet disappointing, and sometimes non-existent) IPOs that we’ve seen in the past two years: think Uber, WeWork and the plethora of internet wonderkids that tried to come along for the ride.
Nobody wants to be the bag holder for a private fund’s exit trade.
Investors in private markets will promptly argue that the grass is always greener on the other side and point to the risks of illiquidity and immaturity in their investments which they have taken. Indeed, they are sitting on massive gains in valuation in their portfolios, especially those with the cream of the start-up crop on their books: from Airbnb in the US to the likes of Gojek, Grab and Ant Financial in Asia. Yet with very few exceptions – Ant Financial being the latest to be finally put on the path to a listing – many of these gains are paper gains, at least until a proper exit.
Furthermore, these valuation gains aren’t necessarily “mark to market” – they are more often based on the valuations at which subsequent primary rounds are raised, rather than a valuation from an actual exit transaction. As one manager based in Asia once told us, the valuation of their book is “marked to belief” rather than “marked to market”.
Squaring up the “marked to belief” valuations held on private books with the expectations of future upside held by public markets is the challenge. With investment mandates squarely divided between “private” (also unlisted and illiquid) vs “public” (aka listed, liquid and “safer”), the question is how that void gets bridged.
One possible answer: SPACs.
Adding SPACs into the mix changes the game for private funds and especially VCs. While they were a bit of a curiosity in prior years (last year’s highlight of the SPAC space being Virgin Galactic), they’ve certainly taken on a life of their own this year. Known as “blank cheque” companies, SPACs have emerged as an increasingly popular route for VCs to exit earlier than they normally would be able to, and likewise for the public to get involved in early stage opportunities earlier than they previously were able to.
And 2020 is shaping up to be the year of the SPAC.
Modulating the spectrum of risk
The recent popularity of SPACs adds another notch to the spectrum of risk/reward that is offered to investors. Traditionally, the notion of “risk” has always been proxied by a measure of volatility, specifically the standard deviation of returns based on a historical data set.
For starters, we find that definition highly misleading: just because an instrument has low volatility hardly equates to low risk. Think a bond that is in default and trading (steadily) at its probability-weighted recovery value – its volatility is low, until such time as a recovery is made (a huge pop up) or a writeoff is confirmed (a huge move down). Such instruments can hardly be said to be “safe”.
Likewise, a market-leading stock which takes up a huge proportion of the index swings around, driven by flow dynamics. Yet its structural growth story underpins its upward trajectory, despite the volatility, and the business of the underlying company is growing at exponential rates. The volatility of returns is high, but conversely, exposure to such an instrument can hardly be termed “risky”.
For us, risk is not just a case of volatility. The fundamental underpinnings of an investment case matter – hence our focus on “emerging opportunities”, characterised by structural developments (or decline). But even those are general in nature. The biggest, specific determinant of risk, in our view, is liquidity.
Liquidity determines one’s ability to change one’s mind – to buy into (or sell out of) a position at a moment’s notice. It determines the hurdles to making such a transaction: spread, timing and most importantly opportunity cost and the underlying capital put at risk in taking on the position in the first place.
Aside from price discovery (which is far from well-defined in the private market world), liquidity is the key difference between public and private markets: public markets, especially exchange-traded instruments, offer market participants access to a readily available pool into (and from) which they can sell or buy. Made a wrong decision? Just reverse the transaction, albeit at a cost, even if small.
The same cannot be said for private markets. Make an investment into a PE or VC fund and you typically face lock-in periods of anywhere from 10-13 years, at the discretion of the General Partner (the fund manager). The capital calls that an investor commits to are a binding agreement, non-performance of which is material for potential legal liability. Change your mind halfway through? Aside from the trouble of trying to find someone to buy out one’s stake without an onerous discount, there’s also the whole issue of whether such a premature exit is permitted by the manager. And we haven’t even got to the matter of fees, which feature in most cases the classic 2/20 combo that the hedge fund world pioneered, without the frequent reporting and valuation demanded of public market funds.
The trade-off, according to PE/VC fund managers, is that a private investment offers massive upside and access exclusive to the cream of the investment management crop, a differentiated offering that cannot be accessed anywhere else.
Either high liquidity and “average” returns or rock-solid illiquidity and the promise of superior returns – that’s the dichotomy that investors have been offered over the past decade, although as we pointed out before, the “Public Market Equivalent” performance of most VC and PE funds largely track the S&P 500.
The best of both worlds?
SPACs appear to offer investors the best of both worlds: access to growth opportunities while they are much earlier stage, at a similar liquidity profile (at least so far) of a standard listed stock. Or as we like to put it, “VC-type returns profiles with listed instrument liquidity”.
SPACs aren’t alone in this “best of both worlds” category – they are accompanied, although slightly further up the volatility spectrum and largely still confined to the financial services space, by digital assets. Both categories of instruments can, in theory, offer us much more asymmetric “reward to risk” ratios than the classic menu.
Of course, no one really gets to have their cake and eat it. Aside from the difficulty of finding a target company that’s simultaneously worth investing in and is willing to split the upside with a SPAC, there’s also the question of the initial set-up of the investor base of a SPAC: you guessed it, they’re mostly speculators.
The resulting volatility, added to the very real risk that some of these target businesses may never live up to their hype, is not something that is suitable to most palates, even if the names of some of the companies (and their investment cases) that have gone (or are going) public via the SPAC route are tantalising, to say the least. The likes of Luminar (autonomous cars, backed by Peter Thiel) and MPMO (a rare earths mining business, listing via FVAC) have investment cases that make for extremely interesting reading, although much more work needs to be done on our part before we make any decisions about whether they play a part in our portfolio.
We would recommend everyone else do the same before venturing into this new domain.
Back to the future
In the end, it never fails to make us wonder how things always turn out to be a bit cyclical in their nature, even if they come back in a slightly different form from their previous incarnation.
And thus we find ourselves back in a situation that looks like the IPO frenzy of the late 1990s and early 2000s, where companies that were much earlier on in their life cycle are coming onto the market, opening up a plethora of exciting, though equally volatile (and potentially materially risky) opportunities for investors. Many came and didn’t last, but within the list of those who did, we find some of the champions of today.
After almost a decade of seeing private investors hoarding the best opportunities and keeping them “private for longer”, the market has now dictated that private market players open up (whether by necessity or by volition) these opportunities again to the public markets, where – not surprisingly – the capital pools still remain significantly deeper and more diverse than their private market counterparts, even after the latter’s unfettered growth in recent years.
Public market investors complained that things were getting stale, especially with ETFs and passive flows taking the value out of investing.
From digital assets that trade on open (even decentralised) exchanges offering really early stage exposure – sometimes even days old – projects, to SPACs that occupy the space that IPOs in the “old world” used to sit: the structure of markets and the interplay between the public and private realm is once again in flux.
Fortunately, managing that flux doesn’t require a flux capacitor, nor plutonium or a DeLorean.
It just takes a spirit of curiosity, lots of a reading and a dollop of common sense.