New Listing Frenzy: IPO’s, Direct Listings and SPAC’s

Aside from the pandemic and election related news this year, you are probably also aware of a significant wave of private companies going public in the market to great fanfare and even greater one day share price appreciation.

Some notable examples this year have been: Snowflake, Unity Software, DoorDash, Airbnb… just to name a few. Those companies took the traditional route to market via an IPO (Initial Public Offering), but there has also been a wave of companies coming public in a “non-traditional” fashion through the use of direct listings, such as Palantir, or through the use of SPACs (special purpose acquisition vehicles), such as Nikola Motors and Draft Kings.

How much of this new listing frenzy have we at GCI participated in during 2020? The answer is none, for reasons we will discuss in this article.

At a high level, we are always a little wary that a surge in IPOs is typically less a sign of the fundamental strength of the companies going public and more a sign of overly exuberant demand for these companies – demand that eager investment bankers are happy to fill, generating huge fees for themselves in the process. Unfortunately, to fulfill exuberant levels of demand often means going ever lower down the quality and due-diligence spectrum in relation to the companies going public.

2020 has shown evidence of this exuberance that we have not seen in many years. To give you some idea of the scale we’ve seen this year: during the last four years an average of 171 companies IPO’d in the US each year. During 2020, we have already seen more than 400. This explosion has been even greater in SPACs: more money has been raised in SPACs during 2020 alone than raised in the entire last decade.

When the bankers and companies want to tap into this demand, they are faced with three main options to list their stock: traditional IPO, a Direct listing, or via a SPAC. Let’s walk through each in turn:

IPO Overview

This is still the most common and traditional route to market. In an IPO, a private company wishing to ‘go public’ and raise capital on the stock market will enlist the help of an Investment Bank who will help them sell that stock to investors. The bank does this through the following process: first they prepare an S-1 for the company (outlining the details of the company and the proposed stock listing), they will then take the company’s executives on an extensive roadshow to market the IPO to potential investors. Then, once the bankers have gathered sufficient interest (typically from their main client base) they will set the price of the IPO. Finally, they will hand select which investors are lucky enough to be allocated shares in the IPO when the stock begins trading publicly.

If all goes as planned, the company wishing to go public will end up with an infusion of capital and liquidity for the private owners, the investment bankers will get a fee based on that infusion, and the investors who got in at day one will benefit from the company’s initial performance in the public markets which, as we have seen, can be substantial. That last step, however, is where things get messy.

There exists within the traditional IPO process an inherent conflict of interest – the investment bank is acting as the broker for both the buyer (the investment firms buying shares) and the seller (the private company going public) in this transaction. History has shown that in this conflict, the bank often prefers their institutional investor firm over the company going public.

Banks will typically try to ensure IPOs are sufficiently hyped during the roadshow that the subscriptions (people wanting to buy) are 20x-30x the actual amount of shares available- so most firms who want to participate won’t get an allocation, almost guaranteeing a buying frenzy on day one of trading- to the benefit of those lucky few firms who did get an allocation (remember that the banks hand pick who these are). It is that last step- the hand picking of allocations, that typically precludes retail investors from participating in IPOs. And as the bank not only chooses who the buyers are but also sets the price, they are able to effectively direct profits to their favorite clients.

Why do this? Well, while it is true that the Investment Bank represents both parties, it is also true that banks will typically only work with the company going public once and will continue to work with their investment firm clients for many years in many different capacities (trading, research, etc). This might naturally shift the incentive for the Investment Banker to make sure their clients receive a nice profit in the first day of trading.

Now to be fair, we cannot lay all the blame for a lot of the huge first day ‘pops’ at the door of the banks for simply underpricing IPOs. While banks do like to ensure some first day appreciation (to give their clients a nice profit), the huge moves we’ve seen this year are also partly due to some large-scale irrationality that has prevailed in many areas of the market- many buyers are currently willing to suspend rationality when it comes to valuation in order to chase hot stocks. Many IPOs begin trading at what are arguably already stretched valuations, and then they double again on day one. Such a scenario is not unusual at the height of an IPO boom, but is typically a situation that does not last for a long time.

Should we Invest in IPOs?

Firstly, there is nothing special or fundamentally different about valuating a company that is going from private to public compared to valuing any other company. When it comes to a business, what we care about is the future risk-adjusted cash flows- that is always the place to focus.

We regularly read through S-1s to understand new businesses – both to understand them directly and to understand how they may affect our existing portfolio holdings, or possibly disrupt existing industries. For example, Snowflake was a recent IPO that is clearly trying to disintermediate some of the large cloud infrastructure players – reducing switching costs for the incumbents over time. This lines up with our internal expectation that margins for the infrastructure portion of cloud offering (Azure, AWS) will compress over time.

But what about investing? Why haven’t we bought any of these IPOs? Firstly, fundamentally there is an information asymmetry between buyers and sellers: we are on the other side of the trade to the most knowledgeable seller imaginable (company insiders), which is always a concern. Even once a company is listed and public, we typically know a lot less about it that one that has been trading for many years. In addition to that (as discussed above), investment banks are actively marketing the company to the point where they know there is more demand for the shares than there is supply available. Animal spirits, optimism, and hype at IPO day are probably near the highest level they are going to be (once the IPO is done, the bank usually immediately stops marketing the stock). So, we have knowledgeable sellers and irrational exuberance – this is rarely the set up for a bargain.

And this is even less so today when we consider the overall market level and demand for these new issues. So, while IPOs are a great source of actionable information about industries, they may not present great value for the prudent long-term investor – as always, each one needs to be considered on its own merits, and an appropriate intrinsic value for the business needs to be developed in isolation to whatever the bankers may be saying.

Direct Listing Overview

Direct Listings solve many of the inefficient pricing problems that exist with IPOs. In a Direct Listing, the existing shares of a private company simply begin trading on a public stock exchange like any other stock, making them available to everyone at the same time – there is no huge marketing effort and no special treatment for large institutional investors. Spotify was the first to go public in this fashion, followed by Slack, and most recently Palantir.

At first glance, this is preferable to the current IPO process of Investment Bankers doing their best to ‘guess’ a price and allocate IPO shares at that price to their best buddies. But there is a regulatory issue:  currently the SEC does not allow businesses to raise fresh capital in a Direct Listing, meaning only well-established private companies with no cash flow issues can pick this route as is. In most cases, the main motivation for a public market listing is to raise capital. So, what is arguably the most efficient and fairest method of doing so is not an option – hence why so many companies are often forced down the unfair, inefficient, and expensive IPO route.

These regulations could change in the future (we would hope they do), and if so, Direct Listings would likely become the clear choice for taking companies public – a route that is more transparent, fair, faster, whilst also being considerably less expensive.

SPAC Overview

The last main method for listing a company on the stock market is via a SPAC, the so called “Blank Check” companies that have exploded in popularity recently.

A SPAC is a shell company that a Sponsor (the group that will be looking for the deal) takes public in an IPO, raising cash from institutional investors through a fairly normal IPO process (as described earlier). The idea is that this newly listed SPAC (which is 100% cash, no operations) then goes and buys a private company, effectively bringing that company public. Until a target company is found the SPAC just sits in cash (which it invests in risk free government securities, earning interest). These have been referred to as ‘back door listings’, as the target company who wants to become public is able to do so via the existing public market listing that the SPAC already has.

Once a SPAC has been created and IPO’d (raising a mountain of cash for an acquisition) there is usually a two-year time limit for the Sponsor to find a deal. If a suitable deal isn’t agreed upon during that time frame then the SPAC shareholders will get their cash back plus interest (based on the original listing price, not what someone might have paid to buy stock in the SPAC in the open market). If a deal is announced, the investors in the SPAC then get to vote on whether or not they want the deal to go ahead. If they don’t like it, they can opt for their money back.

Now think about this from the point of view of the parties involved. For the Sponsor, they typically get two things for their hard work of finding the target company and arranging the deal: 1) 20% of the SPAC’s common stock, known as founder’s shares, and 2) Warrants to purchase more common stock in the future, which depending on the deal could be worth billions. Of course, they only get this if they actually find a deal to take a company public in this fashion, meaning that if the two-year time limit is almost up then they are incentivized to “reach” for a deal, even if it is of arguably questionable quality.

For the company wishing to go public, there are a number of potential benefits. Firstly, this is often a quicker path with less regulatory due diligence than a traditional IPO. Secondly, the company may find multiple SPAC’s competing for them, and as each SPAC is incentivized to make an investment, the company can often get a very good deal. This is why VC (venture capital) investors have been quick to promote the merits of the SPAC model – it’s a much better way for VC investors (often large holders of these private companies) to maximize the value they realize on a public market listing.

For the Institutional Investors that got in on the ground floor at the SPAC IPO, they effectively get a great deal of having a no downside, cash-like security which has considerable additional upside optionality if the Sponsor can find a good deal. A whole industry of SPAC arbitrage players has emerged to play in this field, providing the fuel for even more SPACs to emerge.

Should we Invest in SPACs?

 If you are lucky enough to be allocated a position in the SPAC IPO from your Investment Banker friends, then these can make sense as an arbitrage play. But most investors only have access to SPACs trading in the open market – typically at a premium to their cash value. This then introduces downside risk: yes, investors are returned their cash if no deal is done, but they will only be returned the per share amount of cash that was originally invested at IPO, which will be less than the price paid in the open market if the SPAC is trading at a premium. And not only is there no guarantee that a deal will be completed in the timeframe, but there is also zero visibility on what the deal itself will actually be, so these are vehicles where you have to place your faith (and capital) entirely in the hands of the sponsor.

For us, that’s often not a risk worth taking – particularly as the current SPAC craze is likely to be self-correcting. As more and more SPACs compete for deals, their standards end up getting lower, and the prices they have to pay move higher; so more and more will end up creating losses for investors. It is our expectation that as these vehicles gradually become less profitable, they will become less popular, and the boom will fade.

Conclusion

There is nothing inherently wrong with investing in companies that are going from private to public – but they should be analyzed the same way we would analyze any other investment. Every company should be judged based on its own future and prospects, and it should be valued appropriately in isolation of any outside forces (particularly those of biased individuals presenting ‘valuations’ to us).

And without doubt the sheer level of IPO and SPAC activity at present does give us reason to pause and remain wary. We will continue to rigorously conduct our due-diligence on any investable company and strive to own those in which we see a high probability of an attractive risk-adjusted return.

Update 12/23/2020

Coincidentally, within a matter of hours of publishing this article the SEC announced that they will at long last allow companies to raise capital through a direct listing- changing a rule that’s been in place for decades. We regard this is a very positive step forward for investors, private company owners and capital markets as a whole. Now companies will now be able to issue new shares and sell them to public investors in a single transaction in one day. This should result in companies being able to come to market more quickly, more efficiently and without having to pay millions of dollars in investment banking fees. The price setting mechanism for a direct listing should also ensure more appropriate and fair pricing on day one, removing the ability for investment banks to direct profits to their favored clients.