What's to become of the SPAC boom? | Howard Marks on market valuation

The Sharpe Angle: Atreides' Gavin Baker

How the retail investor is winning the year and the future of SPACs

SPAC activity all but ground to a halt in recent months after insatiable activity during the fourth quarter of 2020 and into the first quarter of 2021. An SEC clampdown and other regulatory concerns are partially responsible for the slowdown.  But there may be a lesser known reason, according to Atreides Management CIO Gavin Baker. Here's Baker in the latest Sharpe Angle conversation for Delivering Alpha on SPACs and more, including how the retail investor is winning 2021.

Leslie Picker: So you believe that some of these changes to how many of these SPAC mergers are financed is really what's to blame here, and no one's really talking about this?

Gavin Baker: In my mind, there's three kinds of SPACs. There's, I would say, unserious SPACs, you know, sometimes you have celebrity sponsors. There's unscrupulous SPACs that I think were preying upon retail investors and were highly concentrated in the EV SPAC area. And then I think there's a third category of very, very serious SPACs, and these are being sponsored by really high quality — your premier venture capital growth equity hedge fund firms, or, very sophisticated operators who can kind of add value to their target companies. And for that third category of SPACs, where we've been a very active participant in the PIPEs, it's important to realize that what drives that market is the PIPE. This is the money that is raised after the SPAC finds a target. And the reason that's essential is the only way a SPAC can be competitive with an IPO or a direct listing, as a path to going public for high quality company, is to have a PIPE that is at least 2x and realistically probably 3x larger than the SPAC itself, because that blends down to kind of the SPAC sponsors 20% effective fee….And this is actually why amongst these high quality sponsors, the axis of competition has really shifted to those who are willing not only to kind of whether it's defer their fee, lock their fee up, have it aligned with the performance of the underlying target over time. But more importantly, sponsors who commit to put their own money into the PIPE, because it de-risks that process for high quality companies. But this third category SPAC, which I think is here to stay, this is temporarily frozen. And the reason is, towards the beginning of this year, I think accountants, attorneys, CFOs, and a lot of different funds looked at PIPE commitments and said, "You know what, these are now material. These are relevant and we should classify them as illiquid investments." And that mattered a lot, because a lot of funds have internal limits on the percentage of their capital that they can have in illiquid investment, whether it's a PIPE commitment or a venture growth equity investment, and a lot of funds were all of a sudden over their commitments. And that really froze the market, along with the fact that 70% of SPACs are trading at $10.50 or less which is not a great outcome. And I think, as that kind of pig of PIPE commitments works its way through the proverbial python, you will see the market loosen up and probably more high quality companies continue to access the public markets via that, that third, SPAC route.

Picker: Because it's become clear that [PIPEs] are so important, does that then give investors beneficial treatment relative to history, in terms of various preferences embedded in these, certain pricing that may favor them? Are there certain negotiations that are going on behind the scenes right now?

Baker: Absolutely. And I don't know if it's beneficial, but I think it's a little funny, strange, ironic, whatever word you want to use. Sometimes the target company, you know, they'll spend months negotiating with SPACs, picking a sponsor, you'll feel so good about it, and then they'll go to raise the PIPE — which, again, if you're a high quality company, you want it to be 2x to 3x the amount of the SPAC —  and the PIPE investors are like, "Oh, we love this, but here's the new price." So it is very common for the PIPE investors to actually renegotiate, or increasingly common for the people who are investing in the PIPE, to renegotiate the deal that the SPAC sponsor had negotiated with the underlying target. And I think for the first time, you are beginning to see what is called structure take place in these PIPEs. So you are seeing PIPE investors get a mix of common equity and preferred equity to get deals done. This is a rare phenomenon, but one that you have just begun to see for the first time in the market.

Picker: But none of that actually solves the problem that you mentioned with regard to the accounting and being marked as illiquid versus liquid investments. So do you think that this kind of gradual losing that you're talking about, does that mean that we'll go back to some of the frenzied activity that we saw fourth quarter of last year, first quarter of this year? Or, is it going to be more of a normalized steady state, maybe a bit higher than where we were in 2019 but not anything like we saw in the six months from last year to this year?

Baker: I think the unserious and the unscrupulous SPACs, it's hard for me to see them coming back. Like if you were unscrupulous, like you may be in some trouble right now, and maybe, well, you probably should be. 

Picker: What does that mean, unscrupulous SPAC? 

Baker: I don't want to be specific, but I think there are a lot of them in the electric vehicle area...One of the big advantages of a SPAC is you can issue projections and make them public relative to traditional IPO. I think serious, high quality sponsors and companies going public via that route, they take those projections really seriously and understand they are giving guidance, they're beginning to kind of build trust with investors. I think there are some unscrupulous SPAC sponsors who took advantage of that to give what, you could just look at the numbers and know that they were unrealistic and like really fanciful kind of pie in the sky projections, faster growth than you'd ever seen for many companies in the EV sector before - and there's been there's very high growth companies there. Just obviously unrealistic projections that got retail investors very excited. I don't think that that is coming back. And I certainly hope it doesn't come back, because I don't think that's to anyone's benefit. But I do think as investors who've made PIPE commitments, as those companies kind of de-SPAC and effectively go public and your PIPE commitment becomes liquid, you have more capital to deploy into future PIPEs. And I do think that that market will come back and I would suspect it will come back at a higher level than you saw in 2019. But this is going to take time, because the other dynamic, maybe the more important pig that has to work its way through the python, is you had so many SPACs raised, and they only have two years to go find a target and you're already seeing right now that the SPAC bid for a lot of companies in late stage private markets is at least 1.5x to 2x the bid from a traditional growth equity participant. And that's just because they have money literally burning a hole in their pockets. And so I think that needs to wash through too. 

Picker: Is it better for these earlier stage growth companies to be going public in that stage of life as opposed to later in their product lifecycle? Some critics would argue that it's best for the retail investors and people who traverse in public equities to come in with more mature businesses and be investing in more mature businesses and leave the earlier stages to the professionals, the VCs out there who specialize in this stuff.

Baker: I think one thing 2021 has probably taught all professional investors is retail is winning so far this year, right? Institutions like Goldman Sachs and Morgan Stanley, they have different baskets of stocks you can look at. So they have a work-from-home basket, a travel basket, they'll have a high quality basket, a low leverage basket and all sorts of different baskets so you can measure how different fundamentals are doing. And I think, I haven't looked in a while, but the best performing basket this year is retail favorites. Everybody thought that this January phenomenon was a flash in the pan. I think a lot of people probably expected some of these stocks to fade back to levels before the retail mania. George Soros has this great phrase, reflexivity, which is that markets can change reality. And I think that happened. For a lot of these companies, they were able to raise capital, permanently change their balance sheets, permanently change their destiny. So I think everybody - me, CNBC, everyone - we should have respect for retail, because they're winning. This is a performance-oriented game, and they've done empirically well this year. I don't want to say that certain stocks are fit or not fit for retail investors, but I would say for me, I believe that it is better for companies to be more mature when they go public and I think a lot of the immature companies going public via SPAC were concentrated in those first two buckets: either unserious, or unscrupulous. And the serious, high quality, institutional SPAC sponsors, I would say, have generally targeted very mature businesses. And they're almost always in a bake off with the traditional IPO process and a direct listing. If you're a high quality company, you can go public however you want it. So if you're a high quality SPAC sponsor looking to take one of those companies public, you're competing with those other alternate paths. So the companies in that last SPAC bucket that I think and hope will be here to stay, tend to be higher quality, more mature companies, and not the really immature science projects that may have been targeted by other kinds of SPAC sponsors.

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