2020 is officially in the rearview mirror. In the few months (or has it been several years?) since my Q3 commentary, much has happened. The coronavirus vaccination distribution is ramping up, however imperfectly, and our United States of America has its 46th president. The stock market as a whole tends to be forward looking, and investors like me try to accept the current reality while keeping our eyes on the future. This mentality helps to explain the seemingly inexorable upward march of many stocks in the midst of a global pandemic. Before diving into a few facts from the fourth quarter of 2020, I am proud to announce that SM Carlton Advisory is beginning 2021 with eleven clients and approximately $5 million in assets undermanagement. Now to the facts:
Q4 2020
- It is unfortunate but critically important to share that more than 417,000 Americans have died more than 25 million known cases of COVID-19.
- Tesla, the electric vehicle and renewable energy company, surpassed Facebook to become the fifth largest public company in the world by market capitalization, making Elon Musk the richest human on the planet. (He trades the top position with Amazon’s Jeff Bezos depending on each company’s stock performance on a given day). Notably, due to its rapidly increasing size and prominence, in combination with a string of consecutive profitable quarters, Tesla was also added to the S&P 500 Index.
- The Bureau of Labor Statistics released the jobs report for the month of December, 2020, which showed the economy lost 140,000 jobs. The country had been adding jobs every month since April, but this announcement demonstrates a reversal of the trend. The United States lost more than 9 million jobs for the year, representing the most intense job loss since World War II. The unemployment rate now sits at 6.7% which is nearly twice what it was before the start of the pandemic in February of 2020.
- Despite a massive drop in March, the S&P 500 Index ended 2020 up 16%. Arguably more impressive, this gain is on the heels of an increase of nearly 29% in 2019.
I will not to pretend to understand why or how the market sentiment continues to be so strong and optimistic. There are many theories, ranging from optimism about economic stimulus provided by the federal government to historically low interest rates causing investors to seek ever more risk in attempts to chase returns. Ultimately, to me, these explanations are noise and do not impact my process of discovering and investing in quality companies. Strong businesses with long term growth potential can weather storms of economic uncertainty in the short term, and the best-in-breed companies will thrive regardless of the macroeconomic climate over the long term.
Contrary to what common sense might dictate given the extreme uncertainty and chaos in the country, many companies have chosen to go public in 2020, and raised record amounts of capital in the process. In addition to a few hotly anticipated IPOs like Airbnb and DoorDash, some companies have begun to consider using other pathways to the public markets that are newly in vogue. Some recent headlines I’ve seen begin with phrases like, “SPAC Mania,” “Beware the SPAC,” and “SPACs Attack.” It felt timely to dedicate some attention to explaining the primary mechanisms for taking a company public, and why it is increasingly popular to choose a non-traditional path. Before diving into the different options companies have for going public, let me zoom out and explain the bigger picture:
Why do companies go public? There are both positive and negative features to becoming a public company:
Key advantages to being a public company:
- Access to investment from the entire investing public.
- Transparent value of the company based on its easily available share price.
- Increased liquidity (ability to convert an asset to cash), for employees, investors, and founders.
- Acquiring new companies is more easily accomplished with share conversions.
- Prestige associated with being a publicly traded company, and liquid compensation stock plans, are excellent employee retention tools.
Key disadvantages to being a public company:
- Initial process to become public is expensive.
- Increased scrutiny on financial accounting, and the required disclosures, is costly. Public companies must report their results on a quarterly basis for legal and transparency purposes.
- Increased time and effort required for reporting.
- Fluctuation in a company stock price can be a distraction and lead to short-term decision making. Public investors do not always share a similar investment horizon as founders or CEOs.
The term IPO, which is shorthand for initial public offering, is commonly associated with Wall Street in downtown Manhattan. However, the first known “modern” IPO is credited to the Dutch in 1602 with the offering of shares in the storied Dutch East India Company. The number of companies that IPO each year is often tied to the booms and busts of market cycles. Some of you may remember the dot-com boom (and then bust) in the late 90s, in which seemingly any company that added “.com” to their name could raise money in the public market regardless of an ability to produce a real product or service. More recently, after the Great Financial Crisis in 2008, the number of new IPOs declined precipitously.
As I alluded to earlier, 2020 was a surprisingly good year in terms of the number of IPOs and the amount of capital raised. In fact, according to the Wall Street Journal companies raised a record $167.2 billion through 454 public offerings. This was possible because of a surge in the number of special purpose acquisition companies, or SPACs, that went public, accounting for about half of the capital raised.
So what exactly is a SPAC, and why have they become so popular? To fully understand the answers, it is important to have a grasp on the reasons companies go public, and the mechanisms to do so.
The Traditional IPO:
The path to becoming a public company has been a huge profit engine for investment banks. Firms like Goldman Sachs have long held a vice grip on the pathway for companies to raise capital in the public markets, due to their entrenched relationships with institutional investors (financial institutions with large pools of money). When a private company chooses to partner with an investment bank, the bank will take the company on what is known as a “road show.” This is a months-long journey in which company management pitches their story and asking price for their shares (determined by the bank’s analysts) to institutional investors. Once enough investors have agreed to purchase shares at a set price, thereby creating a valuation, the bank “underwrites” the new share listing to one of the major stock exchanges --e.g., the New York Stock Exchange (NYSE) or Nasdaq.
By agreeing to this process, the company seeking to go public cedes a degree of control of their future to the investment bank. The bank both determines the valuation of the company, and also owns the investor relationship of the institutions looking to buy the shares before the company is public. For providing these services, the banks typically charge a 7% transaction fee. When companies are raising hundreds of millions, or billions, of dollars, that percentage amounts to a hefty fee.
The rationale behind this fee and the value of using an investment bank is the security in knowing the bank will guarantee the shares trade above a minimum price. Once the shares begin trading, the bank typically agrees to ensure the company’s new stock price does not fall below a pre-determined price by promising to buy the shares themselves. This is a risk the bank takes if the IPO is unsuccessful. It is both disheartening and financially painful to the newly public company if its shares trade below what they were sold to institutions. A lower share price negatively impacts the wealth of the employees and company management who own the shares themselves, not to mention the indication that public investors don’t believe in the growth potential of the company. The IPO is typically deemed successful if there is a “pop” in the stock price, an increase of 20% or more, on the first day trading. Without this initial surge the industry analysts may call the IPO a “flop,” like Facebook’s entrance to the public market in 2012.
Many forces have been at work over the last several years that have made the role of investment banks an excessively expensive part of the process. The number of massive private equity and venture capital firms has meant companies have been able to raise more money in the private markets for a longer period of time, allowing them time to build strong and valuable brand equity prior to an IPO. The rise of the internet has dramatically increased the flow of information to the average investor. As many companies see their share prices double in value, or more, on the first day of trading they realize that a lot of money was left on the table because of the traditional IPO process. And so, the popularity of alternate paths to going public has increased as companies believe they can raise more money with lower fees by minimizing the role of investment banks.
The Direct Listing or Direct Public Offering:
In a direct listing, a private company goes public without underwriters (the investment banks), which until recently meant without selling new shares. This last point has been a key reason why few companies chose the direct listing path. Historically, a private company would only eschew investment banks if it didn’t need new capital. In other words, the company goes public to provide liquidity to its private shareholders and employees (remember, it’s easier to sell shares of a public company than a private one) but did not need to raise new capital in the process.
Well-known companies like Slack and Spotify are examples of companies that chose to go public in a direct listing. Both had been sufficiently funded in the private markets, and generated enough revenue, that raising additional capital was not a priority when considering going public. While the fees paid by Spotify and Slack were significantly lower than had they chosen to do a traditional IPO, without a floor set by the investment banks, the price of their shares could theoretically drop significantly if investors in the public market believed the company’s value was lower than the one determined by private investors in the prior funding round.
While Slack’s success as a public company can be argued (Salesforce has agreed to purchase them), it is fair to say that Spotify did not require the assistance of underwriters to prop them up. The SEC approved a new rule in December 2020 that will allow companies to directly list using both existing shares (as in the past), and also issue new shares (similar to the IPO) without requiring an underwriter. Historically very few companies have chosen to directly list their shares because it did not allow them to raise new capital but only list existing shares. It will be instructive to see the impact the new SEC rule will have on the number of companies who choose to go public in a direct listing in the future.
Special Purpose Acquisition Companies (SPACs):
Technically speaking, Special Purpose Acquisition Companies, or SPACs, are companies formed to raise capital in an initial public offering with the sole purpose of using the proceeds to acquire one or more private companies. As Camila Domonoske eloquently explained in an episode of NPR’s The Indicator podcast, SPACs flip the traditional IPO process on its head. A single or group of experienced investors raise a large amount of cash with the intent to merge with or purchase a private company, but only have an idea of the industry or sector of interest. The investors form a company that is essentially just a legal entity with a large bank account. Instead of going through a whole roadshow (remember, there’s no actual business), the SPAC’s management team take public this legal entity that consists of a bank account and an idea in an IPO. After a few short weeks, BOOM, there is now a stock trading on the public market that is a ticker symbol for a chunk of cash (there are a few technical differences associated with the capital structure and forming these companies, but for purposes of understanding the concept they are somewhat irrelevant).
Once public, the SPAC has less than two years to find a private company to merge with or purchase. During this time, individual or retail investors can invest in the SPAC despite not knowing which company it will plan to merge with. The rationale for investing in a SPAC prior to its announced acquisition, is the belief that its management team will purchase a private company that a retail investor wouldn’t be able to invest in until AFTER the IPO. There is an inherent gamble or faith to trust the vision of the SPAC’s investment approach to choose the private company wisely. If the retail investor is successful, they will be able to own shares at an earlier stage than the traditional IPO, not too dissimilar from the institutional investors having access to purchase shares during the road show.
A prominent recent example is the private space travel company Virgin Galactic founded by famed British entrepreneur Richard Branson. A publicly traded SPAC called Social Capital Hedosophia merged with Branson’s private company, and once the transaction was complete, Virgin Galactic became the publicly traded company. Had you been an investor in Social Capital Hedosophia before the merger, you essentially would have been able to own shares of Virgin Galactic before it went public.
The SPAC itself is has been around for a couple decades, but for many years had an image problem. Some casually refer to them as “blank check” companies which had often been associated with fraudulent schemes. But there is nothing inherently wrong with SPACs, and there is a fair amount of corporate governance mechanisms that are now in place to protect shareholders.
So why, as you see in the chart below, has there been a surge in the formation of SPACs?
Personally, I believe there are a few reasons:
- Increasingly Socially Acceptable: A handful of well-known private companies, like space tourism company Virgin Galactic and online gambling innovator DraftKings, chose the SPAC as a means to go public which normalized the process. Famed “mega-investors” such as Social Capital’s founder Chamath Palihapitiya have used their clout to help promote the process (and their successes). Even former NBA all-star Shaquille O’Neal has his own on SPAC, called Forest Road Acquisition, naturally leading some to jokingly refer to Forest Road as the “Shaq SPAC.”
- Cheaper than an IPO: The cost to private companies is lower, and the amount of money raised in the transaction is typically larger.
- Faster than an IPO: The time it takes for a private company to become public by merging with a SPAC is significantly shorter than the traditional IPO process, often saving a company months of hassle.
- New Power Dynamic: Companies no longer need to leave their future in the hands of investment banks. Roblox, an insanely popular kid’s online gaming company, previously filed to go public in an IPO. After seeing shares of Airbnb and DoorDash soar on the first day of trading indicating the investment bank underpriced and misjudged those companies, Roblox announced it would no longer go the traditional IPO route (it will likely DPO, instead of merge with a SPAC, but still represents a loss to the banks and a shift in the balance of power).
Final Thoughts:
In my opinion, more private companies becoming public is a net positive for the individual investor. By being publicly traded, businesses enable millions of individual investors like me (and hopefully you) to share in their future growth. While it is important to the private company seeking to go public which path to choose, it ultimately has little impact on my investment approach. It can take a few quarters for management to get accustomed to the increased scrutiny of quarterly reports. There is also hype surrounding hotly anticipated companies leading to volatility in the newly public shares. I therefore prefer to wait and watch before purchasing newly public shares. I do occasionally make exceptions if I believe in the long term growth and narrative of the company, but would only invest a small percentage or allocation of the portfolio. There are several companies that went public in 2020, by the three mechanisms I outlined, and I look forward to studying them and potentially investing in them over the next few quarters.
Important Notice: The above commentary is provided for informational purposes only, and should not be considered investment advice. Please do your own research before completing any financial transaction.
