SPACs as a Call Option on Hype

Plus! More on the Twitter Hack; Corruption, Liquor, and the China Bubble; Q/Q vs Y/Y; more...

This is the once-a-week free edition of The Diff, the newsletter  about inflections in finance and technology. The free edition goes out  to 8,866 subscribers, up 636 week-over-week. This week’s  subscribers-only posts:

In this issue:

SPACs as a Call Option on Hype

Special purpose acquisition vehicles have raised record amounts in the last few years.  has tracked 28 SPAC IPOs this year, raising $8.9bn. At the current  pace, that’s a $16.5bn run-rate, beating last year’s $13.6bn and  massively ahead of the 2011-2015 average of $1.7bn.

SPACs have a simple model: raise funds, then find a company to merge  with. When they announce the merger, shareholders can either accept  stock in the new company or redeem their shares at the original price of  the offering. So, to the SPAC issuer and the company the merge with,  the SPAC is a deconstructed IPO. There’s a very short roadshow (you just  negotiate with one investor). To the SPAC investor, it’s a subpar money  market fund with a Kinder Surprise Egg-style option attached: invest,  and for the cost of tying up your capital for a while, you have the  option to get… something.

There’s been a recent blizzard of SPAC deals:

Where did they come from? What does it mean?

SPAC advocates say that SPACs are cheaper than the traditional IPO, and avoid the “IPO Pop.” Matt Levine has pretty thoroughly destroyed that theory:

Compared to an IPO, the SPAC is much less risky for the  company: You sign a deal with one person (the SPAC sponsor) for a fixed  amount of money (what’s in the SPAC pool ) at a negotiated price, and  then you sign and announce the deal and it probably gets done. With an  IPO, you announce the deal before negotiating the size or  price, and you don’t know if anyone will go for it until after you’ve  announced it and started marketing it. Things could go wrong in  embarrassing public fashion.

The SPAC structure is less risky for the company than an IPO, which  means that it’s riskier for the SPAC (than just buying shares in a  regular IPO would be), which means that the SPAC should be compensated  by getting an even bigger discount than regular IPO investors.

And that’s true.

SPACs are expensive for investors. One pseudonymous banker says:

Compare that to the average SPAC IPO size of $318m year-to-date, and  that’s a pretty healthy vig. It omits the sponsor’s fees—typically,  sponsors get 20% of the SPAC’s pre-merger equity. (Because of the  redemption option, while this is technically equity, it’s equivalent to a  call option that’s exercised on the date the SPAC’s acquisition closes.  That’s still an enormous option grant.)

There are a few ways to look at SPACs:

But the most interesting explanation for SPACs is not that the IPO  process is costly (it’s expensive, but cheaper than a SPAC), but that it  takes a long time. And that’s especially challenging for companies that  want to ride a hype wave. The dot-com bubble had incredible turnaround: was founded in July of 1997 and filed its S-1 in March of  1999. launched in November of 1998 and went public in February  2000. Hotjobs, a comparative laggard, was founded in February 1997 and  didn’t manage to produce a prospectus until June 1999.

In the 90s, you could start a company, prep it for IPO, take it  public, and white-knuckle your way through the lockup, all before the  bubble popped. Today, there are higher standards and there’s a longer  process. The market is not structured to quickly turn well-hyped  businesses into public companies.

SPACs change this. If Nikola had planned a normal IPO, they’d  probably schedule it for some time after they had a working product,  rather than renderings of prototypes. It wouldn’t make sense to hire a  big-name CFO this early, though there’s a long list of senior finance executives with EV experience to choose from.

The standards for SPACs are lower, so any time there’s a well-hyped  trend, or the possibility of one, a SPAC is the right vehicle for a  quick IPO. Nikola is not a coincidence. MP Materials, for example, is a  trade war play; they’re the only US producer of rare earths, and China  has used rare earth embargoes as a policy tool in the past. So now is a great time to offer the market a pure-play on domestic rare earths.[1]

Multiplan is another opportunistic SPAC deal: They’re a healthcare  claims processing company, going public at 11x 2021’s revenue (and  somehow 13x adjusted EBITDA. I’m in the wrong business). Multiplan is  one of those companies that converts one-time operating expenditures  into long-duration cash flows, which, when rates are low, have a very  high net present value. So they’re also a timely bet.

Virgin Galactic doesn’t fit with the model of riding trends, but it  does fit with the model of creating them. I was long the stock before  the deal was announced, on the simple theory that Chamath Palihapitiya  is a) smart, and b) more importantly, very willing to say crazy things  on TV. For example, Slack had to disclaim  any endorsement of, or responsibility for, the things he said about  them on CNBC when they were in the middle of their direct listing  process. Statements like “You know, one of our biggest investments  is a company called Slack, and I still think to myself, why did we not  just lead every single round and write the entirety of the fund into  that company. It was obvious from day one that Stewart Butterfield is an  iconic CEO, and that Slack is going to be one of the most important  tech companies in the world.” I figured a crazy interview would either  make the stock drop by half or double, and since I could redeem it for  $10 either way, my free option was underpriced. The timing was off, but  the thesis was right; Virgin was hyped to the moon, mostly by bored  day-traders, and it did end up more than doubling.

This pattern means that SPACs tend to be very adversely-selected. The  companies that go public via SPAC are not usually the ones that planned  an IPO for a long time, but the ones that suddenly had an opportunity  and really wanted to take it. The SPAC is the Vegas Wedding Chapel of  liquidity events; it seems like an urgently good idea at the time, but  doesn’t always turn out that way.

But in another sense, SPACs are a return to normal. The IPO process  isn’t broken because it’s too expensive, just because it takes so long.  And now it’s faster.

The form of finance is a lot more flexible than the fundamentals.  Take risk tolerance: In the 20s, bucket shops offered their customers  absurd amounts of leverage—up to 100:1 in some cases, so you could lose  all of your money in one bad afternoon.[2] During the Depression, the  Federal Reserve instituted margin restrictions, requiring investors to  put up a set amount of collateral before borrowing.[3] But investors  find a way to take risks, by speculating in small-cap stocks, uranium  miners, and assorted fly-by-night operations. By the 60s, leverage  started to move from investors' balance sheets to companies' balance  sheets: you couldn’t get much margin debt, but you could get all the  levered excitement you wanted by investing in deeply-indebted  conglomerates. And then, by the 70s, retail trading in futures was  getting big, and anyone with excessive risk tolerance could lever up as  much as they wanted. (The pseudonymous “Dash Riprock” from Liar’s Poker  and actual Jeff Skilling both lost money trading futures while they  were in school in the 70s. There is nothing new under the sun.)

Regulators have flexibility in determining the form of risk  tolerance. But they ultimately can’t change its existence that much.  Some market participants crave volatility, and they’ll find it one way  or another.

Similarly, regulators can make the IPO process slow. But some  companies have a preference for speed, and some traders have very  specific and urgent needs that can’t be satisfied in time by the usual  way of going public. We are, as always in finance, somehow back to  square one.

[1] I suspect their share price will have some interesting reflexive  properties: a rise in their stock implies that Americans with money are  worried about a rare earths embargo, which also implies that it would be  effective, which could potentially make it happen. There are  precedents: Armen Alchian figured out one of the components of hydrogen bombs by watching stocks,  and his research was destroyed. A few decades later, Paul Tudor Jones  mused that the world’s best commodity traders worked for the USSR.

[2] This sounds like straight up gambling, and it was: bucket shops  didn’t execute customers' orders at the exchange; they basically offered  a swap. This gave bucket shops a pretty simple business model:  encourage all their most levered customers to buy the same stock. Then  short the stock until the customers all got margin calls, and then buy  it back. As long as the transaction cost of pushing a stock from $100 to  $99, then covering, was smaller than the value of 99:1 levered customer  deposits backing long in the same stock, this was profitable.

[3] This is done through Regulation T, which used to be a tool for  fine-tuning the market to prevent or encourage speculation. Collateral  requirements were 40% in the early 40s, hit 100% for a while in the late  40s, and bounced around between 50% and 90% until 1974, when they were  set at 50% and haven’t changed since.

A Word From Our Sponsors

Here’s a dirty secret: part of equity research consists of being one  of the world’s best-paid data-entry professionals. It’s a pain—and a  rite of passage—to build a financial model by painstakingly transcribing  information from 10-Qs, 10-Ks, presentations, and transcripts. Or, at  least, it was: Daloopa uses machine  learning and human validation to automatically parse financial  statements and other disclosures, creating a continuously-updated,  detailed, and accurate model.

If you’ve ever fired up Excel at 8pm and realized you’ll be doing  ctrl-c alt-tab alt-e-es-v until well past midnight, you owe it to  yourself to check this out.


More on the Twitter Hack

Brian Krebs has identified a suspect in the Twitter hack. Interestingly, this hacker had  used SIM card attacks in the past (a possibility I discounted in my  post on Wednesday’s incident, since so many accounts got compromised).  If Krebs is right about the suspect, then the thesis that the hackers  were not financially sophisticated checks out. As does one non-monetary  motivation for the breach: bragging rights.

Corruption, Liquor, and the China Bubble

Chinese equities had their worst day in months ($) after a massive 20%+ rally in the last three months. One reason: a negative story  ($) about Kweichow Moutai, the megacap liquor/bribery company. Moutai  is a vehicle for bribes: it’s popular among Party members, because Mao  liked it, and some bottles are expensive but have a liquid market.  Perfect for a plausibly-deniable bribe.

I’ve written before about how China’s corruption accidentally imposes  some healthy economic incentives. Bribes usually pay for land and  loans; a bribe for land is tantamount to a Georgist tax (which is  economically optimal), while bribes for loans are something close to a  Tobin Tax (which doesn’t work in practice, except in economies with a  fairly closed financial system—like China’s). So Chinese equity traders  are reacting in about the right way: in a system where bribes are  necessary to get anything done, getting rid of an avenue for small  dollar-value bribes means slower growth.

Q/Q^4 != Y/Y

A minor piece of economic trivia, almost never relevant, is that the  US quotes GDP growth in a strange way. Most growth rates get quoted in  year-over-year terms. Quarter-over-quarter can make sense for anything  that grows fast and doesn’t have seasonality. But for some reason, we  quote GDP growth by taking quarter-over-quarter growth and compounding  it for four quarters. As Scott Sumner warns, this will lead to many non-comparable comparisons. The current Atlanta Fed Nowcast  expects GDP growth of -34.5%, but that’s actually a 10% quarterly drop,  extrapolated for a full year. Normally, GDP growth is not volatile  enough for this to matter much, but Q2’s GDP numbers will make some  needless noise.

Wolf Warrior Diplomats to Puppydog Plenipotentiaries

Via Politico’s China Watcher:  China’s diplomats have occasionally drifted into very aggressive  rhetoric, which has been dubbed “Wolf Warrior” diplomacy after a popular  action flick. But recently, they’ve expressed milder sentiments:

One particular view has been floating around in recent  years, alleging that the success of China’s path will be a blow and  threat to the Western system and path. This claim is inconsistent with  facts, and we do not agree with it. Aggression and expansion are never  in the genes of the Chinese nation throughout its 5,000 years of  history. China does not replicate any model of other countries, nor does  it export its own to others. We never ask other countries to copy what  we do. More than 2,500 years ago, our forefathers advocated that “All  living things can grow in harmony without hurting one another, and  different ways can run in parallel without interfering with one  another”. This is part of the Oriental philosophy, which remains highly  relevant today. The American people have long pursued equality,  inclusiveness and diversity. The world should not be viewed in binary  thinking, and differences in systems should not lead to a zero-sum game.  China will not, and cannot, be another US. The right approach should be  to respect, appreciate, learn from, and reinforce each other. In its  reform and opening-up, China has learned a lot of useful experience from  developed countries. Likewise, some of China’s successful experiences  have also been quite relevant for some countries in tackling their  current challenges. In this diverse world, China and the US, despite  their different social systems, have much to offer each other and could  well co-exist peacefully… Some friends in the US might have become  suspicious or even wary of a growing China. I’d like to stress here  again that China never intends to challenge or replace the US, or have  full confrontation with the US. What we care most about is to improve  the livelihood of our people.

This could simply be a matter of phrasing. Maybe one aspect of  “growing in harmony without hurting one another” involves an invasion of  Taiwan. A simple comparison of growth rates implies that the longer the  US and China delay a serious confrontation, the better that  confrontation goes for China. (Demographics complicate this somewhat:  2050 is better for China than 2020, but 2030 is a bit ambiguous.) So US  policymakers should pay close attention to when China’s diplomats  respond to escalation in kind, and when they suddenly start emphasizing  peace, cooperation, and co-existence.

Another example of this: China says it will stick with the phase one trade deal. That’s interesting, because they’re not on track to adhere to it so far. But the thought counts.

More Evidence That the Next Stimulus Round Will be Slow

The $600/week unemployment top-up runs out at the end of this month,  at which point either a) some level of transfer payments will be  continued, or b) the US will switch to contractionary fiscal policy at a  time when inflation is running at +0.6%, TIPS imply 5-year inflation  expectations of +1.3%, unemployment is 11%, and the economy is otherwise  signaling that more spending wouldn’t hurt and would probably help.

Negotiations are in progress. The latest: Trump wants a payroll tax cut  to be part of the next deal. This is not a bad idea, at least coupled  with continued unemployment benefits: the main goal of Covid economic  policy is to put as much of the economy as possible into a deep freeze  where debts can be serviced and people can get back to work as soon as  it’s safe. But a payroll tax cut coupled with a drop in unemployment  benefits creates a dangerous situation, where the government is  subsidizing a return to work whether or not it’s safe to do so. The cost  of an affordable stimulus that goes on for years is lower than the cost  of a huge one that only lasts for months.

Keeping the Big City Network Effect Alive

I’ve argued before that superstar cities will not get hit as hard by the remote work phenomenon,  because the network effect is driven by in-person meetings rather than  work in offices. But network effects are just as important on the way  down as on the way up: when people leave a city, fewer people have an  incentive to stay.

New York is trying to address that: while schools won’t be fully open, the city will offer some daycare options to compensate.  This is a very important tool for keeping white-collar workers in the  city. It doesn’t make a ton of sense from a pandemic-prevention  perspective: schools are dangerous if they spread diseases, and putting  students in a room that’s labeled “daycare” instead of “classroom”  doesn’t matter much to the virus.