Traditional IPO, SPAC, or Direct List?

State of IPO market

The amount of companies coming public towards the second half of 2020 has been a bit insane to say the least. According to SEC regulatory filings, Q3 2020 has seen 81 IPOs (ex-SPACs) making it the busiest Q3 by deal count since 2000. The average IPO first-day pop has been 37%. The actions from government organizations to shut down economies have devastated industries such as hotels and leisure but have been a boon to sectors such as Healthcare and Tech. As society pushes for a vaccine, more people than ever are now working from home evidenced by screen time on our favorite devices up almost 60% since the pandemic began. Throw in trillions of dollars in liquidity injected in our capital markets system and you get a volcanic surge in demand for these companies. Tech and Healthcare companies have rushed for the exit as they make up over 50% of deal count this year. Many heads of private companies are unsure if this craze will continue and the FOMO is palpable. We have all experienced this to some degree, for the first time ever we are starting to get stock tips from Uber drivers. There is no denying there is something in the air.

SPACs – From zero to hero

Historically, SPACs got zero respect, they raised minute amounts of money and performance post-merger left a lot to be desired. In 2014, SPACs started to get a bit of traction with 12 SPACs raising 1.8B. Fast forward to Q3 2020 and a jaw-dropping 83 SPACs have come to market raising a total 30.6 billion. In addition, the size of SPACs continues to rise with Ackman’s largest-ever SPAC raise of 4B. Why now the deluge? Well, a few reasons. Firstly, SPACs are now leveraging the star power of hedge fund personalities and the reputations of asset managers to raise capital. Names like Chamath, Ackman, and Apollo headline all-star casts helping to raise gobs of capital with the promise to give potential issuers a path to come to market quickly and cash in on the recent craze. What would you be thinking if you were the founder of a private company and witnessed Snowflake IPO at 170 times TTM revenue? Cue the frenetic napkin math. A benefit to private companies that decide to IPO the SPAC route is forgoing the extensive due diligence involved in the standard IPO process. In fact, the SPAC sponsors seem not to care even if the company is pre-revenue! Early-stage companies that have went the SPAC route this year like Nikola and Fisker serve as good examples. The market is saying, “here is a pool of cash and no worries about proving your concept.” There is no doubt scarcity value within certain sectors and SPACs are a byproduct of this appetite explosion. Not surprisingly then, the SPAC momentum increases because it is increasing. SPACs pending acquisitions averages a 29.4% return and a median return of 9.9%. Sounds like a risk-free trade, all you have to do is buy the units and sell the news.

SPACs are not a replacement for the typical IPO process but a nice complement that increases the range of potential private companies that are considering going public. It offers something different. Guaranteed capital and a quick way to get to market without having to go through too much scrutiny. This comes at a cost of dilution to shareholders of the SPAC and the issuer. As you can guess, this can be quite a costly route for investors and companies. SPAC sponsors that eventually end up taking 20% of the merged entity without providing any ongoing value can be a hard pill to swallow for some.

DFIN’s share of the SPAC market is consistent with their broader IPO market share. SPACs also continue to rise in terms of complexity and size which means more coordinating with counter parties and increased dealings with regulatory agencies. All good news for DFIN. It is hard to be optimistic about SPAC staying power given post-acquisition performance is consistently negative for the group. This being said, DFIN will enjoy a bump from the current environment.

Direct Listings – The new kid on the block

Sounds like an IPO killer, right? Why pay those pesky underwriting fees, when you can let open access, supply and demand take care of everything? It is easy to picture VCs backslapping and yelling, “turns out we never needed those banker dudes to begin with, haha!” Well, not so fast. There is merit to Direct Listings, as any of you that follow Bill Gurley will no doubt have heard a million times before. To understand this, it is first best to start by dispelling the stunning misperceptions surrounding Direct Listings. The media gets it wrong in interpretation, impact, motivation, and pretty much everything else. Here is an example of an article that gets it exactly wrong. The mistake they are making is assuming certain similarities exist with standard IPOs. They are confusing the reference price with the offer price in the primary market. It is not. For a standard IPO, this is the price set through Dutch auctions during the book-building process. Primary market transactions are indeed happening at this price. The reference price is more or less meaningless in the sense that it is meant to serve as some sort of ethereal valuation rather than an indication of transactional activity. For example, The price of Palantir is down on its debut this year, not up. Its first trade was at $10 a share and it finished at $9.5 dollars a share. Direct listings are a completely different animal in that investment banks are no longer underwriters but financial advisors. There is no book building and there is no primary market. The issuer receives zero funds from any buyers and on day one of trading, the float is effectively equal to the shares outstanding because there is no lockup. Any insider can dispose of their shares if they please. This gives us all we need to understand the intent of a Direct Listings. The sole motivation is not, as the media thinks, to avoid paying investment banking fees. Direct Listings are also expensive. Listen to the Slack CEO talk about the costs. The primary intent is for insiders to not be diluted and locked up. As of the time of this writing, Direct Listings can only facilitate a secondary market. Initial offerings have to be approved and the exchanges are trying to push this through SEC review right now. I suspect the SEC will eventually pass this sometime next year but investor protection remains an issue. Underwriters are on the hook for public disclosures when a company goes public the traditional route. Without the underwriter acting as a watchdog, I suspect the SEC will attempt to add certain regulations to the Direct Listing process to assume a similar level of investor protection with IPOs.

The ability to conduct a direct listing has been an option for quite some time, so why now? In short, certain companies have been around long enough, have extensive VC support and generate enough cash where they don’t need the money. Also, they do not need a bank to sell them. Companies like Spotify, Slack & Asana have institutional investors tripping over themselves to get a piece. Why go on a roadshow when everyone wants to see you? Unfortunately, the vast majority of private companies, do not enjoy such an advantaged position. As it stands, only four of companies have completed a Direct Listing in the last few years. The inability to conduct a capital raise being the primary deterrent currently from conducting a Direct Listing but there is more than that. Contrary to what some might believe, investment banks do in fact add value by putting company founders in front of their clients. They effectively have a distribution arm that is valuable to founders and worth paying for. Especially when the company realizes they will have to pay for financial advisors anyway to help with the market making, regulation and analyst support. The traditional IPO process is not of much value to a few select unicorns and for those, Direct Listings are a better alternative. Bill Gurley’s refutation to this is that someone will build a platform so all investors can jump on and see the latest investor day presentation and interest can be drummed up that way– no need for a bank to sell anything. I think this misses the point that for wider Direct Listings to be a success, you need broad institutional participation which would simply not happen for smaller & less well-known companies. Selling and relationships still matter when it comes to raising money and investment banks acting as intermediaries in this capacity are here to stay.

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