June 11, 2021

To SPACS and Back

This week we're going to go to SPACs and back, and that's an acronym. It's an acronym that sounds strange, sounds unfamiliar, sounds technical. We'll explain what they are and why they getting so much attention.

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This week we're going to go to SPACs and back, and that's an acronym. It's an acronym that sounds strange, sounds unfamiliar, sounds technical. We'll explain what they are and why they getting so much attention.


Will Page: Welcome to Bubble Trouble, conversations between the economist and author Will Page, that's me, and independent analyst Richard Kramer. Gonna layout some inconvenient truths about how financial markets really work. Today, SPACs. Don't know SPACs from spackle? We'll tell you what a SPAC is and isn't. More on than that in a moment.

Last week's trouble forms this week's bubble. You have our five building blocks and now it's time to build awareness of bubbles and block against them causing trouble. Let's put those blocks together. An absolute one that learned about, those who got paid to praise, not appraise, the [stenographers 00:00:38] and the sycophants. And two, we questioned the trends and trajectories that appear too smooth to be true. And three, we offered an alarm call so you can wake up from those themes and dreams that caught you sleeping. And four, we paid attention to the economics of attention, the contestability where one merchant's gain is another's pain. And, of course, the constraint, there is only 24 hours in the day.

Finally, five, we brought Bubble Trouble, full circle and discussed money, not our money, but someone else's money, and how debt means very different things to a corporation than to an individual, who, by the way, might be investing in that corporation.

That's a wrap, the five jigsaw pieces, so we can start solving some puzzles. Now, remember, the reason we're doing this podcast is to pay homage to that English rock band, The Who, and make sure you won't get fooled again. So this week we're going to go on a trip to the SPACs and back.

Richard, welcome back.

Richard Kramer: Hi, Will.

Will Page: So this week, we're going to go to SPACs and back, and that's an acronym. It's an acronym that's gonna scare a lot of our listeners, sounds strange, sounds unfamiliar, sounds technical. Before we get to what the SPACs are, I think we need to go to another acronym and build ourselves towards this, which is the IPO, the initial public offering. This is a process where companies which are private, such as a startup, then becomes public, where you can buy and sell stocks on a normal platform. Walk me through the basic steps of the IPO process before we take that trip to the SPACs.

Richard Kramer: Sure, Will. In most markets, there are requirements for any company having an initial public offering of their stock to have some sort of track record. Usually three years of operating history, and some revenue in- in the old days that used to require some profits. This isn't the case anymore. There are also tend to be, in most markets, some sort of junior market. In the UK, you have AIM and NASDAQ, you have a lot of very small companies, almost penny stocks. They're outside of the big, high-profile IPOs that make the front page of the newspapers, whether it's in the UK or the US.

And that process, it tends to run through, uh, a- a series or a grouping of investment banks called a syndicate that will bring together those shares and offer them out to all the clients in the market, and say, "Okay, who wants to buy?"

There are also other ways to list a company. There's direct listing, there's buying a shell company and reversing the assets of a startup into that company. And then there's the newer idea, the SPAC, the special purpose acquisition company, which we'll come onto in a second.

The one thing that all of these methods have in common is they require that the banks shepherd the companies through the process of becoming publicly listed, typically a feeding, a hype cycle, and hopefully explaining the company to its prospective investors, trying to entice them to invest, and, uh, doing all the- the legal and background work to justify what is a typically up to a 7% fee of the cost of the listing.

Will Page: Now, I think we need some self-regulation here. I think this podcast should fine its presenters 10 pounds to go to a charity of a worthy cause every time we say an acronym without spelling it out. So, very briefly-

Richard Kramer: Yeah.

Will Page: ... you said AIM earlier on. What does AIM stand for?

Richard Kramer: Alternative investment market. And again, that's a junior market where smaller companies are enticed to list, as opposed to the bigger companies listing on the main stock exchange.

Will Page: Grand stuff. So, if we take stock through the IPO process, you have a company that's formed through an idea, through a theme or a dream, as it were.

Richard Kramer: Mm.

Will Page: It gets to level scale, gets the bankers on board to go public. And then it becomes traded. Sometimes people talk about this like it's a rites of passage, it has to happen, but it doesn't always happen. Correct?

Richard Kramer: Absolutely not. And there's many highly successful companies that have stayed private. Typically, there's a couple of reasons why a company might want to go list itself on the stock exchange. One is, obviously, to raise a large amount of capital, and to do that through the equity of the company, as opposed to taking on debt. Another, what we consider a less good reason, is to raise the profile of the company. And that's quite a scary prospect, the idea that you're going through all this cost and- and hassle of an IPO process, and committing yourself to quarterly earnings reporting and- and all the legal requirements of directors of public companies, with a simple idea, that it's a publicity exercise to get people to know your name.

Will Page: So we have the choice of equity over debt. And now we're going to turn to SPACs, which is a beautiful segue. We've got this thing called SPACs. I'm seeing it in the press all the time.

Richard Kramer: Mm.

Will Page: I'm particularly seeing it in the US press, less so here in the UK. And I want to pick you up on that in a minute, but just unpack this acronym SPAC for us, make it really simple so we can follow what goes on, vis-a-vis the traditional IPO process, which I've gotta say, you described beautifully just earlier.

Richard Kramer: Right. So, a SPAC is a special purpose acquisition company. Think of it as a company formed to buy another company. In the past, you would have formed a SPAC to effect a transaction. You want it to create a company that would do the acquiring, while the existing company carried on its normal course of business. And then that acquiring company would be folded into the existing company.

Now, the bizarre thing that happened in the first quarter of this year was that you had an astonishing hundred operating companies go IPO. They raised $39 billion, which was up 476% on what was raised in the first quarter of 2020. And you think, wow, $39 billion, that's an astonishing amount of money to raise. But that was dwarfed by the fact that you had almost 300 SPACs come to market-

Will Page: What?

Richard Kramer: ... and raised $87 billion. Now, the key thing to understand about SPACs is they are a means to an end. They are not an end in itself. And remember, as I described in a previous podcast, a good definition of a SPAC, for a complete lay person, is, "Give me money for an idea I haven't had yet." These companies are being formed with the sole purpose of buying another company. Effectively, think about it as putting money into a bank account, which is also listed, with the idea that that bank account is going to be emptied out at some point to buy something that you would think yields further value down the line.

Will Page: Let me try and understand this correctly. We've seen tech stocks go ballistic at the start of lockdown, you know, going on a rally, which raises questions in itself. Are SPACs continuation of that rally of tech stocks, is it all this cash washing around, there is an alternative, [inaudible 00:07:19] the acronym again, where it's like, if you can't make it on tech, we need to go and invent tech that hasn't been invented yet, and wrap it up in a SPAC? Is that's what's happening is a continuation from where tech's left off?

Richard Kramer: You could look at it in that sense. You could also look at it as a reaction to, or a natural extension of, the extensive money printing that's happened by central banks in the last decade or more. So there's all that money sloshing in the system, because the Fed's balance sheet has expanded dramatically. You've had enormous amounts of money injected into the system, the money supply, which is something you would've learned about in your halcyon days as an undergraduate economist, have all injected liquidity for the past decade into the system. And that liquidity needs to find a home.

Now, some of the companies that will be acquired by SPACs are certainly going to be tech companies, but you'll see SPACs targeting investments in all sectors. Now, one of the key things about SPACs, which makes them potentially weapons of mass financial destruction-

Will Page: [laughs]

Richard Kramer: ... is that they tend to have a two-year lifespan. So you don't have a SPAC bolt together with the notion that money is going to sit there in the bank account forever until you find something to spend it on. Instead, you'll give a finite period for that management team of the SPAC, the sponsor or promoter of the SPAC, to find a target for their investment.

Will Page: So, I love your analogies there. My favorite one so far is, I think, that it was a premature baby born without a business plan. SPACs are happening earlier than IPOs, without the business plan substance of a traditional IPO. So it really is gambling on themes and dreams, one of the earlier episodes of our podcast, I guess.

Richard Kramer: Hmm.

Will Page: Let me move to a- a more technical question. It's a question that would worry anybody, if they're holding stock in a company, and they hear there's a risk of this D-word, dilution. You forwarded me a paper recently, which talked about the rate and pace of dilution happening in SPACs right now, it was a sort of real-time metric to cause alarm. And you've explained beautifully the bubble. Now take me through with word dilutions, explain the trouble.

Richard Kramer: One of the problems with SPACs is that the money that gets injected into the SPAC, it comes before both the promoters of that SPAC and the investment banks that have brought that SPAC to market have taken their fees out. And oftentimes those promoters will grant themselves founder shares or warrants to take more. Maybe they'll say, "You know what, I'm not going to get paid anything now, but I'd like an option over a portion of the company in the future."

And so that combination of the promoters' fees, the underwriting fees, or the fees to bring that company to market, and some sort of warrants or rights, oftentimes can add up to half the costs of the cash that's delivered at a merger, or 15% or so, according to an excellent paper by some folks at Stanford Law School, of the costs post-merger. So you're paying a huge price for someone to manage that bank account for you, administer it, and then withdraw that money from the bank account and put it to work.

Will Page: Wow. So you could find yourself underwater very quickly with no sign of getting back up for air.

Richard Kramer: Yeah. And to be fair, there's also risks in traditional companies of the management issuing stock options to itself and diluting existing shareholders. But in those cases, you tend to invest in a company where you have a pretty good idea already of who the management is gonna be and of what their business is gonna be. And the big question in SPACs is, you don't necessarily know what the target of that SPAC might be.

Will Page: Asymmetric information.

Richard Kramer: Absolutely.

Will Page: Got it. It sounds risky. And before we go to the break, can you just kick us a couple of smoke signals, so we can just wrap up our SPAC debate here, in terms of what the listeners should be looking out for?

Richard Kramer: Sure. I- I think the first smoke signal, and this applies not just to SPACs, but to any company, is to play out the string. If you're really gonna invest, and by invest, I mean not just day trade the way the Reddit crowd might look at a- a stock like GameStop, but you're really gonna invest. Then you've gotta look down the road at the dilution that's coming. Is the management issuing options to itself? Was the SPAC's founders deciding to issue themselves a ton of warrants over the future value of the company? And, as a famous Beat poet once said, "Watch whose money you take."

Will Page: Got it. Smoke signal number two.

Richard Kramer: Smoke signal number two is, do you have to determine the visible wisps or whether it's a raging fire? What we're seeing in the market right now is many companies with either very speculative cash flows or, frankly, a raging fire of cash burn.

Will Page: [laughs]

Richard Kramer: But they're hoping to make money over time. So, you can't take cash burn to the bank. You can only let it continue or try to lessen it. And if you are writing a blank check to somebody based on their track record, well, you've gotta realize, look, no athlete makes the same play twice. Just because a manager was particularly talented in one specific area, doesn't mean that manager can do it again in the same space, or take that skill and apply it to another space.

And you know the old saw that you hear about all the time when considering investments, that past performance is no guide to future returns, but here we are, again. With the SPAC phenomenon, you've been offered the chance, based on past performance of managers or celebrities or whatever the promoters might have come from in terms of background, to invest in their future returns, but blindly, because you don't know what the target of their returns is going to be.

Will Page: Drives me crazy. It makes me think about Michael Lewis, the author of the book and the film, The Big Short. Does he actually have to write a sequel, or is the market writing a sequel for him?

That's going to wrap up part one. Uh, we've got to SPACs, and now we need to get back. And this is where I want us to grapple with the great rotation or the cyclical rotation. That is, there's all this money sloshing around SPACs and tech stocks because we're in abnormal times. So where does that cash go when we get back to normal? Is that the trouble that will pierce the SPACs bubble? Back in a moment.

Welcome back to Bubble Trouble. This week, we're going to SPAC and back. Now, we've got to SPACs in part one. Now we need to get back to some sort of normality that resembles what we were used to just 14 months ago. We could measure the recovery by tracking pollution levels, and yesterday I was on Highgate Hill and I could literally see smog above London. A clear but unwanted smoke signal, if you like, that we're slowly and surely getting back to normal.

So when we talk about getting back to normal, we're hearing this term called cyclical rotation. That's where we leave the party, or the 14 month long rave that we've been having with tech and SPACs and alphabet soups of acronyms, and we rebalance our portfolios with stocks and bonds and cash that are perhaps more stable, more predictable allocation, less inclined to get wrapped up in bubble trouble.

So we, if we leave the party, how does the party wind its way down? Richard, if we're going to discuss cyclical rotation, try and break it into two here, give me a binary understanding. What's a... what's a dividing line that was deemed normal this time last year, compared to what's behaving abnormally this time this year. I mean, you talk an awful lot about the importance of cash flow, not many other people do, which is something I really respect about your perspective in the market. Does it really all come down to cash?

Richard Kramer: Let's take a great example, since you mentioned being up on Highgate Hill, because yesterday I took a run up to Parliament Hill. And looking out over London, the one thing you really notice is the number of cranes. Now, cranes generally are not used to build small houses where people are in lockdown and work from home. They are tending to be deployed in large office blocks or huge development projects. And you have to think about how many of those projects were on the drawing board a year or two years ago, before we realized that commercial real estate may not be filled with a 100% occupancy of office space the way everybody expected would happen when they were thinking about it in the first quarter of 2020.

So it's a great example of a way that we went from what we perceived as normality to the new normal, which is, if we're gonna go back to the office, it's gonna be a few days a week, and we're gonna have a very different type of demand for office space. But yet all those cranes are still up there, halfway through those giant projects.

Now, one of the things about the cash flows out there is that, as I mentioned, the fed balance sheet has expanded dramatically. Europe, Japan, many other markets, have been printing money like crazy and piling on debt. That means it becomes harder and harder to find returns. And in this case, greed isn't just good, as we would've seen in Gordon Gekko in Wall Street, greed has almost become a religion. And you've had this endless search for higher returns in a world where the cash in the bank is going to provide lower and lower and even negative returns.

Will Page: So, if we're gonna be discussing rotating our portfolios back to wherever they came from, en masse, in unison, altogether, like yourself, a wide mass of belly dancers returning back to their original dancing position, it makes me feel about a famous Warren Buffett quote, which [inaudible 00:17:11] on the lines of, "It's only when the tide goes out that you can see who's not wearing any clothes." It feels to me like the tide is going to go back out again, back to where we came from. Who do you think's not going to be wearing any clothes when the tide does go out?

Richard Kramer: You know, that brings up, I think, the quote that we keep coming back to in this podcast, which is, "Never expect a man or woman to understand something when their job depends on not understanding it." One area where the tide clearly is at risk of going out and leaving people exposed with perhaps less than the svelte figures that they may wish to have shown off in their bedroom mirrors. When the tide goes out, you will see the companies that were expecting to find a miraculous operating leverage from burning cash to generating cash, find that to be more of a struggle.

Maybe, when the cost of debt rises, those companies, which borrowed money that they were planning to burn, are going to find that they have higher borrowing costs, but are no closer to turning the corner to your profit. So if you look at the market right now, in 2020, you had a record level of companies which were generating negative or zero net income. So you've had more loss making companies in the market than ever. That's been enabled by the fact that interest rates and the cost of debt are so low. So if those costs inevitably have to rise, central banks can't keep printing money forever, at some point, we're going to have to reflect the true cost of taking on debt and the dilution that comes down the road, then all of those cash burning companies are going to face a reckoning, when they're borrowing costs to continue burning that cash keep rising.

Will Page: You make me think of a potential experiment we could run, which is scraping the financial press or the internet to look at references to the words "cash flow during the bubble," and then counting the references to the words "cash burn during the trouble." And if we start to see references to "cash burn" outpaced the words "cash flow," that could be a sign that the market's beginning to turn.

Richard Kramer: I'll tell you one aspect of that, which is very natural in terms of human psychology, is, when you're in a disaster, as we've been through in the past year with the pandemic, you're not worried about how much cash you're burning. If you've gotta upsticks and move country, if you're a refugee, you're not concerned about what it's going to cost you. You're concerned with your survival.

So, for a lot of companies for a lot of sectors, as we discussed in a previous podcast, this last year has been an existential crisis. If you were a hotelier, if you were an airline, any sort of company in the travel sector, your business ground to a halt. You weren't concerned with cash burn. You were concerned with reducing your expenses and hoping you could see this through to the other side. And that's true for a lot of sectors.

So the discussion of cash flow and cash burn was naturally shelved. And you would expect that hopefully the government would step up and give you support. Now, can that support last forever? Can we keep monetizing that debt and printing money forever? Certainly not, but you weren't concerned with it. And now, as you get that sort of rotation, you'll switch back to thinking about, "Well, who's gonna be able to generate a return in this new world when we go back to whatever the new normal turns out to be?

Will Page: So we maybe have two tides, which could be working in unison or even against each other, undercurrents, to use the word. One, you have the tide of cyclical rotation, which is, "Okay, I went to this party of tech stocks for 14 months. Now, it's time to come off those drugs, uh, maybe cool down a little, uh, rebalance in a more sensible way to what I used to do 14 months prior. Tide number two, to which you're alluded to so eloquently there, is government support. When government starts to switch off the taps of financial support, that's another tide that's going to go out and reveal who else is not wearing any clothes as well.

Richard Kramer: Well, and an interesting aspect of this you can see in the US, and certainly you can see it in- in parts of Europe as well, is you're going to have to put some of that money to work investing in infrastructure. And I'm looking at our producer Eric here, and he's sitting in New York City, and I know he commuted in from New Jersey, and he's crossing either bridges or tunnels, which are 50 to 100 years old. And at some point that cyclical recovery has to shift back to rebuilding hard assets that we all use every day, as opposed to building intangible assets that you tend to get in the tech sector.

Will Page: I'll try and take this complex world of finance and investment options and just try and bucket them really simply. I'd call out three, maybe four. You got commodities, oil, wheat, timber, metals, for one unit as the same as the next. You got stocks and bonds, equities and debt. You got hard assets, property and land. And if you really wanna go to the casino, I guess you've got currencies too.

Sometimes it feels like we're squeezing the sponge of each in turn, before we move on. And if I look at the property market, and we talked about London and cranes earlier, property seems to have been flat in this country for quite a while. So does the bubble begin to move into the property market once again, like we've been here before just 10 years earlier? Or what about oil and gas? When the world revs up and starts polluting, do these prices spike up too?

Richard Kramer: Within all these various asset classes, you have cyclical rotations. So, for example, in the commodity sector, it doesn't move as one. Clearly, the demand for oil and gas is linked to overall economic growth, but maybe reduced by some function of the demand. For example, combustion engine cars being sidelined in favor of electric vehicles. Within the hard assets you mentioned, property and land, the value of land, certainly to produce agricultural products, may be going up, because it can be quite scarce. But, when you think about the property market, there's going to be a dramatic shift between the value of commercial property and residential property, because all those giant office blocks, we expected to fill it with workers, five days a week, are clearly not going back to the old normal of going to the office every day, or even agglomerating in large offices.

Now, we can debate the wisdom of some tech companies saying we can work from home forever, whether that will hold true and they'll be able to preserve their cultures remains to be seen. But the notion that we'll all be commuting back to the office en masse, the way we were in the first quarter of 2020, seems far-fetched right now. Within each of those asset classes, you are seeing cycles and rotations, depending on where the currents of demand are going.

Will Page: And who's doing those rotations? I wanna get lost in the mire here. Is- is it that fund manager who's making that decision to reallocate that huge fund? Or who does the rotation?

Richard Kramer: The rotation is done by the market en masse. And that's a function both of the perceptions of all of those fund managers, large and small, of where they're going to put their money. And of the interpretation of the news. For example, when governments around the world issue climate targets and say, "We must reduce reliance on petrol or gasoline engines," that is going to put a time limit on the value of the reserve sitting on the balance sheets of oil companies.

So you think about the asset classes, that they have some level of duration, whether it's land, which can last a very long time, or commodities, which can be used up very quickly, there's gonna be a duration to those assets. And there's going to be a perception about the demand over that duration. So it's fine to sit on the stockpile of a commodity where the demand is low today, if you're certain that that demand is going to be high in the future. Then you're just facing the time value of money of holding it.

But it's not good to be holding a value of a commodity which is going to perish very quickly, holding a lot of it, like fresh fish in your fishmonger, if you know that it's only gonna last a day or two, and there's only so much fish that the neighborhood can consume.

Will Page: What terminology are we going to be hearing about tomorrow? It almost feels like somebody's scripted a play here, and we're just watching it play out with these dramatic words.

Richard Kramer: I'll tell you one of our favorite themes in tech that you hear about endlessly, and I think is grossly overused, is disruption. Clearly, if we think back to our themes and dreams, and the giant total addressable markets, it's easy to imagine a future where, hey, we can magic water and electricity out of thin air. But the reality of coming up with the technology to make that happen requires large pools of capital to perform the R and D and test the new methods to make them a reality.

Will Page: You've been with Bubble Trouble. This is Will Page and Richard Kramer.

Richard Kramer: And let's not forget, Will, next week's bubble is definitely going to be troubled.

Will Page: [laughs] If you're new to Bubble Trouble, we'd encourage you to follow the podcast wherever you listen. Bubble Trouble is produced by Eric Newsom and Jesse Baker at Magnificent Noise. You can learn more at bubble trouble.podcast.com. See you next time.