Why SPACs Won’t Replace Traditional IPOs -- and Vice Versa

SPACs may be the hot way for firms to go public now, but rest assured the pendulum will swing back towards traditional IPOs eventually.
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Will SPACs replace traditional IPOs? I think to a degree, they already have -- at least for now. Longer-term, however, I think that traditional investment banking will survive, and that there will always be room for both methods of going public.

Part of why I say that traditional IPOs will survive is due to the sheer abundance of SPACs out there right now. Can they all find winning companies to merge with? What happens to those that don't find the right dance partner? Surely some will wither and die. But at the same time, the SPAC model is probably here to stay since it does simplify and expedite the whole process of going public and raising capital. And so I think that SPACs will survive even once we’re past the current manic stage.

First, understand that IPOs and SPACs are really just two ways of getting a private company from point A (in need of capital) to point B (capital needs satisfied and trading publicly). As you'll see, it's really a matter of putting the wagon before the horse, or the horse before the wagon. And the same model doesn’t work for every private company in every situation.

The IPO

The traditional IPO, or Initial Public Offering, has been around since the beginning. This is what investment bankers, among other things, do for a living. As a former senior New York Stock Exchange floor trader who worked as part of the IPO team for what was considered the hottest investment bank during the internet bubble of the late 1990's, early 2000's, I have a great deal of experience in both supporting and in running the execution end of traditional IPOs, either from the booth, or in the crowd at the point of sale.

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In simplified form, IPOs involve private companies working with an investment bank or several investment banks to raise capital by “going public." The investment banks place a value on the private firm through a strenuous level of fundamental analysis, all the while gauging or trying to drum up demand. That part of the job is often referred to as a "road show."

The private company must also register with the exchange where it plans to list, as well as the Securities and Exchange Commission. There is a lengthy process that must be followed, as well as numerous requirements, such as compliance around transparency in financial reporting, that must be met.

The investment bank or banks, also known as the underwriters, may guarantee the IPO by purchasing the offering in a firm commitment and then selling the shares themselves in the secondary market. Without this "firm" commitment, the IPO is considered to be a "best effort" agreement, in which the underwriter sells the shares with no guarantee.

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In my experience, the vast majority of IPOs are indeed “firm commitments” in which the underwriter takes on either the profit or loss (the risk) when selling shares after having priced the IPO. In the case of a "best effort'' IPO, the investment bank is really more like a broker and advisor than a trader, and passes on to the formerly private company's shareholders the proceeds of those initial sales.

The SPAC

The SPAC, or Special Purpose Acquisition Company, has become increasingly popular lately. Some of you may have heard of "Blank Check Companies." This is another term for basically the same thing as a SPAC. The whole idea is simply to raise funds first and then target private companies to merge with afterwards.

In this way, the private firm is able to get in position to quickly merge with an already-public company, greatly simplifying the process of going public. At that point, the shareholders or owners of the private company can either redeem their stakes at the offering price, or accept stock in the newly-merged company, depending on their preference.

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Why would a private company choose this route over a traditional IPO? There are several good reasons. The first is speed to market. By foregoing the whole "road show" process and merging with an already public firm, the company can now bypass all of the registrations and regulatory requirements. In addition, the risk of allowing investment bankers to price the deal is removed once the merger is agreed to.

What makes SPACs so attractive to private companies that might be in need of capital? It’s pretty simple -- in a traditional IPO, the private company chases the capital, but with a SPAC, the capital chases the private company.

Notably, the SPAC structure is less risky to the owners of the targeted private company. The private company negotiates and agrees to a deal. Their work is now done, and the risk is transferred to the SPAC. This is great -- if you happen to run a highly sought-after private company in a suddenly hot industry. That is another reason why speed matters. No one ever knows how long the iron (or industry) stays hot.

Now, for the less highly sought-after private business, there will always be a need for a traditional investment banker since these companies still need to raise capital and will need help finding investors. However, in the IPO model, the workload and the risk are more on the private company than they are on the bank -- at least until the issue is priced and regardless of whether a firm commitment has been made.

The Bottom Line

In my opinion, there will always be room in this marketplace for both traditional investment bankers as well as SPACs. For now, amid a pandemic, which has largely taken the "road show" aspect out of the IPO, and as certain industries have taken off seemingly overnight, SPACs have taken as much as half of the market for new issues.

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That is the current environment and it is not only subject to change, it will change. As some SPACs fail to attract potentially hot new private companies, their ranks will thin. In a market that’s tougher than the current bull one, raising money ahead of a deal becomes more difficult, and the pendulum will swing back toward traditional investment bankers who provide access to a broader array of potential investors.

That said, these are two ways of going about doing the same thing. Neither is going away. Quality will succeed where success is deserved, and so quality investment bankers will outperform lower-quality SPACs and vice versa. Where quality is less obvious, there will be failure to last, or to find the right dance partner. The route chosen may depend on just how desirable, or choosy, the private company is able to be.

Stephen “Sarge” Guilfoyle writes on stocks and the markets each trading day for Real Money, TheStreet’s premium site, including his popular Market Recon column every morning. Guilfoyle is also co-portfolio manager of TheStreet’s Stocks Under $10.