Buying an IPO. Again.

by Travis Johnson, Stock Gumshoe | September 14, 2017 12:00 pm

This is the third time I’ve bought an IPO on its first day of trading, and the second time I’ve bought exposure to a SPAC over the past year — hopefully it will work out as well as the others.

I saw Chamath Palihapitiya speak at the Delivering Alpha conference on Tuesday, along with Starwood’s Barry Sternlicht, and I was impressed (more thoughts from that conference coming in the Friday File tomorrow). They had a fascinating discussion about the future of technology and about investing in venture capital (and real estate, which is Barry’s realm as he invests his Starwood billions), and there were some headline grabbers, like Chamath sayhing that he has been massively long bitcoin since 2013 and that governments will not be able to eliminate it because “the genie is out of the bottle.”

But Chamath is primarily interesting because of his insights into operating technology companies, thanks to his experience, even at quite a young age, as a Silicon Valley venture capitalist (he got his start, and much of his initial seed money, as an early Facebook executive). He talks about going in deep with his venture investments, working with them on operations and improving their data and their technology as well as developing reasonable businesses that have actual cash possibilities — but what was perhaps more interesting than his comments is that he’s launching a “blank check” company that will aim, if you read between the lines a bit and have some imagination, to build a tech empire.

He described his investment firm, Social Capital, as like a “bastard stepchild of Berkshire Hathaway and Blackstone and BlackRock” back in 2015, and this new collaboration called Social Capital Hedosophia that went public this morning (ticker IPOAU, which will become IPOA for the stock and IPOA.WS for the warrants once the units are split to trade stock and warrants separately) is the first opportunity for individual investors to ride along with him. So I’ve bought a few shares.

The S-1 filing is here[1], and it includes the usual safety features built into a SPAC (like the option to redeem your shares or opt out of a business combination when they do find one, and the liquidation of the money held in trust if they fail to find an investment). There is always a real chance that a SPAC/Blank Check company can fail, either because they don’t find an acquisition and have to liquidate or because they rush into making acquisitions and do a terrible deal… but I like the odds for Social Capital Hedosophia, and it will be big enough to be a pretty powerful player in venture capital if Chamath is really as smart and connected as he appears to me (and, of course, if they are fortunate and the wind blows their way).

If you’re not familiar with the concept of a SPAC, it’s a Special Purpose Acquisition Company, and it’s often called a “blank check company” for a good reason: A SPAC is essentially formed by an investment manager who raises a bunch of cash selling “units” of the SPAC, and promises to find something profitable and appealing to do with that cash within a certain time frame. Until the acquisition or business arrangement is made, the money sits in a trust. If a deal is not made within the time period designated, then the cash ($10 per share) is returned to the unitholders. Those units will be split within the next two months or so, so unitholders today will end up seeing each of their units convert into one share and one third of one warrant (though there will be no partial warrants).

So the risk is that you’re giving someone this money for two years, and you don’t know whether they’ll do something useful with it… though if you’re buying at close to the $10 IPO price the downside is typically very limited, at least until they make a deal, and the upside is that they can make a really appealing deal and everyone gets excited… and the SPAC holders get five-year warrants, with the five years not starting until the deal is made, which can be quite powerful. The insiders end up owning 20% of the company after they make a business combination (an acquisition or merger) at essentially no cost, but they don’t get 20% of the funds held in trust if a deal doesn’t happen. Those insiders also buy warrants at the IPO that give them more upside leverage, and the money they pay for those warrants essentially covers the investment banking fees from the IPO and their basic operating expenses while they seek an investment — so the insiders are very much incentivized to make a deal within that two-year window.

So we have a maximum of 24 months to wait and see how it plays out — if they don’t make a deal within 24 months, the SPAC shares liquidate, shareholders should get $10 a share, and the warrants are worthless; if they do make a deal, then the shares and the warrants will trade at whatever the market thinks the acquired company is worth. Sometimes that’s a lot less than $10, sometimes it’s quickly more than $10 if the deal is attractive. Oftentimes these SPACs run under the radar, but this one is unusually large so it will probably get a fair amount of attention when (if) they do make a deal.

Like most SPACs, these will be “units” that consist of shares and warrants — in this case, the warrant consideration will be one third of a warrant per unit, with each full warrant enabling holders to buy the stock at $11.50 per share for five years after the “business combination” is made (there are also private placement warrants going to the sponsor, which is a Caymans holding company, which essentially covers the listing fees and keeps the net assets in trust at $10 per share, though it offers more potential dilution if the stock does rise following their business arrangement).

I think betting on Chamath is a smart idea, he made a great impression on me during this conference partly because of his ability to acknowledge mistakes (like passing on Uber), as well as his focus on getting deeply involved in the companies where he’s an investor… and, of course, he helped with the early growth of a great company in Facebook when he was there at its very early stages (he was at Facebook from roughly 2005-2011 before cashing out to form his own venture capital firm, which included investments from folks like Peter Thiel), and he has already made successful investments for Social Capital (Social Capital’s investments are tracked by crunchbase here[2], FYI).

I worried that all the chatter about this guy, who has been a CNBC fixture for a couple years and is a prominent speaker on VC issues, and seems to be widely admired, might cause the IPO to pop and become wildly overpriced — you don’t want to pay $800 million for a company that’s represents just $500 million in cash and a hypothetical investment idea, even with those tasty warrants, but since the valuation wasn’t too crazy I decided it’s worth a nibble at about $10.30. Based on the price of $1.50 that the insiders paid for their warrants, it’s rational to value those warrants at 50 cents per unit (since each unit gets a third of a warrant) — which would mean that paying anything up to $10.50 per unit has at least some basis in rational thought. Paying more than that increases your downside risk pretty much penny for penny, but there’s still that comforting $10 floor valuation.

We’ll see how it plays out. Certainly he’s a fascinating guy, hopefully he’s able to make a great investment for us… and if I don’t like the investment he decides on, I can still elect to pull my capital out before the business arrangement is made. The other founder, Ian Osborne of Hedosophia, is also a venture capital investor, though I know much less about him.

The risk, in addition to the risk that this is really an investment I’m making because of my respect for a person who’s relatively untested in this particular role, is that they’ll invest in something stupid or not find anything to buy at all. And that risk is potentially compounded by the fact that these two principals will also continue to run their own venture capital firms, so there’s some conflict of interest possible when it comes to “who gets to make the deal first.”

That shouldn’t end up being a material risk, though, because this fund has been formed to put $500 million into buying 100% of that company (or at least a majority interest) as an alternative to that company doing its own IPO. Neither Social Capital nor Hedosophia has specialized in making massive $500 million investments into a single company in the past (both firms are reportedly still relatively small, in the billion-dollar range), those firms have been focused on investing at earlier stages — so the public SPAC will get the crack at the larger firms that are closer to being ready for prime time.

It’s also possible that they’ll end up doing a public offering in conjunction with an investment, so they might end up buying a company that has a value substantially higher than their $500 million (or $600 million now, since the IPO was boosted in size at the last minute) and offering up more public shares of the combined company at the same time. That would be more complicated and would dilute control, but I’ll wait to see what they decide to invest in before passing judgement.

And, of course, we have no idea whether they’ll be able to find a deal that makes financial sense — companies in the $500 million-$1 billion range that are ready, from an operational perspective, to be publicly traded, have plenty of other options… they can go through with an IPO, they can be acquired by a much larger company, they can usually hold out and remain private, given the huge amounts of capital chasing attractive companies… being well-connected and smart doesn’t guarantee you an attractive deal, though they do at least have a requirement to get a third-party valuation on any acquisition they make.

The other SPAC I’ve been exposed to recently is Yatra Online (YTRA), which was the result of a SPAC formed a couple years ago that merged with that Indian online travel agency late last year — on that one I wasn’t involved earlier, but bought the warrants after the deal was announced. In the past I’ve dabbled in others as well, notably the SPAC that ended up becoming Retail Opportunity Investments Corp (ROIC), which also ended up providing a very lucrative return from its warrants (as well as becoming a great compounding REIT that has done well for me for more than six years now).

And I noted at the top that this is the third IPO I’ve bought on the first day — which is odd for me, because I don’t generally like buying IPOs. If you’re keeping track, the other two companies I bought this year on their first day of trading after the IPO were both special situations as well — those were PCSB Financial (PCSB), a mutual bank conversion, and NI Holdings (NODK), a mutual insurance company conversion. Neither had huge growth potential, but both were low-risk, my intention is to hold PCSB for three years to see whether they become a takeover candidate, as I expect, once their takeover moratorium ends; I’ve already sold some of my NODK but am holding the rest to see what they do with their extra cash raised from the IPO.

Endnotes:
  1. S-1 filing is here: http://www.nasdaq.com/markets/ipos/filing.ashx?filingid=12270015
  2. tracked by crunchbase here: https://www.crunchbase.com/organization/social-capital/investments

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