VC firms sat out the early SPAC craze. Now many are changing their tune.March 9, 2021
When the blank-check company craze took off last year, many venture capitalists were initially sheepish about forming SPACs of their own.
Venture firms were wary of adding a strategy that differs from their core business and concerned about the lack of public market expertise. But then VCs watched from the sidelines as a long string of private equity firms, hedge funds and other investors rushed to take advantage of abundant capital and lucrative opportunities in the SPAC market.
Fast forward to this year, and some venture firms have concluded that the lure of SPAC sponsorship has become too attractive to resist. In recent months, more than a dozen venture firms have jumped into the SPACs game, including Foundry Group, General Catalyst, Fifth Wall, Lerer Hippeau and Khosla Ventures, which formed four separate vehicles.
"I think every fund is thinking about doing this now," said Amy Wu, a partner with Lightspeed, which has been mulling starting a SPAC since last summer.
What VCs lack in public market savvy, they make up by tapping into their rich pipeline of companies that could potentially be acquired by the SPAC. Blank-check companies raise capital in an IPO to merge with a private company that then becomes publicly traded, so it's critical to target a company that can be well-received by public investors.
Venture capital's delayed arrival to the SPAC scene isn't a surprise. While VC's main mission is to fund disruptors, the industry itself is seldom quick to embrace new trends in firm fundraising and operations. In the case of SPACs this may not be a bad thing given the many questions about the long-term viability of the instrument.
VC firms' foray coincides with new heights in the SPAC frenzy. Already, this year has seen 217 SPACs raise capital in the US IPO market, compared with 227 for all of last year, according to PitchBook data.
The appeal of SPAC sponsorship cannot be more transparent. Managing a special-purpose acquisition company can lead to impressive returns with little risk.
"Economics for SPAC sponsors are bananas," said Wu. Sponsors need to provide just 2% to 3% of the IPO value, the so-called risk capital, in return for about 20% of the SPAC's total equity, a financial benefit known as the "promote."
"A SPAC manager doesn't need to put up a lot of capital to turn it into something very valuable," said David York, a managing director with Top Tier Capital Partners, a VC-focused fund-of-funds. Top Tier backed Social Capital's last venture fund, which Chamath Palihapitiya used to launch a blank-check company that ended up famously merging with space company Virgin Galactic in 2019.
York said that Social Capital put up around $l0 million in risk capital and quickly turned it into a nearly $200 million stake in Virgin Galactic.
Indeed, deal sponsors not only make on average a return of nearly 10 times their investment, according to a recent study by JP Morgan, but it is also virtually impossible for them to lose money unless a SPAC doesn't find an acquisition target within two years. Deals not done in that time frame result in dissolving the SPAC and giving shareholders their money back.
While a failed SPAC could be hard to swallow for individual investors, the millions that a VC firm contributes to the SPAC doesn’t amount to a tremendous loss in the context of a venture fund structure.
Bradley Tusk, CEO and co-founder of Tusk Ventures, said that the risk capital on his $300 million gaming-focused SPAC, which he started as a project not affiliated with his VC firm, was only $8 million. For venture firms, losing that money is similar to making a bad early-stage investment, he explained. "We assume that about 35% of our venture deals will go to zero anyway," Tusk said.
Another highly attractive element of SPAC sponsorship is that a vehicle can be raised quickly in the current market environment, especially when compared to the effort it normally takes to secure commitments for a traditional VC fund.
"It took me two years to raise my first $37 million venture fund and only three months to raise a $300 million SPAC," Tusk said.
Taking portfolio companies public
What’s more, VC-sponsored SPACs could potentially use the SPAC funds to buy one of their own portfolio companies. This may seem like a conflict of interest, but the SEC allows this as long as certain guidelines are met.
One such requirement is making sure that a target isn’t identified before raising a SPAC.
"This is a gray area," said John Kaercher, a partner with Baker Botts, a law firm that advises on SPAC deals. "The deal may be permitted if substantive discussions did not happen in advance of the IPO."
These regulatory complexities are the reason most VCs with SPACs say they are looking for a target in and outside their portfolio, but the unstated intention for many is to merge with a company they are already invested in.
Lightspeed's Wu said she thinks that some firms are attracted to SPACs precisely because they are already investors in the type of companies that are targeted by other blank-check companies. "If other people are 'SPAC-ing' my companies, then I should do it myself and get the sponsor upside," Wu said.
G Squared, a late-stage investor, is one firm with a SPAC that had several of its portfolio companies announce or complete reverse mergers with other SPACs, including Metromile, 23andMe and SoFi.
The firm's managing partner Larry Aschebrook said that G Squared hopes to take one of its current investments public through its SPAC. "If we are a trusted partner to these companies while they are private, it's logical that we could be a preferred partner to them as they access the public markets," Aschebrook said.
G Squared is such a believer in this strategy that it's doubling down. The firm just filed regulatory paperwork for a second SPAC targeting $125 million, only a month after pricing a debut $300 million IPO.
If VC SPAC sponsors like G Squared succeed with acquiring their portfolio companies, the transaction could turn into a triple payday. Proceeds from selling the private investment, the "promote" for managing the SPAC, and any appreciation in the shares of the combined entity, all accrue to the firm.
"The outcome for our funds will be significant if we're successful with taking a high-quality business public," Aschebrook said.
But pulling off such an auspicious transaction may be more difficult for smaller early-stage funds like Santa Monica, Calif.-based Science Inc., a consumer products-focused venture firm with $108 million in assets under management, according to PitchBook data, and a $310.5 million SPAC.
"We have companies in our portfolio that would potentially fit our SPAC criteria, but the majority of the companies we have considered so far are not Science investments," said Michael Jones, managing director of the firm.
LPs welcome strong SPAC return potential
While sponsoring a SPAC is a strategy shift and a diversion of VCs' attention from their core business, limited partners are generally not opposed to their firms raising SPACs.
"LPs should be happy with the phenomenon of SPACs," said Lindel Eakman, a partner with Foundry Group, which recently raised a $225 million SPAC. Not only are SPACs going to provide liquidity, but LPs could also benefit from their GPs' sponsor economics, he explained.
According to Eakman, many VCs raise their SPACs inside their current venture fund. In this structure, the SPAC is treated like any other investment in the portfolio.
Foundry Group, Lux Capital and G Squared are some of the firms that are employing this structure and sharing the SPAC spoils with their LPs.
"We wanted to make sure that we were aligned with our LPs," said G Squared's Aschebrook. "From our LPs' perspective, a SPAC should be a significant enhancement to the outcome and not a drain."
An uncertain future
But whether many more VC firms will form blank-check companies largely depends on how SPACs perform and if they remain popular with public investors.
According to Wu, firms like Lightspeed are for now continuing to evaluate whether a SPAC will add to or distract from their core businesses.
Some VCs have concluded that SPAC sponsorship isn't a good match for their firm.
Jeff Crowe, a managing partner with Norwest Venture Partners, is convinced that sponsoring a SPAC and trying to get the market timing right is a very different strategy from being a venture investor.
"Venture is a long-term game," said Crowe. "Our firm has been doing this for decades and we will continue to do this for decades."
This story has been updated to reflect the final value of Science Inc. SPAC. The deal ultimately raised $310.5 million, not $270 million, after the sponsor exercised the over-allotment option at the IPO. (March 24, 2021).
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