Up until recently, special-purpose acquisition companies, or SPACs, were considered a “financing of last resort.”

But SPACs raised by high-profile sponsors, such as Social Capital’s CEO Chamath Palihapitiya, and their strong performance on public markets have helped turn these vehicles into the hottest financial product of 2020.

Sponsoring these blank-check companies has become a highly reputable and lucrative undertaking, attracting top-brass investors and experienced operators. As of early December 2020, 221 SPACs went public in the year, which is nearly four times the 59 SPACs that hit the equity markets the previous year, per data provider SPAC Research.
While for a large portion of the year VCs were observing the SPAC party from the sidelines, within the past few months about half a dozen venture capitalists joined in on the SPAC-sponsorship bash.

Ribbit Capital, FirstMark Capital, Lux Capital and General Catalyst each separately announced they were raising SPACs. In addition to SPACs formed by funds, several individual VCs decided that this vehicle could be a personal side business. Reid Hoffman, a partner with Greylock Partners, Bradley Tusk, co-founder and CEO of Tusk Ventures, and Ryan Gilbert, a partner with Propel Ventures, each have partnered with other investors and operators to raise SPACs.

However, the sudden SPAC fervor is leaving limited partners in these funds scratching their heads about the implications of these new financial structures on existing investments. Some concerned LPs are asking GPs many questions and are engaging their consultants to help figure out if there are conflicts of interest or synergies between traditional funds and SPACs sponsored by the same managers.

“It makes me nervous how fast this is moving,” says an LP of a public pension fund. “We spoke to our consultant and their conclusion is that there are usually conflicts, but the type and level vary widely.”

Miguel Luina, Hamilton Lane

One of this LP’s main concerns is that SPAC economics are attractive regardless of deal outcomes. Funds and individual GPs could be drawn to raising SPACs instead of spending time on fund management duties and supporting their portfolios. Another key question is whether LPs are benefiting financially from their GPs’ SPAC sponsorship.

The SPAC boom is in its early days and many investors are still trying to understand the product, explains Miguel Luiña, head of global venture and growth equity for Hamilton Lane, a firm that advises LPs and backs mid- to late-stage venture funds.

The tricky thing about SPACs is that their structures vary significantly from sponsor to sponsor, according to Luiña. “Everyone is doing them differently.”

Investing in one great late-stage deal

A SPAC is an investment vehicle that takes a shell company public by raising capital from public and private institutional investors. It then has about 24 months to buy a private company, usually in a pre-determined industry.

If a SPAC does not find a company to purchase for the shell, then the SPAC dissolves and capital is returned to investors. And if any of the investors do not like the acquisition target, they can decline to participate and request all their money back before the merger closes. This is why the quality of the sponsor team matters. Investors trust the people running the SPAC to identify a company that will be well-received by public
markets.

In certain ways, a SPAC sponsorship is more suitable for buyout and growth equity funds because these types of firms are already accustomed to buying controlling stakes in private companies that could be large enough to evolve to the public markets.

“SPACs do not fit the earlier-stage, pooled investments model VCs normally do,” says Greg Martin, a partner with Liquid Stock, a secondaries firm that invests in pre-IPO companies.
But VCs are good at sourcing private companies and they are experienced board members, which is important because a SPAC is a “public company board in a box,” he says.

The fact that many VCs with SPACs are investing in early-stage start-ups for their venture funds while looking for a larger target for their SPAC avoids the large potential issue faced by private equity and growth equity firms.

“It’s a big conflict of interest for a [PE] fund to also raise a SPAC, particularly when there is overlap with the fund in strategy, size, etc,” Christopher
Schelling, managing director at Windmuehle Companies and former head of private equity at Texas Municipal Retirement system told sister publication Buyouts.

“How can investors get confidence one is not getting prioritized dealflow versus the other? The fund should eat first, but if the GP stands to make more money from the SPAC, you have to wonder,” Schelling explains.

Sharing the spoils

VCs could potentially run into a similar issue if they regularly invest in late-stage deals.
“If you are deploying under $10 million per deal, you are less likely to see dealflow suitable for SPACs. But if a VC is writing $15 million to $40 million checks, they are exposed to ‘SPAC-sized’ companies,” says Bill Haddad, a partner with the law firm Venable.

One way to avoid making it seem that the SPAC is competing for deals with the fund is to share SPAC economics with LPs by putting the SPAC inside the active fund and treating it like any other investment in the portfolio, Haddad says.

This is precisely what many fund-sponsored SPACs are doing. As an example, Lux Health Tech Acquisition is owned by Lux Capital’s sixth fund, the firm confirmed. In this case, all SPAC fees are paid by the fund and LPs get the benefit of what one LP called “wildly advantageous SPAC economics.”

“It is hard not to make money in a SPAC if you are a deal sponsor,” says Kenneth Koch, an attorney with the law firm Mintz. This is because the sponsor puts up only $25,000 for about 20 percent of the shell company, which is called the promote and is similar to fund carry, plus about 2 percent to 3 percent of raised assets as sponsor capital to cover IPO fees and other expenses.

Thanks to the promote, a SPAC sponsor could still be making a hefty profit after the stock price falls significantly, as is the case for the sponsor of Nikola, an electric truck company whose shares are now more than 70 percent off its post-merger high.

In June, Nikola completed its merger with VectoIQ, the SPAC formed by Steve Girsky, a former GM vice-chairman. Public market investors were enthusiastic about the deal before potential problems with Nikola’s technology were revealed in September, causing the stock to sink.

Nikola’s stock is trading above the SPAC’s $10 debut price, but SPAC economics allow for the sponsor to make money even if shares fall below $10.

Off-strategy investing irks some LPs

While some LPs are realizing that having their managers sponsor a SPAC within the fund could be performance-enhancing, they may not appreciate that VC managers are not investing in the type of companies and structures they said they would.

“Most funds have mandates in their limited partner agreements that VCs invest directly in start-ups, not enter into SPAC mergers with them,” says Yash Patel, a general partner with Telstra Ventures, whose portfolio company Skillz announced in September it would merge with a SPAC.

But some funds, especially those managed by top-tier VCs, have fewer restrictions on how to invest LP capital.

Flexibility in fund documents also allows GPs to keep their LPs out of the loop on some significant investment decisions. Several LPs told Venture Capital Journal that their managers recently launched SPACs without informing them in advance.

“GPs are doing what they think they can get away with. The best practice is to tell LPs in advance, rather than to have them read about it in the press. This doesn’t build a great degree of trust between GPs and LP,” says Kelly DePonte, managing director of placement agent Probitas Partners.

When Social Capital’s Palihapitiya formed his first SPAC in 2017, he put the SPAC inside the firm’s latest VC fund.

“What annoyed us is that he did not ask us for permission to use fund capital for a SPAC,” says an LP in Social Capital’s last fund. “Investing in a SPAC is not in the spirit of what we asked him to do.”

But Social Capital’s LPs have little to complain about in retrospect. In less than a year after merging with Virgin Galactic, Palihapitiya’s first SPAC is on track to return about 15x invested capital, this LP says.

“If you are the sponsor of a SPAC, you don’t need to put up very much money to turn it into something that is very valuable,” he adds. After the success of Virgin Galactic, Palihapitiya started to fund his SPAC vehicles himself, this LP says.

Asymmetric economics

One issue that comes into play for some managers with SPACs is the conflict of time and attention. This potential problem is especially relevant for GPs forming SPACs independently from their funds.

“Key person risk is much harder to enforce or measure. It may be about how much trust there is between LPs and the GP,” says Patel of Telstra Ventures.

However, it is often the case that the fund documents allow key GPs to not be full-time managers of the fund, says the attorney Koch. He adds VCs are known to engage in various other activities without normally raising a flag for LPs.

What worries LPs is that some managers may prefer to raise SPACs rather than focus on their VC fund.

“The problem is that the payoff structure with SPACs is so asymmetrical compared to a fund. It is also a lot easier to raise capital for a SPAC,” says one public pension LP.
Most fund documents prevent managers from launching another fund until about 70 percent of the capital from the current fund is deployed, DePonte says. If the firm’s LPA allows for non-traditional investments, a similar rule applies to SPAC-formation, which means that these vehicles could only be raised in between traditional funds. However, it is not clear if these rules extend to SPACs sponsored independently by individual GPs.

LPs consider going direct

Meanwhile, LPs, in their constant search for alpha, are beginning to wonder how they could actively participate in the SPAC boom.

“SPACs could possibly be a solid investment. They are publicly traded, so it is possible to get out,” the public pension LP says of buying pre-merger SPACs in the open market to create a portfolio SPACs. While he has yet to give this investment strategy serious thought, this LP believes that if the pension were to create a SPAC portfolio, it would be considered an alternative asset just as other blind pools of capital are.

It may also be possible for LPs to co-invest in SPACs by investing in their PIPEs, or private investments in public equities, which are raised from institutional investors at a time of a merger with the target. The capital raised in a PIPE deal allows SPACs to purchase a bigger company and helps guarantee that there are sufficient funds to close the deal.

“If you are a fund with a SPAC, it makes sense to offer your LPs co-investment opportunities,” Koch says.

Evolving structures

While the SPAC boom is less than a year old, the investment product is already undergoing some transformations.

Sponsor economics are compressing amid increased competition. Some SPACs are going public with a promote that is 10 percent or lower, and sponsors’ percentage ownership could be renegotiated further down in advance of the business combination.

Some SPACs are also coming out with more investor-friendly terms out of the gate. For instance, the SPAC sponsored by General Catalyst is structured so the interests of the public stockholders and the sponsor are economically aligned. In other words, General

Catalyst’s healthtech-focused SPAC does not receive the promote unless the deal makes money for investors, according to Koch.

SPAC structures will likely continue to evolve as long as this method is still a popular tool for taking companies
public.

“As more of these vehicles become public, there will be lessons learned for GP sponsors and their LPs,” says Luiña of Hamilton Lane.