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ANALYSIS: Private Equity Eyes SPACs, Direct Listings Over IPOs

Nov. 4, 2019, 12:04 PM

Unhappy with the performance of large initial public offerings in recent years, private equity will increasingly seek alternative exits for its startup investments in 2020.

Private equity, including venture capital, has poured money into startups, particularly those in the technology and e-commerce sectors. However, long-term stock holdings are not part of their business model: They need an exit.

The two most popular exits for private equity have long been mergers and acquisitions and public offerings. Two options likely to draw increased attention in 2020 are SPACs and direct listings.

Special Purpose Acquisition Companies

Increasing volatility and uncertainty in the IPO market is driving private equity to special purpose acquisition companies, or SPACs—a type of blank check company.

SPACs rely on management teams with private equity experience, flipping the script by providing IPO funds to a team that hasn’t yet built a business. Investors provide capital to a shell corporation, the SPAC. Managers, whose resumes normally reflect experience as a PE general partner, then find and acquire a target corporation, often a small- to mid-sized business in a specific industry. The acquisition must be completed within 24 months of the IPO—or, as is more typical, not later than 36 months, if the SPAC is listed on NASDAQ.

A SPAC provides advantages for private equity over a traditional IPO exit. These investment vehicles offer more flexibility than is typically offered in private equity fund agreements. The SPAC sponsor retains a 20% equity stake after the IPO is completed, a feature that can pay off handsomely once a suitable merger is accomplished.

Conducting the IPO regulatory approval process up front reduces the overall time involved and reduces costs to the company (e.g., a 5.5% underwriting commission instead of 7%). A SPAC can also speed up regulatory hurdles when it comes to making an acquisition. An exit by reverse merger with an exchange-listed SPAC may also avoid some of the price volatility of an IPO, allowing for greater valuation confidence.

The SPAC’s status as a publicly traded company also significantly broadens the potential investor base: Mutual funds and even ordinary, non-accredited investors may invest directly. SPACs expand the opportunities for retail investors to participate in private markets. Not least, going the SPAC IPO route provides private equity an easy exit to liquidity because the shares are exchange-listed.

Direct Listings (Direct Public Offering)

A once-rare alternative to the IPO exit has suddenly become the hot track everyone wants to download: direct listings.

When Spotify’s music streaming service offering dropped on the investing public in 2018, it came not as an IPO but as a direct listing. People took notice but also wondered if this was simply a one-hit wonder. Then another unicorn, Slack, followed Spotify with its own strong direct listing effort.

Meanwhile, turmoil at the top of the IPO market had fingers pointing all around: VC and private equity-backed unicorns going public are overvalued and overly mature, investment banks are mispricing shares and charging excessive fees, and IPO investors are expecting big post-IPO price pops. The IPO model is breaking down—and some in private equity see direct listings as a possible solution.

Direct listings do not raise capital for the company. Instead, they are simply a liquidity event for private investors and employee shareholders, permitting those early investors to cash out by selling their shares on an exchange. Private equity-owned shares are not subject to the usual six-month lockup, and there is no underwriter discounting the offering price to ensure a price pop (at existing shareholder expense).

Direct offerings generally require a mature company with strong revenues, although not necessarily one that’s profitable, and shares face possible initial share price volatility. If the company needs to raise capital, a direct listing will not be suitable by itself, and the company will need to pursue other fundraising options.

Airbnb has its direct listing tentatively booked for 2020. If the company’s offering goes well, expect a small but growing number of companies going public to opt for a direct listing.

Read about other trends our analysts are following as part of our Bloomberg Law 2020 series.

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