IPOs for the Long Run
From the Archives
Over the last few weeks and months you may have heard or read about an acronym that is experiencing a renaissance among investors: SPAC (Special Purpose Acquisition Company). Investopedia provides a simple explanation of how SPACs work:
“SPACs are generally formed by investors, or sponsors, with expertise in a particular industry or business sector, with the intention of pursuing deals in that area. In creating a SPAC, the founders sometimes have at least one acquisition target in mind, but they don’t identify that target to avoid extensive disclosures during the IPO process. (This is why they are called “blank check companies.” IPO investors have no idea what company they ultimately will be investing in.) SPACs seek underwriters and institutional investors before offering shares to the public.
The money SPACs raise in an IPO is placed in an interest-bearing trust account. These funds cannot be disbursed except to complete an acquisition or to return the money to investors if the SPAC is liquidated. A SPAC generally has two years to complete a deal or face liquidation. In some cases, some of the interest earned from the trust can be used as the SPAC’s working capital. After an acquisition, a SPAC is usually listed on one of the major stock exchanges.”
SPACs are just another one of the hundreds of financial contraptions and instruments that have been concocted over centuries. What is interesting about SPACs, is that they were previously derided and looked down upon because many of them ultimately enriched their creators while hurting shareholders. Lately, however, they’ve made a resurgence. In recent years there have been a few high-profile examples of successful SPAC deals, such as Virgin Galactic and Draft Kings.
In the case of Virgin Galactic, Richard Branson’s company went public by merging with the the publicly traded SPAC Social Capital Hedosophia (IPOA). The Social Capital Hedosophia SPAC went public on the exchange in the summer of 2017, and public market investors were able to purchase shares of the newly listed company at $10 in the hopes that the SPAC executives would be able to find an attractive technology company to merge with / acquire. The SPAC would have two years to find such a deal, and if not, the money would be returned to investors. Flash forward to 2019, and the SPAC announced that it was merging with Virgin Galactic in a deal that would bring the space exploration company to the public markets, and the newly listed entity would trade under the ticker SPCE.
What’s Old is New Again
Bill Ackman’s new Pershing Square SPAC that went public this week offered a throwback to the 17th century by naming the SPAC after a centuries-old financial instrument that has been described as “part annuity, part mortality lottery”: The Tontine. Pershing Square Tontine Holdings is the largest SPAC offering on record, raising $4 Billion by offering 200 million shares listed at $20. Before going any further, however, what is a tontine? We will do a deeper dive into the history of tontine’s in an article linked further down, but here is a brief description of this financial instrument’s history:
“A tontine is an investment scheme through which shareholders derive some form of profit or benefit while they are living, but the value of each share devolves to the other participants and not the shareholder’s heirs on the death of each shareholder. The tontine is usually brought to an end through a dissolution and distribution of assets to the living shareholders when the number of shareholders reaches an agreed small number…
The word ‘tontine’ is derived from the name of Lorenzo de Tonti, an Italian political exile living in France. He proposed the original tontine to Jules Cardinal Mazarin in the early 1650’s as a means for French King Louis XIV to raise revenue. The French treasury, battered by the Thirty Years War and the rebellions within France known as the ‘Fronde,’ needed to raise money. The tontine scheme reputedly evolved from similar offerings in Italy, albeit on a smaller scale, to raise income from a broad spectrum of the population.
As envisioned by de Tonti, tontine subscribers would buy a special kind of annuity at 300 livres a share. Investors could name a third party, often referred to as the nominee, as the life in interest for their stake in the tontine. Participation was structured in groups of equal size according to the age of the nominees: e.g. 0 to 7, 8 to 14, all the way through the age of 63. Each beneficiary was to receive an annual payment based on the interest earned by the combined initial capital contributed of investors in the applicable age cohort. The rate of interest increased with the age of the nominee. As nominees died, the share related to that nominee became worthless and the payments based on each of other surviving nominees would increase. The subscriber represented by the last nominee in each group would get all the interest generated by the capital within that band. On the death of the last subscriber, the capital would revert to the government.”
The main thing to remember about tontine’s is the aspect of surviving shareholders benefiting from others dying. That said, how is the Pershing Square SPAC related to this morbid financial instrument? A Bloomberg article stated:
“Pershing Square Tontine Holdings will reward investors who hang on to their shares after an acquisition is selected by giving them a fixed number of warrants. When shareholders cash out, those who remain receive more warrants, giving them an incentive to stay.“
Like tontines, the SPAC rewards “living” shareholders (those that don’t sell their shares after the SPAC’s acquisition) with the additional warrants leftover from “deceased” shareholders (those that sold their shares). Less morbid, same idea.
The Tontine Coffee House
Another fascinating aspect of the tontine’s history is the the Tontine Coffee House in New York City, which was the predecessor to the New York Stock Exchange. This article from a website of the same name provides an excellent overview:
“Those who know a bit about New York’s financial past have almost certainly heard of the Buttonwood Agreement. In 1792, two dozen stockbrokers signed a now famous pact agreeing to trade directly with each other, bypassing any middlemen, under a Buttonwood tree on Wall Street. This agreement standardized trading between them and is thus thought of as setting the foundation for what would become the New York Stock Exchange. But connecting the agreement signed in 1792 to today’s stock exchange on the corner of Wall and Broad is a story involving an antique insurance product and a coffee shop by the same name.
Needing a place to do business outside the rain, Wall Street’s earliest brokers settled on a coffee shop. But no existing one would suffice, a new one, called the Tontine Coffee-House, would be created for the purpose of being New York’s first post-Buttonwood exchange. Where does insurance come into this story; well, the startup capital for the place was provided for by an archaic annuity-like scheme called a tontine…
The product worked as follows: Investors each buy shares in the tontine, akin to paying up front for an annuity. The pool of capital is then invested, in a coffee house in the case of our story, and investors receive dividends on their shares until their deaths. Once the number of survivors shrinks to a small group, the investment is wound down…
the tontine that financed the construction of the coffee house had a total of 203 shares sold. Each was $200 in value providing a startup capital of just over $40,000…Nonetheless, once built in 1793-94, the Tontine Coffee-House was no ordinary coffee shop; it became a hub for traders in the fast-growing city around it. It may have been no Royal Exchange or Paris Bourse then, but in time it would evolve into an exchange bigger than them all.
So where exactly was the Tontine Coffee-House? It stood on the corner of Wall Street and Water Street. Paintings and engravings of the three-story building show it on the northwest corner of the intersection, where 82 Wall Street stands today just one block past Deutsche Bank’s New York offices at 60 Wall Street. A 1797 painting by Francis Guy, with the coffee shop located on the far left, shows the masts of ships close by. Back then, Water Street really was by the water; landfills have since expanded the profile of Manhattan by one block in that direction.
Today, the coffee house is long gone. In 1817, trading moved up the street when the New York Stock & Exchange Board was formed and rented space at 40 Wall Street. The old Tontine Coffee-House would go on to become a tavern, a hotel, and then a newspaper publishing office before being demolished in the middle of the century. The New York Stock Exchange, as it was renamed in the 1860s, moved once more in 1865, and then again to its present location in 1903.”
Financial Contraptions, Vehicles & Instruments
Roughly 400 years apart, the Tontine and SPAC are just two of hundreds of financial contraptions, vehicles and instruments that have been launched over hundreds (and thousands) of years by investors / financiers. Some of these contraptions and innovations have proven to be beneficial to the average investor, like the first investment trusts that were launched in the 18th and 19th centuries in order to provide the investor of average means with access to public markets. Other instruments like the modern CDO (Collateralized Debt Obligation), however, have been famously described as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
That said, this week’s Sunday Reads will primarily focus on some aspects of financial history that are related to SPACs and IPOs, but will also cover the history of financial instruments and contraptions more generally.
So, let’s dive in!
At first, the link between SPACs and the South Sea Bubble is not very clear. When preparing for a recent interview I did with Professor William Goetzmann for my upcoming online financial history course (subscribe to stay updated on this), his article on the South Sea affair reminded me of the recent boom in SPACs for two reasons.
The first is that it represents another type of financial contraption or “innovation”, as described below:
“The first innovation was in government finance. Both the Mississippi Company in France and the South Sea Company in Britain – the two most famous firms in the bubble of 1720 – exchanged equity shares for government debt; in effect converting the national debt of their respective countries into corporate stock. This was clearly perceived at the time as a new financial technology. The 1720 bubbles have historically been attributed to these large scale debt-for-equity conversions.”
More specifically related to SPACs, read this excerpt and tell me that this doesn’t seem at least somewhat similar:
“The fourth innovation was the short-lived attempt by corporations in Great Britain to pursue opportunities beyond their charter. Leading up to 1720, entrepreneurs had purchased chartered firms and repurposed them by using their rights to issue stock as a means of financing new enterprises. One such entrepreneur was Case Billingsley, the co-founder of the Royal Assurance Company, who, in 1719, purchased the York Buildings Company, a poorly performing London waterworks. He recapitalized it with the issuance of shares to the public and used the proceeds to purchase confiscated Scottish estates. These properties were intended to serve as income-producing capital to underwrite life annuities and life insurance policies.
The legitimacy of these and other attempts to expand the scope of corporations was examined by the Attorney General and debated by Parliament during the course of 1720. It ultimately resulted in the Bubble Act; an anti-speculative law that stopped the London boom in IPOs and the “mission-creep” of existing firms. The fluctuations in share prices of repurposed firms, or firms without clear Parliamentary charter, as well as the many IPOs that were ultimately banned by the enforcement of the Act were, among other things, a barometer of public expectations about the future powers of the corporation vs. the state.“
While it’s not a direct parallel, the concept of investors buying a company that had a royal charter with the intention of converting it into a separate line of business seemed reminiscent of investors buying SPACs with the intentions of “converting” into another business through an acquisition / merger.
“Firms that entered the stock market in the 1990s were younger than any earlier cohort since World War I. Surprisingly, however, firms that IPO’d at the close of the 19th century were just as young as the companies that are entering today. We argue here that the electrification-era and the IT-era firms came in young because the technologies that they brought in were too productive to be kept out very long. The model assumes that the stage before IPO is a learning period during which the firm refines the idea before committing to it at the IPO stage. The better the idea, the higher is the opportunity cost of a delay in its implementation, and the earlier the firm will have its IPO.”
One of the most common explanations for why SPACs have become so popular is that they represent a more enticing option for private companies looking to go public. SPAC’s provide private companies a lower cost and faster path to public markets that endures less scrutiny than a traditional IPO, since they are going public via an acquisition or merger instead of an independent IPO.
Bearing that in mind, this article looks at the long history of IPOs, and the decisions driving entrepreneurs to list their shares on the public markets. For example, the popular narrative today is that companies are staying private longer, but what has this trend looked like historically?
Like I said in the introduction, not all financial contraptions and innovations are bad. Some, like the investment trusts of 19th century Britain, were designed to democratize access to public markets by providing small retail investors with a diversified portfolio. This was particularly important in an era of declining yields:
“The early years of the 21st century have been a difficult and challenging time for the managed funds industry. The neglected history of managed funds reveals prior episodes of sustained growth, questionable practices, upheaval and inevitably, regulation. The first fully diversified managed fund appeared in Britain in 1868, and the industry remained largely a British preserve until the rise of the investment company and the mutual fund in the United States during the 1920s. This paper documents the features of the early trusts, discusses the rise of the industry and the challenges it survived in the early years, and draws parallels with facets of the finance industry of today.”
On the other end of the spectrum, this article looks at the worst aspects of financial innovation and contraptions… or as Warren Buffett called them: Financial Weapons of Mass Destruction.
“While CDSs may only be about a decade old, they are linked to a fundamentally similar, equally risky arcane financial instrument, which helped bring down the market in the Panic of 1907, known as the bucket shop. Bucket shops became very popular after the Civil War, even rivaling the stock market in size and the amount of money exchanged, until they were outlawed after the Panic. CDSs and bucket shops are linked not only through the fact that they are very similar financial instruments, but also, at one time, they both were regulated under the same laws. However, through deregulation, CDSs eventually followed the same path that bucket shops of the past took and brought down our market.
As it was deregulation of these instruments that condemned us to repeat the past, it is regulation which will lift us to a prosperous and sustainable economic future. Our government has begun to take action and is continuing to devise various plans in hopes of reversing our economic downturn. We can learn from the past—specifically analyzing the bucket shop response and market response to regulation in the aftermath of the Panic of 1907—to better understand how the regulation of CDSs should be handled and the possible effects on the market that these potential regulations will have. The way in which we resolve this economic crisis will echo throughout our history. Thus, steps must be taken to ensure that an economic disaster of this magnitude will not again occur due to a lack of proper oversight and understanding of financial instruments such as CDSs.
This Note seeks to analyze the role that CDSs played in the 2008 United States economic crisis drawing an analogy to the bucket shops that contributed to the collapse of the market in the Panic of 1907, and recommending potential regulations for the CDS market. Part II describes bucket shops, their effects on the economy, how they contributed to the Panic of 1907, and their subsequent regulation. Part III offers the economic fundamentals of CDSs, their development, and their lack of regulation, establishing a connection to the bucket shops of the past. Part IV recounts the recent fall of our economy, outlining the fuse burning towards disaster, and the role that CDSs played in the eventual implosion of our economy. Part V concludes the Note by offering recommended regulations for the CDS market, while presenting the lessons that can be learned from the regulation of bucket shops after the Panic of 1907.”
“A tontine is an investment scheme through which shareholders derive some form of profit or benefit while they are living, but the value of each share devolves to the other participants and not the shareholder’s heirs on the death of each shareholder. The tontine is usually brought to an end through a dissolution and distribution of assets to the living shareholders when the number of shareholders reaches an agreed small number.
If people know about tontines at all, they tend to visualize the most extreme form – a joint investment whose heritable ownership ends up with the last living shareholder. The all or nothing nature of that form is memorable. The last survivor principle has been the basis for a number of dramatic works whose plots hang on the machinations of a tontine participant to murder his co-investors to insure the core property reverts to him. In fact, tontines are far more innocuous and served as an important step both in developing modem insurance plans and providing some of the earliest reliable actuarial data on which the later insurance plans could be developed.
Since tontines have been neglected for many years, this Essay is primarily concerned with providing background information. It covers the history of their development and the broad variety of uses they have served from the 17th to the early 20th centuries. It concludes with a brief exploration of the revival of the tontine as a possible addition to the range of modem financial tools.”
MISS LAST WEEK’S SUNDAY READS? CATCH UP HERE