Idea Brunch with Raj Shah of Stoic Point Capital
Everything you want to know about De-SPACs
Welcome to Sunday’s Idea Brunch, your weekly interview series with underfollowed investors and emerging managers. We are very excited to interview Raj Shah!
Raj is currently the Co-PM at Stoic Point Capital Management, a Palo Alto-based equities fund he co-founded in July 2018. Before launching Stoic Point, Raj was a managing director and partner at Stillwater Investment Management, a partner at Light Street Capital, and an analyst at Highline Capital Management. Today, Stoic Point manages two long/short funds, one of which is devoted exclusively to de-SPACs. Raj recently started tweeting @stoic_point on Twitter.
(Editor’s note: Going forward Sunday’s Idea Brunch will temporarily change our interview cadence from every Sunday to the first and third Sunday every month. This will help us consistently publish great interviews with the next ones coming on Sunday, August 7, and Sunday, August 21. Please do not hesitate to hit reply with any questions or concerns.)
Raj, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch Stoic Point Capital?
Thanks for having me, Edwin! I’ve been long/short investing for over 13 years and have had the good fortune to work at large well-established funds, sector-focused funds, and startup funds. I really think this is the best job on the planet. I get paid to research a company or situation with an unbiased view and ascertain whether value is likely to be created or destroyed. I also get to interact with some of the smartest people I’ve ever met, including my partner with whom I started Stoic Point four years ago.
I started out my career at Highline Capital in New York where I cut my teeth covering a variety of sectors but ended up gravitating towards technology. That eventually brought me to join Light Street Capital, a TMT-focused growth manager in Palo Alto. While in Palo Alto I was introduced to Adam Weiss as he was un-retiring after managing Scout Capital, a $7bn concentrated fund. I joined Adam and a truly fantastic team to launch Stillwater Investment Management in 2015. This was a big learning moment for me. Building an investment approach from scratch, including the systems and processes to scale, and seeing how important culture matters at the outset is an education I’m thankful to have gotten firsthand. Perhaps equally as important, I shared coverage of Stillwater’s portfolio with Cullen Rose, an investor whose acumen I came to greatly respect and whose style complemented mine. Cullen and I shared a commitment to process-oriented investing and balanced each other out—my growth orientation versus Cullen’s background in value and activism.
Cullen and I launched Stoic Point together in mid-2018, leveraging the guiding principles (Quality, Misunderstanding, Self-Knowledge) from our prior firm. We also migrated our investment committee process, including a 30+ factor investment scorecard by which we grade every idea across those three principles. The best way to summarize our values system is to think of Quality as how we grade the business, Misunderstanding as how we grade the opportunity, and Self-Knowledge as how we grade ourselves. Quality and Misunderstanding exist across a spectrum—of course, we’d love to own the highest-quality businesses that are most misunderstood, but those circles are rarely completely concentric. Self-Knowledge is an inward-looking measure of how comfortable we are with what we don’t (and can’t) know about an investment, and what our reactions will be to some likely scenarios that may come to bear (some call this a “pre-mortem”). The numeric grading output from the scorecard across these three vectors determines our position sizing and feeds into risk management. Everything I laid out applies on the short side as well.
We also took something else important with us: the experience of building an investment management business from the ground up. It’s easy to overlook that running a hedge fund isn’t about just investing, it’s also about managing a business. We specifically engineered Stoic Point to give ourselves the longest possible runway. The race to put up numbers and scale is incredibly distracting to an already incredibly difficult task of investing. Fortunately, we took some lessons learned with us when starting Stoic Point.
What we did not take with us is AUM. Stoic Point didn’t take seed capital and launched with something like $2mm on Day 1. As if that wasn’t enough, we made it even harder for ourselves by being Co-PMs, a structure we were told repeatedly that allocators hate—something that never quite made sense to us. We consider two decision makers married to the same investment process and principles to be a real asset, not an impediment. It also never made sense to us to misrepresent our investment committee process by making one of us “Portfolio Manager” and the other “Director of Research.” I’ve worked for PMs who were prone to emotional decision-making. As process-oriented investors we seek to remove as much emotion out of the decision-making process as possible…hence the name Stoic Point. Stoics knew that you can’t do anything to control what happens around you (the market), only what your reactions will be. Having a partner and process in place to remind you of the scoring that went into a decision in the first place—when your emotions are telling you something different—is extremely valuable.
How’d you come to get involved in the SPAC universe?
I’m not prone to hyperbole, but this is the single best hunting ground for SMID-cap longs and shorts I’ve ever seen. We’ve long paid attention to SPACs given the potential for Misunderstandings, but there was relatively limited activity every year, and it was never a universe known for quality. But one of our early investments at Stoic Point was APi Group (NYSE: APG), a high-quality business services company that came public via a UK-listed SPAC in 2019. The deal was priced at a substantial discount to any other public comp, had great anchor investors, and the sponsor, who has been very actively involved in company strategy, had a great track record of value creation. The stock only traded OTC in the U.S. prior to the deal close which became our opportunity to buy at an attractive valuation.
As the SPAC fervor took over in late 2020, we increasingly focused on the opportunity set.
I don’t need to convince you that it’s been a phenomenal source of shorts, which was our original attraction to the universe. We kept seeing SPAC mergers with cash-hemorrhaging, pre-product companies (like companies that roll non-functional trucks down hills) double or triple at deal announcement. This was also around the time of the retail/Reddit meme stock mania. People were calling for the end of shorting... which is usually around the time you should be pressing all your shorts. But it’s incredibly hard in the moment, and if you are reckless, it can cost you your business.
But SPACs provided an incredibly useful tool for risk managing shorts—the five-year warrant. As the SPAC boom gained momentum there were numerous opportunities to short the stock and buy warrants trading below intrinsic value. All you needed to do was wait for exercisability of the warrant and you had locked in a nice arbitrage profit. At the time, the arb spreads were so wide that people assumed there was a catch. And the kicker was your stock short position was much bigger and the warrant was so cheap relative to the stock that if the stock blew up (and basically all of them did) you’d make even more money than the arb spread.
That observation about a very wide arb spread led us down the path of further exploring the warrant market. Our general takeaway was that the instrument was very hard to price and prone to inefficiencies given some of the market dynamics, namely liquidity and varying market participants (yield funds, arbs, fundamental investors, retail traders, etc.). The warrants tended to significantly underprice volatility relative to the stock, yet SPAC stocks tended to be highly volatile. We ultimately constructed a portfolio of long warrants and short stocks of various hedging ratios to take advantage of the volatility mispricing.
What are you doing now in the SPAC space?
Over the past two years, about 300 companies have gone public via a SPAC. With the help of an analyst, we have processed nearly all of these deals to quickly ascertain if they are potentially actionable, long or short. Spoiler alert: the vast majority seem like shorts, certainly at $10. The current pipeline of announced and unclosed deals also contains many short ideas. And now that we are at the bottom of the barrel of SPACs still desperate to find a target, any target, before they expire, we suspect many of the deals announced for foreseeable future are potential shorts.
Yet amidst all the carnage, there are at least 15 names we think could be multi-baggers over the next few years. So, while we are still actively shorting in this universe, we have considerably increased our long exposure to De-SPACs.
As negative and pessimistic as we sound about the universe, there are many reasons to believe there could be a handful of great long opportunities. As mentioned earlier, part of our investment framework and process is identifying Misunderstandings. We will highlight a few likely at play here. First, there is the baby with the bathwater effect—the good companies being tossed out with bad just because of the go-public structure. The De-SPAC index is down nearly 80% since the beginning of 2021. Many of these situations are now almost orphaned securities—too small or illiquid to care about. The original sellers are no longer liquidity providers at the current price and the market caps have been chopped, so it is very difficult for any large long-only funds to build a meaningful position. There is also a healthy amount of investor distraction and fatigue. There are at least 100 broken regular-way IPOs from the last two years—so who is going to put a broken De-SPAC at the top of their due diligence list given all the pessimism? While some of these companies picked up decent sell-side coverage, many still suffer from a lack of interest and coverage. These stocks generally have much less passive support than their comparable more liquid peers that have been public for longer. These companies also have spotty and often wildly inaccurate data in financial databases like Bloomberg and FactSet. They often show up incorrectly or not at all in screens. Then there is just the typical stock chart feedback loop—the charts on some of these names look horrible. Clearly, something must be wrong, some have cut their original guidance. That’s fair. But many of them raised a considerable amount of cash (especially relative to their current market caps) and the risk/reward looks very different at $5 or below than it did at $10. There is also considerable secondary “overhang”, potential new investors could be worried about big secondaries as soon as the stock moves up. We think secondaries leading to increased liquidity will contribute to multiples re-rating upwards over time. We have an opportunity at our size to participate earlier in the potential upside.
Finally, we continue to think the end game for many of these companies is to just go private again. The costs of being public are significant (and rising)—many of these companies talk about $5-10mm per year. For some of these companies, EBITDA would increase significantly just by eliminating these costs. Why stay public? Just so you can report quarterly earnings to the seven people who might actually care about the stock and conduct an annual carbon emissions study? Not to mention we just went through an epic private equity fund-raising cycle resulting in a LOT of dry powder waiting to be deployed.
Long way of saying our bias in the SPAC world has always and continues to be on the short side. But due to the epic carnage this “asset class” has experienced, we have uncovered a meaningful number of long opportunities.
What are some of the common red flags and positive signs you are looking for when researching a de-SPAC? And which de-SPAC sectors have the best opportunities for shorts and longs in your view?
This sounds glib but going public via SPAC is a red flag. The incentives are perverse. The fees are high. The opportunity to mislead people is too great. So, let’s start with that. A company should have a good answer for 1) why it is coming public this way, 2) why it is partnering with this sponsor, and 3) why this financing structure makes sense.
A year ago, an example of a good answer to these questions would have been that the business was deeply impacted by COVID (travel, discretionary etc.) and would face difficulty from a regular-way IPO process in which management could not forecast a recovery. SPACs can talk about the future (for now) and enable investors to understand what management forecasts (yes, this is frequently abused). Another good answer is that the SPAC sponsor truly does offer value, not just helping the company do a PIPE roadshow or get sell-side coverage. There are sponsors with real operational expertise, M&A, and growth guidance that can add value in the board room.
A bad answer is something like, “SPACs allow us to pick our investors,” or “the merger offers us price certainty,” or “this lets us come to market faster.” SPAC shareholders redeem or sell stock faster than hedge funds getting IPO allocations from Morgan Stanley, a dynamic that has led to companies coming public with as little as $5mm in capital raised (before fees!). There’s no price certainty when you’re back in the market issuing equity again three months later at $5. The De-SPAC process is also taking far longer now, leading to stale valuations compared to IPOs that price the same week they start trading.
Other red flags: serial sponsors with a poor track record; a sponsor merging with a business that has nothing to do with its stated objective or just before SPAC expiration; creative and complex financing; using FPAs (forward purchase agreements) that buy redeemed stock to get a deal over the finish line with a put back to the company at $10 shortly after deal close; absurd projections; and/or nonsensical comparable valuations (many SPACs raise all of these red flags, and more).
It’s also important to look at the other parties involved. SPACs can advertise large PIPEs with a strategic investor in the press release, but the S-1 later discloses a PIPE filed with arb and credit funds, or random “strategic” investors like Palantir. Hedge funds will be gone as soon as the PIPE unlocks and can crush the stock on their way out.
The best areas for short opportunities probably won’t surprise you: electric car companies with no actual product (internally we call those “a drawing and a dream”), charging companies (horrible businesses with terrible unit economics/moat), compute hardware (e.g. quantum computing, bitcoin mining), and fintech (to name a few). I’d also add that any company with less than three years of revenues usually has no business being public.
The best areas for longs are harder to generalize, but I would say we’ve found some great software and consumer businesses that are well established. It’s easier to underwrite historical financials and do real customer/competitor diligence on businesses that have been around for many years. Software exhibits nice recurring revenue streams and generally these businesses are not cash burning and the unit economics are easier to discern. Consumer businesses are generally more tangible and easier to understand.
Raj, many de-SPAC companies have a reputation for promotional, dishonest, and money-oriented management. Are there any management teams that stand out as honest and exceptional in your view?
“Exceptional” is a very high bar. In fact, honesty is even a high bar for most SPAC management teams. It may be too early to say who’s truly exceptional. But there are a handful that appear to have the right ingredients and that we already hold in high regard (and are honest): CCC Intelligent Solutions Holdings (NYSE: CCCS), AvePoint (NASDAQ: AVPT), Cvent (NASDAQ: CVT), Janus International Group (NYSE: JBI) and Nextdoor (NYSE: KIND).
First, they’ve aligned themselves with reputable sponsors. Most SPAC deals are bake-offs where management/owners have their pick of who to go public with. Choosing a reputable sponsor, not just the one who tweets great one-pagers or bids the highest valuation, is a good sign. All our longs have partnered with good sponsors.
I tend to gravitate towards founder-led management teams (CVT, AVPT). Founders have real skin in the game and feel a deep obligation not just to investors, but to employees and customers as well. They live and breathe their business and I love that. Relatedly, we look for management teams that are customer obsessed and have reinvested profits back into widening their moats (CCCS, JBI, KIND).
The best management teams are also long-term focused and opportunistic. They aren’t panicked that the stock is down because they are focused on the business trajectory and capital allocation, with the knowledge and confidence that the stock price will figure itself out. I mention opportunistic because they are also smart capital allocators. A few have done smart deals (JBI bought its only real competitor within a few months of coming public), bought back stock at severely depressed valuations (AVPT, KIND), or redeemed warrants at a discount to future fair value (CCCS and JBI).
Being a public company offers a whole new set of challenges and not all these stocks have fared well since their debut (in fact the best are still about $10). These are new public companies in a very crowded (and extremely volatile) field. We very frequently speak with De-SPAC management teams, and it doesn’t take long to figure out the ones that “get it.” They must improve communication, build credibility, and continue to garner investor attention. We are optimistic because communication can always be improved, but they already possess the above characteristics, which are significantly harder to develop. And one additional commonality among these teams is their interest in and openness to investor feedback.
What are some of your favorite de-SPAC ideas on your radar now?
I think about our long SPAC exposure as being in two buckets: 1) good/great businesses trading at deep discounts to peers and/or intrinsic values, and 2) companies with massive option value and/or massive asymmetry.
In the category of good/great businesses that are cheap, I’ll highlight two software businesses. Both are deeply discounted, have strong unit economics, and are run by longtime founders.