SPACs: A Triumph of Hype over Wisdom

SPACs have lured billions of investor dollars with the chance of sensational payoffs. But research shows that post-IPO investors have paid a huge price for relying on that overhyped hope.

In 2020, the U.S. IPO market boomed, with 165 operating companies going public, raising $61.9 billion. IPOs by a special purpose acquisition company (SPAC) set records. A total of 248 SPAC IPOs raised $75.3 billion, more capital raised than in all previous years combined. The trend continued in January 2021 with 91 SPAC IPOs, a record pace.

A SPAC, a blank-check company created by a sponsor, goes public to raise capital and then find a non-listed operating company to merge with, taking the company public in the process. Almost all SPACs created since 2010 issue units in the IPO priced at $10 each. A typical unit is composed of a common share and one or more derivative securities, usually a warrant (a call option) entitling the holder to buy a fraction of a share at an exercise price of $11.50 with an expiration date that is five years after the completion of a merger.

The IPO proceeds are placed in an escrow account where it earns interest. The units later become unbundled, allowing the shares and warrants to trade separately. SPACs typically pay 5.5% of the proceeds as underwriting commissions, with 2% paid at the time of the IPO and the rest deferred, payable only upon the completion of a merger. Sponsors are typically compensated by retaining 20% of the post-IPO SPAC shares. However, they have no access to the trust account. Sponsors also usually purchase-private placement warrants at the time of the IPO for $1.50 each, with the dollars paid for the warrants going to cover the up-front underwriting fees and future expenses, allowing the public investors to start with $10 per share in the trust account rather than the $9.80 in net proceeds from the IPO. The sponsors’ compensation (payoffs on their shares and warrants) and more than half of the underwriters’ fees are contingent upon the consummation of a business combination.

When a SPAC proposes a merger, SPAC shareholders have an option to redeem their shares rather than participate in the merger and get back their full investment plus interest. In addition, shareholders who redeem their shares keep the warrants and rights that were in the units sold in the SPAC’s IPO – the warrants and rights were used to attract IPO investors by compensating them for parking their cash in the SPAC for up to two years. (A notable feature of the SPAC warrant is that merged companies usually have redemption rights for the warrants when the stock price hits a certain level, usually $18. Thus, although the warrants typically have a five-year post-merger expiration date, they may be called early.) If a SPAC fails to complete a merger, it liquidates and returns all funds to its shareholders with interest. The downside protection provided by the ability to redeem shares makes a SPAC IPO the equivalent of a default-free convertible bond with extra warrants, from the perspective of someone who invests in the IPO.