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.
Because some shareholders may choose to redeem their shares, the amount of cash available for a merger is uncertain. To mitigate this uncertainty, in the merger agreement operating companies negotiate a minimum amount of cash that SPACs must deliver to them. Sponsors frequently invite a private investment in public equity (PIPE) investment as a part of the business combination, providing additional cash. Sponsors themselves sometimes participate as PIPE investors. These PIPE investments offset redemptions and augment the cash that is delivered in the merger. If the merger is approved by shareholders and the SPAC still has enough cash after redemptions to meet the terms of the merger agreement negotiated with an operating company, the business combination is consummated, and the SPAC starts to trade as a newly merged company under a new ticker symbol.
An important question is how well SPAC investors have been rewarded. Minmo Gahng, Jay Ritter and Donghang Zhang contribute to the literature with their March 2021 study, “SPACS.” Their database included 378 SPAC IPOs in the U.S. between January 2010 and October 2020 and the return performance of 114 SPACS over the period January 2010 through May 2018. They documented investor returns on SPACs by dividing the lifecycle of SPACs into two periods: the SPAC period, which is between the SPAC IPO and the completion of the business combination or liquidation; and the “deSPAC” period, which starts from the first trading day as a merged company. Following is a summary of their findings:
- Investors have earned on average (equally weighted) an annualized return of 9.3%.
- Although SPAC-period investors earn most of their returns when SPACs consummate business combinations (10.6% per year, equally weighted), even liquidated SPACs provide positive returns because of the interest earned in the escrow account (2% per year, equally weighted).
- Over the deSPAC period, SPACs that consummated business combinations based on a buy-and-hold strategy (in which an investor purchases a merged company share on the first day of trading as a deSPAC company and holds it) had an average one-year return of the merged companies’ common shares of -15.6% versus the value-weighted CRSP total market return of 8.7% for the matched period – an underperformance of 24.3 percentage points. This finding of underperformance was consistent with findings from prior studies covering SPACs that went public before 2010.
- 29% of SPAC mergers ended up having common share returns worse than -90% in the first three years after the mergers (versus just 9% of traditional IPOs performing worse than -90% in the first three years after the IPOs). For those deals, the SPAC shareholder redemption rates were close to 100%, meaning that the actual loss of SPAC investors was minimal, and merging companies ended up going public with little of the original IPO capital raised.
- The average one-year buy-and-hold return of the merged companies’ warrants was 44.3% – warrant investors have persistently outperformed common share investors.
- DeSPAC-period common shares perform worse when there are more warrants and rights outstanding.
- Higher redemption ratios and the late timing of the deals (i.e., toward the deadline) predict both lower SPAC and deSPAC period returns – an indication of misaligned incentives. As the two-year life of a SPAC nears its end and a sponsor’s options for consummating a merger narrow, the sponsor has an incentive to enter into a losing deal for SPAC investors if its alternative is to liquidate. The sponsor’s original investment (used to cover underwriting fees and expenses) adds to the misalignment of interests.
- The total cost of the median company going public via a SPAC merger between January 2019 and June 2020 was 14.1% of the post-issue market cap, while it was 4.8% for the traditional IPOs.
- Sponsors had to give up a sizable chunk of their predetermined compensation, making sponsor profits not as lucrative as critics suggest, especially for weak deals. On average, sponsors forfeited 34% of their common share promotes and 42% of their private placement warrants, transferring most of them to other investors as inducements either not to redeem or to invest new capital. In addition, underwriters surrendered 24% of their deferred commissions on average – sponsors take larger haircuts and underwriters forfeit commissions more when the proposed merger is not welcomed by the market, as evidenced by high redemption ratios.
- For the target company, merging with a SPAC was substantially more expensive than pursuing a traditional IPO, both in terms of the total cost as a fraction of the cash raised and as a fraction of the post-issuance market capitalization. Merging with a SPAC was even more expensive compared with direct listings.
Gahng, Ritter and Zhang did note that the SPAC market is evolving.
Evolving SPAC market
As the market has caught on to the attractive SPAC-period returns, sponsors have found they do not have to be as generous in order to generate sufficient demand to fully subscribe an IPO – the market has been adjusting toward a more sustainable equilibrium by making the structure of the SPAC unit less attractive to the SPAC investors but more attractive to post-merger shareholders. Specifically, there has been a downward trend in the fraction of a share that the warrant component of a unit offers. If the merged company prospers and the warrants are exercised, fewer new shares will be issued, and thus there will be less dilution of the merged company’s shareholders, possibly improving the deSPAC period returns.
Gahng, Ritter and Zhang’s finding of poor returns to deSPAC shareholders is consistent with those of Michael Klausner, Michael Ohlrogge and Emily Ruan, authors of the March 2021 study “A Sober Look at SPACs,” which Bob Huebscher reviewed here. They concluded: “SPAC sponsors have proposed losing propositions to their shareholders, which is one of the concerns raised by the incentives built into the SPAC structure. … Sponsors do quite well, even where SPAC shareholders have experienced substantial losses.” They added: “It is difficult to believe that it is a sustainable arrangement. At some point, SPAC shareholders will become more skeptical of the mergers that sponsors pitch.” And finally, they stated that with rare exception, “SPACs are a poorly designed vehicle by which to bring a company public. … This raises the question whether the lenient regulatory treatment of SPACs is justified. The differential treatment of SPACs and IPOs never was intended. It is an inadvertent loophole.”
Given the poor results, why do SPACs persist? First, the sponsors have done incredibly well. Klausner, Ohlrogge and Ruan found their mean return was close to 400%! That explains why they continue to sponsor new deals. Second, they have also been good deals for IPO-stage investors that redeem their shares, and for SPAC targets. However, in a triumph of hype and hope over wisdom and experience, or perhaps a strong preference for lottery tickets, SPACs’ post-merger shareholders are footing the bill for sponsors and targets and redeeming IPO-stage investors’ good fortune. A third explanation for why companies choose SPACs over traditional IPOs is to swiftly take advantage of favorable public equity market sentiment – the time it takes for an operating company to negotiate a merger with a SPAC and win shareholder approval is less than that of a traditional book-built IPO. For example, observing the spectacular performance of Tesla, starting in mid-2020 a series of companies in the electric and autonomous vehicle industries went public by merging with SPACs that had previously raised cash in their IPOs. Gahng, Ritter and Zhang noted: “The deep-pockets of specialized sponsors can make the negotiation faster and convince SPAC and PIPE investors who are not experts in the specific industry of the merits of the acquisition by committing their own capital, making the SPAC merger process speedier.”
Gahng, Ritter and Zhang provided other explanations for the choice of going the SPAC route:
- “In the U.S., companies going public rarely make forecasts of revenue or earnings, but these are common with merger announcements for which shareholder approval is needed, whether it is a merger between two publicly traded operating companies or a merger between a SPAC and an operating company. These projections are protected from lawsuits with a ‘safe harbor’ provision in U.S. laws for mergers, but not for security offerings: with mergers, plaintiffs have the burden of proof to show that managers knowingly made false statements, rather than merely having had bad luck, if the company fails to meet the projections. Thus, certain companies wanting to make forward-looking statements to maximize their pre-money valuations can benefit from merging with SPACs, essentially engaging in regulatory arbitrage.”
- “Merging with a SPAC may provide relative certainty compared to a traditional IPO. With a SPAC, the merger terms, which implicitly involve agreeing on a pre-money value of the operating company, are negotiated before additional information about the market’s opinion is known. With a traditional book-built IPO, on the other hand, the offer price and proceeds are negotiated after conducting a roadshow and observing indications of interest from potential investors, making the terms uncertain until the very last day.”
- “As with other merger agreements, contingent features such as earnout provisions can be negotiated. For example, sponsor shares are frequently subject to lockup and vesting provisions. … Sponsor compensation and SPAC IPO underwriter commissions are often renegotiated based on the post-merger performance. Operating company shares might have vesting provisions as well. On the other hand, earnout provisions are rare in traditional IPOs.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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