SPACs May Feed the Public’s Worst Fears About Wall Street

This article was written with Stephen Deane and published by Barron's. At the time he was Senior Director, Capital Markets Policy for the Americas for CFA Institute. It was one of several articles we worked on together regarding market integrity and regulation. In addition, I negotiated a column for Mr. Deane on where we wrote a number of articles on market integrity and other capital markets issues.

There are two polar-opposite narratives about the special-purpose acquisition vehicles, known as SPACs, that have taken companies like DraftKings public. One hypes up SPACs; the other pumps fears they will collapse. But it is a third, looming narrative that is potentially most troubling.

First, there is the hype. SPACs are exploding in popularity. They bring retail investors and private companies into the sunlight of public markets. They are the poor man’s private equity, allowing ordinary folks to get in on the ground floor of profitable companies.

Second, there is the critical narrative. Exploding in popularity today, SPACs will implode tomorrow. When they do, these formerly hot investments will leave ordinary investors badly burned. SPACs are riven with conflicts of interest, and their historic returns have been abysmal. They bespeak delusion and dilution.

The first narrative mixes hopes and perceptions of the benefits of SPACs; the second, their most troubling risks. But the combination of the two narratives—great expectations leading to great losses—threatens to feed into a third, now familiar narrative: Wall Street is rigged.

That hasn’t happened yet, but we’ve been in the frenzied stage. Admittedly, SPACs are a financial innovation that could still evolve for the better. But the risks are high that many of the nascent SPACs will fail. Individual investors will lose their money. There will be a lot of pain and anger. Congress will hold hearings. And it will reinforce the rigged narrative.

A SPAC is a publicly listed company but not an operating business. It has no products or services to sell. Its sole purpose is to find a private operating company with which to merge, and it has up to two years to do so. The merger turns the target into a public company, bypassing the initial public offering process.

Just as SPACs involve two key transactions—the initial IPO and the subsequent merger—they also involve two sets of players with starkly different outcomes. The first set consists of the SPAC sponsor, the initial investors in the IPO, and private-placement investors who come in at a later stage. The initial IPO investors often include hedge fund regulars known by their critics as the SPAC mafia. These players, along with the investment banks underwriting the IPO, do very well, thank you. Their profits, however, come at the expense of the second set: retail investors who are caught up in the frenzy and remain after the initial IPO investors have left.

When the sponsor announces plans for the merger, all shareholders are allowed to redeem their shares. They can get back their money plus interest if they don’t like the deal. Most of the initial SPAC investors do just that. You can think of a SPAC as a blank-check company, but it typically gives back more than two-thirds of the initial checks, according to the academic study “A Sober Look at SPACs.” Ironically, many of the remaining shareholders—the ones who stay invested in the postmerger company—are different from the SPAC’s initial investors. That in itself challenges the idea that SPACs are a poor man’s private equity because, first and foremost they are not private. Second, private equity investors typically have five-to-seven-year holding periods, while recent history suggests SPACs are a trader’s vehicle.

But there’s more. The initial IPO investors bought units, customarily priced at $10 each, comprising both shares and warrants. Warrants are like options, and they give the holder the right, but not the obligation, to buy shares (or a fraction of a share) at a certain price (for SPACs, $11.50 per share). When initial IPO investors redeem their shares and get back their cash plus interest, they keep their warrants. It’s like getting something for nothing. But these warrants dilute the value of the shares of the remaining shareholders—the ordinary investors. The latter bought their shares on the open market, typically with no warrants attached.

The second major source of dilution comes from what is called the sponsor’s “promote”: the shares that the sponsor takes for itself, for a nominal price, as compensation for its efforts. The typical promote equals 25% of the IPO proceeds. But the sponsor can keep its promote only if the transaction is consummated, creating a strong incentive for sponsors to make a deal even if it is not a good one.

At the time of the merger announcement, redemptions from initial SPAC investors dig into the IPO proceeds needed for the merger. To replenish the cash, SPACs often make new private placement deals on attractive terms, including discounted prices, side payments, or both. These inducements introduce a third source of dilution. (There’s also a fourth source, but you get the idea.)

The “Sober Look” study further exposes a stunning bifurcation in investors and outcomes. The authors analyzed all 47 SPACs with mergers from January 2019 to June 2020. They found that a median of 73% of IPO proceeds were returned to investors who redeemed their shares (but kept their warrants). As for the SPAC mafia, more than half redeemed all their shares.

According to the study, the redeeming IPO investors walked away with mean annualized returns of 11.6%—all for an “investment” with minimal risk. Sponsors also fared well, even in cases where the postmerger company did not. The study found that mean sponsor returns were 393% both three and six months after the merger.

Contrast that with outcomes for postmerger shareholders. Their returns depend on the success of the newly public company, which is handicapped by the cost of dilution. Sure, a great company with strong management can overcome that burden and still deliver stellar returns. But most SPACs don’t.

The study found that the sample’s 12-month mean return was negative 35%. The SPAC cohort also underperformed benchmarks involving an IPO index and the Russell 2000. Taking a longer perspective, the study found that SPAC post-merger one-year returns underperformed the Russell 2000 for every year since 2010, by 10% or worse. Tellingly, the study also found the poor returns were highly correlated with the level of dilution.

To be sure, nothing requires a SPAC to impose such onerous dilution on ordinary investors. A few do not. But they are the exception, not the rule.

About the author: Stephen Deane, a chartered financial analyst, is senior director, legislative and regulatory outreach, at the CFA Institute. He joined the institute after more than nine years at the U.S. Securities and Exchange Commission.

Click here to read the article on Barron’s.

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