SPACs, or special purpose acquisition companies, have been one of Wall Street’s hottest products in the last year or so. But do they make good investments? LARRY SWEDROE has been looking at the evidence.
A special purpose acquisition company (SPAC) is a publicly listed firm with a two-year lifespan during which it is expected to find a private company with which to merge and thereby bring public. The creation of a SPAC begins with a sponsor (typically a private equity firm or a former CEO) forming a corporation and working with an underwriter to have the SPAC go public in an initial public offering (IPO). Prior to the IPO, the sponsor acquires a block of shares at a nominal price that will amount to 25 percent of IPO proceeds (or equivalently, 20 percent of post-IPO equity). This block of shares (the sponsor’s “promote,”) is the sponsor’s compensation for work it does for the SPAC. In addition, concurrent with the IPO, the sponsor purchases SPAC warrants, shares or both at prices estimated to represent fair market value. The proceeds of the sponsor’s investment cover the cost of the IPO and operating costs while the SPAC is searching for a merger target.
“Poor man’s private equity”
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 are used to attract IPO investors by compensating them for parking their cash in the SPAC for two years. If a SPAC fails to complete a merger, it liquidates and returns all funds to its shareholders with interest. Once considered a “back door” to public markets for companies closed out of the IPO market, SPACs have recently gone mainstream, being touted as a cheaper and faster way to go public than an IPO.
SPACS are also touted as a “poor man’s private equity” in that anyone can invest in a SPAC. As a percentage of total IPO funding, SPACs’ share has increased from almost zero in 2009 to approaching 50 percent in 2020.
Michael Klausner, Michael Ohlrogge and Emily Ruan, authors of the March 2021 study A Sober Look at SPACs, took a close look at the their structure, analysing all 47 SPACs that merged between January 2019 and June 2020 (“2019-20 Merger Cohort”). Following is a summary of their conclusions:
- Costs built into the SPAC structure are subtle, opaque and far higher than has been generally recognised. Post-merger, the median total cost (promote, underwriting and warrants/rights) equals about 14 percent. The 25th percentile cost was about 10 percent, while the 75th percentile cost was about 21 percent, in all cases much higher than that of a traditional IPO.
- From January 2019 through June 2020, six SPACs failed to merge and therefore liquidated compared to 47 that successfully merged—a failure rate of 11 percent. Even among the 47 SPACs that merged, eight merged with $10 million or less in cash.
- The SPAC structure creates a misalignment of 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.
- Although SPACs raise $10 per share from investors in their IPOs, by the time the median SPAC merges with a target, it holds just $6.67 in cash for each outstanding share — a significantly higher cost than that of a traditional IPO.
- Seventy-three percent of the proceeds raise by SPACs are redeemed. That results in the effective underwriting fees for SPACs being much higher than the stated 5.5 percent average IPO fee.
- Much of the cash lost in redemptions is recouped in PIPE investments (private investment in public equity at a price below the current market value), although for most SPACs the replacement is not full. Among the 2019-20 Merger Cohort, the mean annualized return for IPO investors that redeemed their shares was 11.6 percent for a risk-free investment. Returns to redeeming investors include the redemption price plus the market value of their warrants and rights at the time of the SPAC mergers. However, they played no role in bringing a company public.
- Of the cash a SPAC delivered in a merger, the median amount contributed was 64 percent by public investors, 25 percent by PIPE investors and 11 percent by the sponsor.
- Following a merger, SPAC shareholders, including the sponsor, held a median of 34 percent of the company that had gone public, and the sponsor alone held 12 percent.
- The median cost of warrants and rights was 16.6 percent — $1.66 for each $10 delivered in the merger.
- Three-month returns across all SPACs were poor. Mean returns were -2.9 percent and -13.1 percent compared to the IPO Index. Median returns were worse, with half of SPACs losing 14.5 percent or more of value within three months and performing even worse when compared to benchmark indices. Six- and 12-months post-merger, SPAC mean returns were -12.3 percent and -34.9 percent, respectively, with the drops highly correlated with the extent of dilution, or cash shortfall, in a SPAC. This implies that SPAC investors are bearing the cost of the dilution built into the SPAC structure.
- SPACs sponsored by large private equity funds and former Fortune 500 CEOs and senior executives are, on average, more successful than others. However, they are still highly dilutive — just not as dilutive as SPACs managed by other sponsors.
- Reviewing SPAC returns back to 2010, there was never a year in which SPAC mergers outperformed the Russell 2000. Even the best of years underperformed by 10 percent within the first year post-merger, and many years saw excess returns of -40 percent or more.
- The median post-merger market cap of firms in the 2019-20 Merger Cohort was $500 million, similar to the $580 million median market cap for firms listed on the Russell 2000 Index, which are not micro-cap companies.
Their findings led the authors to conclude that “claims that SPACs deliver greater price and deal certainty compared to IPOs, are overstated.” They fail to recognize that the extent of SPACs’ dilution is not known until the time of the merger, when shareholders have decided whether to exercise their rights to redeem their shares. They explained: “The dilution stems from the sponsor’s ‘promote,’ the underwriting fees, and dilution of post-merger shares caused by SPAC warrants and rights. These sources of dilution are in place at the time of a SPAC’s IPO, but redemptions at the time of the SPAC’s merger increase their impact on the dilution of remaining SPAC shares. This is the flip side of the 11.6% return that the pre-merger shareholders earn.”
Twelve Seas: a case study
Klausner, Ohlrogge and Ruan provided an example of just how high the true costs of SPACs can be in the form of Twelve Seas Investment Company, which raised an initial $207 million by selling 20.7 million units to the public. After experiencing 82% redemptions and raising no new money at the time of its merger, Twelve Seas was left with just 3.7 million public shares, compared to over 4 million shares given to the sponsor for its promote. Despite only having $37 million in its trust after redemptions, Twelve Seas paid $11 million in underwriting fees, and issued an additional 375,000 shares to its underwriter as further compensation for services provided in connection with the merger.
Twelve Seas’ units included rights to 0.l shares exercisable at the time of the merger regardless of whether a shareholder redeemed its shares. So, at the time of the merger, Twelve Seas issued over two million additional shares for free. With 82% redemptions, the vast majority of shares issued pursuant to these rights went to redeeming shareholders who had been repaid a price per share equal to the full unit price in the IPO (plus interest). Hence, these former shareholders contributed no equity to the merger. Each unit from Twelve Seas’ IPO also contained a warrant exercisable for another full share. Like the rights, 82% of these warrants were held by shareholders that had redeemed their shares and contributed nothing to the post-merger company. At the time of the merger, these warrants were trading at $0.80 each. The value of the rights and warrants retained by redeeming investors was thus $30 million. The value of the rights and warrants retained by investors that held shares in the SPAC at the time of the merger was $6 million.
In sum, as a result of Twelve Seas’ merger, the combined company received $37 million in cash, but it had shares outstanding that reflected 4 million shares that had been issued as the sponsor’s promote, and $15 million that had been paid in fees paid to the underwriter for shares that had been redeemed. In addition, the combined company assumed warrants outstanding that amounted to $36 million in value. Total dilution was thus 254% of the cash Twelve Seas delivered in the merger, putting this transaction just below the 75th percentile of SPACs in our 2019-20 Merger Cohort in terms of costs.
The authors wondered why SPAC shareholders had accepted those losses. They had no good answers.
A sustainable arrangement?
Klausner, Ohlrogge and Ruan 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 sceptical 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 percent! That explains why they continue to sponsor new deals. They have also been a good deal 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. And it has been a very expensive bill indeed!
The information presented herein is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information contained may be based on third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above you acknowledge that they are solely at your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by Buckingham regarding third-party websites. Buckingham is not responsible for the content, availability, or privacy policies of these sites, and shall not be responsible or liable for any information opinions, advice, products or services available through them. The opinions expressed by the featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners® (collectively Buckingham Wealth Partners, “Buckingham”). LSR-21-44
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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