A year or so ago, I could barely keep up with the firehose of information about SPACs. Now SPACs, as well as the general IPO market, have crumbled. I went to a recent alumni event to meet current Accounting major students of my Alma Mater, Indiana University. Out of curiosity I mentioned SPACs to them, and one student commented something along the lines of “When was the last time someone talked about SPAC’s?” So in the lives of college students where trends change daily, SPACs are already far beyond ancient news. However, I believe they’re still worth our time to understand this moment-in-time bubble, as history has a way of repeating itself.
As promised in my previous article What the SPAC?, I went through and read the entirety of the 100 page study A Sober Look at SPACs. Twice. More detail was, of course, less confusing, as detailed by Figure 2 below. I’ve done my best to summarize the 96 page study, so keep in mind that my “lengthy” article is much, much shorter than the study itself. Don’t worry though, there’s pictures!
The overall reporting and conclusions were shocking to say the least, given the recent hype of the “regulation free” world of SPAC investing. My prediction is, as with the crypto market, regulation will quickly catch up and end the wild west mentality that today’s investors have engaged in.
The study was conducted on forty-seven SPACs that merged between January 2019 and June 2020, with a note that during this period, only six SPACs failed to merge and therefore liquidated. In more recent news, the prior ‘SPAC King’ Chamath Palihapitiyahas is closing two SPAC’s that failed to find deals, another indicator of how drastically the SPAC market has changed in the past 2 years.
The paper begins by explaining what a SPAC is. I enjoyed the shade thrown around what I called step 1, where the authors said “…or individuals with no particularly relevant background” act as the initial investors in a SPAC. My initial understanding was that a SPAC worked similarly to a venture capital investment fund, where investors put their money into the fund, which in turn goes out and invests into a start-up. This understanding was completely incorrect in practice.
In SPAC’s, one group of investors put money into the initial SPAC when it goes public on the market. Yes, the SPAC goes public, not the target. The SPAC then eventually merges with its target, which essentially takes the target company public and should be considered an IPO for that company. The key thing to note here is the study found that the group of investors who put cash into the SPAC when it goes public are a completely different group of people who are invested in the final target company once it goes public. Per the study, “a reasonable inference is that there is a near 100% turnover of shares between the time of a merger announcement and the closing of the merger.” The middle-phase investors are called PIPE investors, who invest between the time of the SPAC IPO and the eventual target merger.
It gets better. through a detailed analysis, the writers of the paper determined 88 hedge funds that are known, I kid you not, as the “SPAC Mafia.” These are repeat-playing hedge funds that hold 70-80% of the initial SPAC post-IPO, but per the study’s defined divestment rate the, SPAC Mafia sells, has “mean and median divestment rates of 97% and 100% respectively.” , meaning they typically hold 70-80% of the initial SPAC, then sell virtually all of it before the target company goes public. The benefit for the SPAC mafia is typically with free warrants and rights given in order to induce them to buy units and thereby establish the SPAC as a public vehicle that can later bring a private company public. The mechanics of warrants and rights go a bit over my head, but the key word there is “free”. They get free stuff now to help get the rocket in the air, then abandon ship before it starts crashing.
Most interestingly, what these warrant and rights mean is that the Mafia get to keep a portion of the later merged target, even if they don’t stick around.What’s more,nothing is ever truly free, so the value of these freebies is taken away from the future shareholders of the target company’s post-merger value, called dilution, as detailed in Table 3 below. So if you put money into the company later, the Mafia takes its cut.
Another key source of dilution is the sponsor – the celebrity or bank that creates the SPAC in the first place is typically guaranteed 20-25% of the future value. So by giving the sponsor $10, your $10 is immediately worth $8 because they get to keep 20%. Neither of these dilution costs are ones incurred in a traditional IPO. Other fees incurred, such as underwriting fees which are part of a traditional IPO, are technically “lower” in the initial company.
All of these decreased costs are temporary, and wind up being higher to the people who don’t have a chair when the music stops. Keep in mind that “lower costs” are one of the key selling points for a SPAC as opposed to a traditional IPO, but the below table shows all of the costs that are only incurred in a SPAC setting. HQ in the table stands for “High Quality” Spacs, as opposed to the cheap knock-off brands.
The net effect of this is that for every $10 share put into a SPAC, the future target only gets $5.70 in cash. The target must be able to provide the additional $4.30 in value in order for the overall process to be value-enhancing for the final shareholders, not just a cash blackhole money grab for the SPAC Mafia.
So…is it worth it? The study goes onto evaluate the Post-Merger Returns to the final shareholders. The first finding?! “Consequently, it omits the “pop” in price that often occurs on the day of the IPO.” This was one of my open questions / obsessive thoughts – we found one market efficiency! As for the post-merger results, I believe the findings are shocking enough to quote the article in full:
As of one year following a merger, the average SPAC had underperformed against the IPO index by 50.9%, against the Nasdaq by 17.9%, and against the Russell 2000 by 4.4%. Many of the SPACs in our Cohort hit their twelve-month anniversary during the SPAC bubble between the fall of 2020 and the spring of 2021, and have seen their share prices decline with the bubble’s deflation. We, therefore, also present returns as of November 1, 2021, the last date data was available for this Article. These returns are worse compared to each of the benchmark indices, with average excess returns of 100.4% under the IPO index, 64.1% under the Nasdaq index, and 38.0% under the Russell 2000. Both twelve month returns and returns up to November 1, 2021 are also far worse than investors would have received had they bought into traditional IPOs at the closing prices for the first day of post-IPO trading. SPAC results measuring post-merger performance using factor models, rather than simply average returns, yield similar results. Figure 7 plots the development of SPACs’ postmerger returns over time, and shows a steady decline, on average.
Overall, some high-quality SPACs did well—a few very well—but most others ranged from poor to very poor. Through lots of magical math, the authors of the study concluded this implies that a major source of SPACs’ poor performance are the costs embedded in their structure
In sum, the costs embedded in SPACs are higher than the costs associated with IPOs. This is true both with respect to cost as a percentage of cash delivered and the dollar value of SPAC and IPO costs. We found in Part III, however, that companies merging with SPACs negotiate merger terms that leave those costs with nonredeeming SPAC shareholders. At some point, that will change, and targets will have to bear at least some of those costs. At that point, the appeal of SPACs to targets will likely diminish.
One last difficult to quantify ississue, as stated by the writers, is we can have no assurance that the selection of companies going public through SPACs is optimal. There could be companies that go public through SPACs that would have been more valuable remaining private (either with or without additional private funding), but that opted to go public through SPACs because of the subsidy from the SPAC. My personal favorite example is that footnote 138 references the Nikola SPAC as being a much better investments that prior SPACs. But should Nikola have gone public? Investors must question this decision now that it’s been revealed Nikola, self-driving car company, used footage of a car in neutral being pushed down a hill in its marketing. Nikola is now facing fraud investigations.
My personal conclusion, now confirmed by an overwhelming amount of data, is that the SPAC structure is bad for investors.
This time it’s different?
This study was based on a period of time ending right before the 2020-2021 SPAC bubble. The authors state:
Since we posted our paper, we have received countless responses to our research from participants in the SPAC world, most of which amounted to “your study is out of date—this time is different.” As Carmen Reinhart and Kenneth Rogoff have said, “More money has been lost because of these four words than at the point of a gun.
Therefore confronted, the authors analyzed the recent SPACs and their performance through December 2021. They were … not great.
Some people did make money, which the authors imply were relying on the “theory of the greater fool” associated with investment bubbles.
The study authors did propose a few changes which could lead to more beneficial SPAC structures. Much of this is bringing the regulations around SPACs in line with those of an IPO. In short, Disclosure Disclosure Disclosure. The metrics used in the paper were derived from available disclosures, but would be much more beneficial if given to potential stockholders in an understandable format. Of particular concern, at least for me, is to help retail investors, meme stock buyers, redditors & Robinhooders understand what they’re putting their money into.
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