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Winners and Losers

Special purpose acquisition companies have seen a resurgence since the start of the pandemic and nowhere more so than in the US. But who really gains from SPAC transactions? And do they play a useful role in public markets? Three new research papers examine these issues.

Issue 18 Winners and Losers - PE article image

“I don’t see SPACs as a proxy for PE. In addition, SPAC sponsors are nowhere near as well resourced as PE funds, which are far more likely to see deals well before SPACs and get first refusal” - Christopher Schelling, Venturi Private Wealth

Special purpose acquisition companies (SPACs) may have been around for decades, but their popularity rocketed in 2020 and 2021. In many markets around the world the number of SPACs rose, but activity in the US far outstripped both historical trends and that in other regions. In 2020, there were 248 SPAC IPOs in the US, accounting for 55% of the country’s IPO market by volume and for 46% of proceeds, according to SPAC Analytics data. In 2021, there were still more – a total of 613 SPAC IPOs (63% of the volume and 48% of the proceeds). That compares with just 59 SPACs in the whole of 2019 in the US, representing only 28% of volume and 19% of proceeds.

The search for returns is likely to have been a driving force behind the resurgence of SPACs, particularly given the record low interest rate environment that has largely persisted since the start of the pandemic.

The allure of gaining access to private companies through SPAC mergers – companies that public market investors would not historically have been able to access – is likely to have been another major selling point for SPACs. For companies, SPACs have often been marketed as offering speed and certainty of listing, when compared with an IPO.

Meanwhile, on the fund manager side, some private equity firms have exited investments through the SPAC market, and others are raising or investing in SPACs themselves. TPG’s Pace Group has sponsored a number of SPACs in recent years, for example, and Apollo Global Management is even believed to be raising a US$500m fund to invest in SPACs.

In fact, SPACs became so popular that politicians and sports stars muscled in on the act – former US House speaker Paul Ryan has raised a SPAC, as have tennis players Serena Williams and Naomi Osaka, and former basketball player Shaquille O’Neal, among others.

Regulatory interest

This boom has attracted plenty of attention – including that of regulators. The US Securities and Exchange Commission (SEC) is considering new rules for SPACs in a bid to improve transparency and to level the playing field with IPO regulations. One area of focus is forward-looking statements, given that some had interpreted existing laws as allowing SPACs to benefit from “safe harbour” provisions (which exempt an entity from legal liability if certain conditions are met). And while this scrutiny has slowed the US SPAC IPO market somewhat, new listings continue to be announced – this year, there had already been 21 by 24 January.

Against this backdrop, academics have been working on three research papers to determine who benefits from SPACs and what purpose they serve in the market. The first, A Sober Look at SPACs, by Michael Klausner, Michael Ohlrogge and Emily Ruan, was originally intended to look at what the authors could learn from SPACs about the process of going public and how the IPO process could be improved. Yet the research soon took on a different dimension.

“We found that SPACs are so complex, opaque and poorly understood that it was hard to draw meaningful conclusions about the process of going public without really getting under the hood of SPACs first. That is what led us to look at them so closely,” says Ohlrogge.

And when they looked in detail, they discovered that SPACs’ costs were far higher than they had first thought. SPAC shares are sold at US$10 each and investors at this stage are often granted warrants (a process that dilutes the interest of other shareholders because the SPAC has to issue more shares when warrants are exercised). The academics found that, after taking into account the sponsor’s 20% promote, plus the dilution caused by the warrants and rights given to IPO-stage investors and underwriters, plus other fees, the mean and median SPACs in their cohort had just US$4.10 and US$5.70 in net cash per share respectively, despite having a nominal value of US$10 when the mergers took place. The authors also found that the vast majority of SPAC IPO shares were either redeemed or sold by the time of the de-SPAC or merger, leaving new shareholders to bear the costs.

“We were shocked at how expensive SPACs were,” says Ohlrogge. “That led us to look at why a company would choose this as a way of going public. It took a long time for us to realise that SPAC merger agreements could be structured in such a way that the costs could be passed on to non-redeeming shareholders.”

For exiting PE firms, the SPAC boom has been something of a windfall, according to Ohlrogge. “Our research finds that the owners of target companies do very well in SPAC mergers,” he says.

“As long as they structure the deal so that they get as much or more value post-merger as they owned pre-merger, it will be a good deal for them. The research shows that the target owners are able to do this quite effectively. They are sophisticated venture capitalists and PE firms who would not be willing to bear SPACs’ huge costs themselves, but are happy to sign merger agreements that pass on those costs to non-redeeming SPAC investors.”

A second research paper, SPACs, by Minmo Gahng, Jay Ritter and Donghang Zhang, also finds that costs are high. It finds that SPAC IPO investors do well, earning an average annualised return of 15.9% between the IPO and merger, but that de-SPAC-period investor returns are more mixed – equally weighted average one-year returns are -8.1%, while those holding warrants earned an average annual return of 68%.

“We hadn’t expected to find that warrants did so well relative to common stock following a de-SPAC,” says Ritter. “And this is not yet part of the received wisdom around SPACs – there is a fairly large difference between the equally weighted and value-weighted returns. In poor deals, there tend to be high redemptions, so that even if the share price drops by 90%, investors do not lose much because they have pulled out most of their cash.”

Who bears the costs?

Yet unlike the research by Klausner et al, this paper suggests that the merged company bears the costs, not the de-SPAC-period investors. “We don’t see the public de-SPAC shareholders as bearing most of the SPAC structure costs,” explains Ritter. “That’s because the de-SPAC shareholders include the legacy shareholders from the target business, and they experience largely paper losses computed from the merger price – a price they didn’t pay.”

For Christopher Schelling, director of alternative investments at Venturi Private Wealth, this is a false dichotomy. “In many respects, it doesn’t matter if it’s the company or the investors that pay,” he says. “The investors are paying in the end because lower reported earnings reduce the equity value of the businesses.”

However, both papers agree that many SPACs have performed poorly post-merger. The Gahng et al paper even says: “On a point forward basis, there are many reasons to believe that de-SPAC period returns may be still disappointing.” One of these is the incentive for sponsors to execute a deal within the two-year time frame – a tough ask in a highly competitive market for private companies flush with PE capital.

Indeed, there is increasing evidence that recent SPACs have not performed well. Analysis by the Financial Times of 199 SPAC mergers completed in 2021 found that share prices had fallen by 40% on average by 19 January 2022; that just 15 were trading higher than their share price at the time of merger; and that only eight had outperformed the S&P 500.

Companies have also increasingly been pulling out of their SPAC mergers, including Acorns Grow, Fertitta Entertainment, Apex Clearing Holdings and Valo Health. There may be signs that investor sentiment is finally cooling on these deals, but it seems odd that this has taken so long.

This slow chilling of sentiment may be partly explained by the time horizon over which the valuations fall, according to Ohlrogge. “There is an oddity with SPACs – the average price of shares immediately post-merger is around US$10. Yet longer-term performance is consistently quite poor. That shouldn’t happen in an efficient market – if prices drop, they should drop quickly after the merger, not slowly over time. This, I think, is one of the reasons why SPACs have persisted. The reduction in share price happens gradually over time. The decision to hold shares rather than redeem is therefore less crazy than it would seem, at least as long as you can keep finding someone else to sell them to before they drop.”

Yet it may also be because of the type of investor that many of these vehicles attract. “Many retail investors think that SPACs are a way to gain access to PE through the public market,” says Schelling. “There has been a huge appetite for them among individual investors.”

He adds, however: “I don’t see SPACs as a proxy for PE. In addition, SPAC sponsors are nowhere near as well resourced as PE funds, which are far more likely to see deals well before SPACs and get first refusal. SPACs are likely to be getting transactions that PE has already turned down.”

A useful purpose?

The third paper, Segmented Going-Public Markets and the Demand for SPACs, by Jessica Bai, Angela Ma and Miles Zheng, offers a different perspective: it asks what role SPACs play in the market. The authors find that SPAC targets tend to be younger and riskier than traditional IPO candidates, and that they have similar or higher three-year growth rates by revenue, market capitalisation and assets. The authors then posit that the promote incentive structure and more lenient regulatory framework enable SPACs to perform a useful purpose by bringing value-creating, smaller and riskier companies to the market, satisfying the demand from yield-seeking investors.

“Our paper highlights the role that SPACs play in spurring innovation and filling a gap in public markets by bringing smaller and riskier companies to market,” says Bai. “This is in contrast to traditional IPOs, where the high potential for Section 11 litigation (around misleading statements or omissions) deters investment banks from working with these companies.”

The authors suggest that this may help to stimulate entrepreneurial activity, although Bai is clear that there is a balance to be struck. “Of course, it’s not necessarily clear whether all smaller and riskier companies should be public,” she says.

A future path

What all three papers agree on is the need for adjustments to the SPAC model to create a more sustainable market. For Ohlrogge, the answer lies in more stringent regulation. He says: “The SEC should – and likely will – implement regulations that make the costs more transparent and level the playing field between SPACs and IPOs around forward-looking statements and liability for misstatements.”The Bai paper argues against such a policy on the grounds that it would reduce incentives to bring riskier companies to market, but the paper does call for greater alignment between sponsors and long-term investors through the use of earn-outs and optimising the mix of stocks and warrants.

Bai says this has already started to happen with more recent SPACs. “Overall, there is a trend for SPACs to become less attractive for SPAC IPO investors and more aligned with investors post de-SPAC,” she explains. “Part of this is through lock-ups of up to five years, as well as earn-out provisions based on long-term performance.”

Ritter agrees that the market is moving towards a greater equilibrium, although he believes there is still some way to go, especially given the redemptionrights and warrants offered toIPO-stage investors. “One issue is that the sponsor’s cut is still too large,” he says. “The other is the value taken by the SPAC IPO investors, which averages out at an equally weighted annualised 15.9% return – that’s for what are essentially default-free convertible bonds, so there is no downside.”

But he believes that the market will ultimately work through this, especially as PIPE investors are withdrawing from the market following some significant losses. “Previously, we didn’t see many liquidations,” he says. “Yet now, because of the flood of SPAC IPOs, it’s quite likely that many won’t be able to find deals. Companies and PIPE investors now have much greater bargaining power because there are fewer of both, relative to the number of sponsors searching for deals. Sponsors are having to agree to vesting conditions to their promote. We found that in some recent mergers, only 25% of sponsor shares weren’t subject to vesting and a three to five-year lock-up. And if the shares don’t reach the price thresholds set, they can’t sell and the warrants are worthless. Sponsor economics have deteriorated tremendously over recent months.”The market may yet take care of some of the frothier elements of SPACs, while the SEC has also made it clear that it is watching these structures very closely. Together, these forces could create a more sustainable market that attracts rather fewer former politicians and sports stars and more professional dealmakers.

In the meantime, however, there may be more pain to come. “The research papers are relatively recent and we’re still working our way through the bubble,” says Schelling.

The Research

In A Sober Look at SPACs, Michael Klausner and Emily Ruan (Stanford Law School) and Michael Ohlrogge (New York University School of Law) examine the structure and costs of SPACs. Initially analysing the 47 US SPACs that merged between January 2019 and June 2020, they find that the costs are subtle, opaque and far higher than previously recognised: on average, of a SPAC’s value at the time of its merger, the sponsor takes 31% in the form of promote shares purchased for a nominal price, underwriters and other financial advisors claim an additional 14%, and a further 14% goes to IPO-stage investors in the form of warrants to induce them to, in essence, rent money to sit in the SPAC’s trust account while it searches for a target.

By the time of a SPAC’s merger, nearly 100% of the initial IPO-stage investors have either redeemed or sold their shares, walking away with the warrants they received in the IPO while contributing nothing to the company going public. The research finds that net cash per share falls from the US$10 typically attributed to them in the SPAC merger to a mean US$4.10 per share. The SPAC shareholders that do not redeem or sell shares bear these costs – the research says that their mean and median market-adjusted returns (as of 1 November 2021) are -64% and -88%, respectively.

In an updated version of the paper, the authors analyse the 209 US SPACs that merged in the 16 months to November 2021 to take account of the “SPAC bubble” period from Q4 2020 to Q1 2021. This period featured lower redemptions by SPAC investors, fewer warrants in new SPAC IPOs, and larger PIPEs, relative to the 2019-20 cohort. The mean net cash per share is higher, at US$6.60 during the boom period of Q4 2020 to Q1 2021, and at US$6.20 post-boom, but it is still meaningfully lower than the US$10 per share issued at the SPACs’ IPOs.

In their paper, SPACs, Minmo Gahng and Jay Ritter (University of Florida) and Donghang Zhang (University of South Carolina) examine the performance of 210 US SPAC IPOs that took place between January 2010 and December 2018. They find that SPAC IPO investors earned, on average, an annualised return of 15.9% during the SPAC period, but that investors in the post-merger period saw more mixed results. They earned -8.1% on an equally weighted average one-year buy-and-hold return basis, while average dollar-weighted returns were 4.5% (largely because of investor redemptions of shares for mergers that ultimately performed disappointingly). They also find that the warrants issued to SPAC IPO investors achieve significant gains post-merger – the equally weighted, one-year buy-and-hold return is 68%. They find, in contrast to Klausner et al, that the merging companies mainly bear the SPAC costs: the cost of the median company listing via a SPAC is 14.6% of the post-issue market capitalisation, but just 3.2% for a traditional IPO.

The authors note that SPAC IPO terms are now evolving as sponsors frequently take haircuts, giving up shares (17% on average) and/or warrants (19% on average) to existing investors to prevent them from redeeming, or to PIPE investors to induce them to provide cash. They conclude that the market is adjusting to a more sustainable equilibrium.

Segmented Going-Public Markets and the Demand for SPACs, by Jessica Bai and Angela Ma (Harvard University) and Miles Zheng (University of Illinois at Urbana-Champaign), takes a different approach to analysing SPACs. It finds that SPAC activity is correlated with positive equity market sentiment, and that SPACs target companies that are younger, smaller and have significantly lower revenues (and are therefore more risky) than those that opt for a traditional IPO, but that they grow at similar or higher rates after going public.

The authors build a model to explain these facts and find that the more lenient regulatory framework for SPACs, together with the equity-based compensation structure, incentivises sponsors to bring value-creating but riskier companies public, thereby filling a gap. However, the authors also suggest that improvements to sponsor compensation structures could better align incentives with those of long-term investors.

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