The special purpose acquisition company, or SPAC, is a company with no commercial or operating history that has listed on a stock exchange with the sole objective of raising financing to identify and acquire another company. SPACs developed after the SEC curtailed penny-stock blank-check companies and have recently achieved cult-like status. In 2020, SPACs accounted for most of the money raised through IPOs on U.S. exchanges. SPACs are also big business in the M&A world, completing nearly $80 billion worth of acquisitions in 2020 alone, and it is not surprising that non-U.S. exchanges are falling over themselves to take a piece of the SPAC action. However, in my recent paper I argue that the positive perception of SPACs in the corporate world masks a darker side, one where SPACs are ephemeral, but lucrative, financial instruments for institutional investors and SPAC sponsors.
Although outliers exist, most modern SPACs observe a structure driven by market and regulatory standards that have evolved over time. Units consisting of stock and warrants are issued through an IPO, with the proceeds placed in an escrow account. Subject to limited exceptions, the SPAC will automatically be liquidated if it has not completed an acquisition within three years. The escrow account can generally only be used to fund an acquisition, pay liquidation proceeds, or satisfy redemption rights of stockholders, which may be exercised at any time pre-acquisition. The sponsor of the SPAC will usually subscribe to equity at a nominal price pre-IPO, known as the promote, which constitutes at least 20 percent of the post-acquisition stock of the enlarged entity (the “de-SPAC”). The customary structure of the modern SPAC, though, creates perverse incentives. Since the promote cannot share in escrow proceeds, it only has value if an acquisition is completed. There is therefore a large incentive on the sponsor to cause the SPAC to complete an acquisition within three years, and evidence suggests that, on average, SPACs are making investments in firms that substantially trail the market.
The initial IPO subscribers are overwhelmingly institutional investors. Why, then, have ostensibly sophisticated investors been investing in SPACs in droves when the incentive structure is so skewed in favor of the sponsor and the evidence suggests that returns are poor for investors who acquire stock at the time of IPO and hold it through the completion of the acquisition? The answer is that a huge proportion of those investors sell or redeem their stock prior to the relevant acquisition, and the long-term stockholders of the post-acquisition de-SPAC are very different from the IPO investors.
IPO investors are usually hedge funds that typically exit the SPAC pre-acquisition. With interest-rates low, those hedge funds derive value by parking unspent cash in a freely accessible risk-free escrow account, with a side bonus of free warrants that can be sold on the market. The post-acquisition investors comprise an eclectic group – the sponsor (with its, now valuable, promote), former target company stockholders who have been issued stock in the de-SPAC as consideration, PIPE investors who have been solicited by the sponsor to fill the gap in acquisition finance resulting from redemptions, and a sliver of long-term investors, who acquired stock in the SPAC pre-acquisition and held their investment through completion. Notably, unlike pre-acquisition investors, PIPE investors and target company stockholders are able to negotiate a price for securities based upon an evaluation of the acquisition and the dilution caused by the promote. They often invest at a discounted price, enabling them to garner returns not available to pre-acquisition investors.
At the other end of the spectrum, the long-term investors get the worst deal. Not only will they have invested at an inflated price, but they will be diluted by a number of sources post-acquisition, including by the promote, PIPE investors, target stockholders, and the post-acquisition exercise of warrants. A clear juxtaposition emerges between the prospects of the sponsor and long-term investors, with the sponsor making sizeable returns even if the eventual target performs poorly, and with the long-term investors only breaking even if the financial performance of the acquired company is sufficiently stunning to transcend the dilution ingrained in the SPAC paradigm.
Who are the poor long-term investors who seem to be at the bottom of the pile? In most cases, they are retail investors who are not as knowledgeable as institutional investors about the incentives and dilution mechanics of SPACs. Additionally, retail participation in IPOs is often severely restricted, and, therefore, most retail investors will be acquiring stock, with no warrants attached, in the secondary market after an IPO but before announcement of the acquisition. Consequently, without warrants, there is very little motivation for a retail investor to invest in a SPAC with a view to simply redeeming its stock and getting its money back three years’ later. Retail investors may also justify long-term investment by the success of the IPO in attracting institutional investors, but such free-riding is unwise when those institutional investors have no intention to remain invested in the de-SPAC.
The SPAC has become a two-part arrangement. The first stage is a financial instrument that generates gains for savvy institutional investors and sponsors, and the second stage is the legitimate acquisition-funding round where PIPE investors invest at an informed price. Retail investors are caught between the two stages, subsidizing the institutional investors, sponsor, and target stockholders throughout the process. Retail investors are a sponsor’s best friend, and the trend to attach celebrities to SPACs is a brazen attempt by sponsors to seduce more retail investors.
This assessment of SPACs has implications for policymakers. The UK has recently amended its rules notionally to attract more SPACs to London. Traditional UK SPACs were different from their U.S. brethren. The UK regulators had required that trading of SPAC shares be suspended upon the announcement or leak of an acquisition by a listed SPAC. The rationale was that potential investors would not have sufficient information to make a well-informed decision as to the merits of the transaction. However, the requirement had the consequence of locking in existing investors, whether they approved of the transaction or not. As a result, UK SPACs represented genuine long-term investment vehicles. IPO investors, almost entirely institutional investors, would subscribe to SPAC shares based upon their faith in the sponsor and its management team with a view to remaining invested post-acquisition. Sponsors had to be more circumspect with their promotes to attract sophisticated longer-term investors, and performance-related remuneration structures were common. With little need to attract short-term hedge funds at the time of an IPO, listed warrants and redemption rights were rare. Without the interest of short-term investors, traditional UK SPACs were, on average, small with little liquidity, and, as in the U.S. (although for different reasons) relied upon PIPE investments and debt to complete acquisitions.
Although those UK SPACs were benign creatures, the trading suspension requirements very much hampered their proliferation (in the same way that U.S. regulations cut penny-stock blank-check companies off at the knees in the 1990s), and the UK regulators viewed the SPAC explosion in the U.S. with envy. As such, in August 2021, the UK’s Listing Rules were amended to provide that the suspension presumption would be waived if a SPAC adopts “investor protection” mechanisms. Those mechanisms are very similar to the market standard terms adopted by U.S. SPACs, including redemption rights for public shareholders, ring-fenced IPO proceeds, and a finite time for acquisition completion. Unsurprisingly, the first UK SPAC to take advantage of the new rules issued listed warrants, and incorporated many of the terms seen in the U.S. The SPACs are coming to London.
Exchanges around the world are grappling with a decline in publicly listed companies. Accordingly, the UK is not alone in craving SPACs. However, it is peculiar that exchanges covet the modern U.S. SPAC, which is not a long-term investment vehicle in the traditional sense, but more a financial instrument that gives hedge fund and sponsor returns priority over retail investor health. While in the U.S. regulators have once again shone a bright light on SPACs, with the SEC scrambling to curtail their excesses, the UK in contrast seeks to liberalize the SPAC market. In my paper, I canvass some of the possible policy approaches that could mitigate the more extreme nuances of SPACs, but ultimately argue that SPACs may not be worth the effort. Reforming the regime applicable to traditional IPOs would better resuscitate the equity markets rather than encouraging an artificial loophole to IPO mechanics that represents a retail investor’s worst nightmare.
This post comes to us from Bobby V. Reddy, an assistant professor of law at the University of Cambridge and a former corporate partner at Latham & Watkins LLP. It is based on his recent paper, “The SPACtacular Rise of the Special Purpose Acquisition Company: A Retail Investor’s Worst Nightmare,” available here.