SPACs and PIPEs as Efficient Tools for Corporate Growth

A SPAC can be understood as an alternative to an IPO, with investors using a large investor, a PIPE, to find out whether the SPAC founder has really chosen a good target or is simply rushing to get a big payoff before investors must be repaid. The PIPE is an expert that gets paid to certify a SPAC, and it is compensated accordingly.

While many sophisticated observers believe that SPAC shareholders receive a bad bargain because their shares are subject to dilution, there is less of an argument to be made for protecting target management from aggressive sponsors. The relevant gap for assessing the target’s bargain is the difference between the value of all of the securities delivered by the target and the amount of cash delivered by the SPAC. Computed in this manner, targets generally do well post-merger. According to recent estimates, the costs of accessing public equity markets are actually less with a SPAC than with an IPO in terms of the accessing firm’s market capitalization, valued one year from the date of the merger or offering (and adjusted for growth in the market).

This is consistent with the suggestion that sponsors provide significant expertise, and they often become part of targets’ management. A SPAC is  a chain of several important tasks, including accumulating capital, discovering a target, validating the discovery, finding further financing, and then managing the target. SPACs have evolved as a sensible way to link several steps in a process of business formation that can appeal to public investors. In this chain, PIPEs not only provide capital when many earlier investors depart, but they do so in a way that certifies SPACs’ good judgment.

This tidy description of the reward system surrounding a SPAC’s formation suffers, however, from a serious problem. The preferential stock prices paid by the sponsor and then by the PIPE seemingly eliminate any signal to the small investor. These intermediaries may well be paid for their evaluations and management services, but how do investors know that the sponsor and PIPE are not being overpaid or, what is the same thing, that the SPAC is a good investment at the higher price required of the common investor? For example, a PIPE that acquires shares at a price of $8 each is not really telling investors that the investment available to them at $10 a share is worth that amount or more. The PIPE could think it is worth $9 in terms of the present value of future profits, and indeed could be counting on the profit produced by innocent investors who are paying $10.

To see this problem and its solution, consider a buyer who is deciding whether to purchase a Toyota or a comparable car from Honda. Typically, the cars look alike, come with similar features, and are available at very similar prices, with comparable warranties. A given buyer has neither time nor reason to invest much in evaluating the car. But now imagine that the individual buyer can observe that a much larger buyer, like the Avis car rental company, has contracted to buy 3,000 of the Toyota vehicles. Avis will know much more about the vehicles than a single buyer. To be sure, Avis’s sizeable transaction will give it a better per-vehicle price than what is available to an individual, and the fact that Avis buys the car gives it yet further bargaining power with Toyota. Both know that Avis’ choice allows many potential buyers to sample the car as a rental, and both know that Avis’ choice tells potential buyers that a very sophisticated buyer has chosen Toyota over Honda.

Still, we have the same problem as before; if the car is available at $25,000, but Avis is expected to pay a discounted price of, say, $22,000, the typical buyer might reason that Avis values the car at about $23,000 and would not buy the car at the $25,000 price required of the typical purchaser. The trick, however, is to recognize that, since Avis is better informed and chooses Toyota – when it could also have chosen Honda and received a similar discount – the one-off buyer does learn something from Avis’ decision. It is also the case that Avis has no direct means of charging one-off buyers for its information; the presence of new Toyota cars can be observed at no cost in Avis’ lots, and the only way Avis can obtain some compensation for its evaluation effort and information is in the form of a better price from Toyota, which will then benefit from making more sales or obtaining a higher price from consumers. Avis’ decision to buy from Toyota and not Honda provides information to the consumer, even though the typical consumer cannot obtain the better price available to Avis.

Similarly, a PIPE has numerous firms in which to invest. It may even have multiple sponsors with which to partner. The fact that a PIPE chooses a given sponsor, when combined with the SPAC’s selection, provides valuable information to relatively ignorant investors. And this is so even though the common investors cannot join in at the same price per share available to the PIPE. The PIPE is in this way rewarded for its investigative efforts and for the information it provides smaller investors.

Note the similarity to other markets. When Berkshire Hathaway purchases a sizeable chunk of a publicly traded stock, other investors who are relatively ill-informed know that an informed investor has found an investment that they can now wisely grab. The large investor has found an opportunity, as a SPAC claims to have done.

There might be substitutes for SPACs and PIPEs. If law allowed prediction markets to flourish, would PIPEs, and therefore SPACs, disappear? Probably not, because one calls on single well-equipped investigators who inform the market, while the other specializes in cases where there are numerous well-informed parties who would convey information if they had an opportunity to profit even just a little without risking much on their own.

Insurance offers a more likely, and lower cost, substitute for PIPEs. It might be offered by third parties, in which case it too depends on a limited number of well-informed players. But small investors must be confident that the insurer is reliable in the event of a loss, and this might require regulation of its own. If the insurance is provided by the SPAC itself, as a side product, smaller investors might be offered the choice of buying with or without what might be called a warranty as easily as insurance. A warranty offered by a seller is not normally subject to regulation.

It should be clear that the development of SPACs and PIPEs should not have been unexpected. Smaller investors everywhere need guidance from larger ones that have reason to invest in gathering information about their targets. These intermediaries are compensated in a variety of ways. It is possible that SPACs will offer a kind of warranty, or insurance, to risk averse and ill-informed small investors they hope to retain or attract. It is even possible that a prediction market will develop so that informed parties without much capital to invest will have a means of profiting from their knowledge. Whether this is a desirable development or an opportunity for a new form of unhealthy insider trading remains to be seen.

This post comes to us from Frank Fagan at EDHEC Business School and Saul Levmore at the University of Chicago Law School. It is based on their forthcoming article, “SPACs and PIPEs as Efficient Tools for Corporate Growth,” available here.