How SPACs Disable Indirect Investor Protection

Special Purpose Acquisition Companies (SPACs) are a trap for unwary investors. In standard public equity securities, even the most naïve investor is protected, first, by the market price – you pay only for what you get – and, second, by the comfort that nothing else is required of an individual investor to realize the full value of the security. SPACs disable both protections. Because of SPACs’ redemption option, SPAC shareholders need to do something – decide whether to redeem – and cannot rely on the market price to ensure they are getting value for their money. Predictably, sophisticated repeat players have done well in this game, while less sophisticated players, including retail investors, have done very poorly. We explain this in our recent paper, The SPAC Trap: How SPACs Disable Indirect Investor Protection, which we summarize here.

Let’s take a step back and consider normal equity securities available in U.S. securities markets – not SPACs. Remarkably, they can be safely bought and held even by investors who understand nothing of the securities’ terms and the underlying business.The underlying mechanisms are what one of us has called “indirect investor protection” – protection that does not rely on the investors themselves or on their agents to be effective.[1] The most important such mechanism is simply the market price. It is generated by competition for mispriced securities between traders who do understand the underlying terms and business. These traders will snatch up any security that is priced too low, and happily (short-)sell any security that is priced too high. This keeps those securities’ prices close to their fundamental value, i.e., their expected discounted long-term payoffs. At the right price, no investment is a bad investment. And once investors have bought a standard security, they do not need to do anything to preserve the value of their investment.

SPACs disable indirect investor protection and thus set a trap for unwary investors. SPACs do this by offering two alternative payoffs from the same security, the SPAC share, through its redemption option. The immediate effect is to force investors to do something, namely decide whether to redeem. Empirically, in the vast majority of SPACs, the right choice – that sophisticated investors made, and that generated far higher payoff – was to redeem, whereas most unsophisticated investors appear not to have redeemed.[2] Effectively, SPACs have thus decoupled the payoffs received by sophisticated and unsophisticated investors. This also disables indirect protection by the market price. Put bluntly, the market prices the higher payoff received by sophisticated investors, whereas unsophisticated investors get the other, lower payoff. Unsophisticated investors thus systematically overpay for SPAC shares. Their overpayment is captured, directly or indirectly, by sophisticated players: SPAC sponsors and SPAC IPO investors. This allows the latter to make money from SPACs even if SPACs create no or even negative social value.

To preview the more detailed explanations to follow, here is the scheme in a nutshell. Under the terms of a SPAC, its shareholders can elect to redeem their shares for their IPO price of $10 (plus interest) if and when the SPAC merges with a target (the “acquisition” that the SPAC is set up for). The redemption value sets a floor for the pre-merger SPAC share price: Sophisticated traders know that a share includes a right to receive $10, so the share trades at $10 or more. But that floor is too high for those who will never exercise that right, instead retaining a share of the post-merger company: The average value of post-merger shares has empirically been far below $10. Thus, investors who buy at the market price of $10 or higher without intending to redeem systematically lose money. Of course, the losing investors’ money does not evaporate: It is directly or indirectly captured by the SPAC’s sponsor and IPO investors, in ways we explain below.

Let’s spell this out in a stylized numerical example of a typical SPAC. Our SPAC issues 25 million shares: 5 million to the sponsor for zero consideration, and 20 million to investors in its IPO for $10 each. The IPO investors’ cash consideration is invested in treasury securities in a trust account. For simplicity, we assume that the treasury rate is exactly zero. Thus, after the IPO and until the de-SPAC, our SPAC has 20×106×$10=$200 million in its trust account. Within the two-year deadline, our SPAC proposes a de-SPAC. A majority of SPAC shareholders other than the sponsor vote in favor, but 75 percent of them elect to redeem and obtain their $10 cash per share. This leaves 10 million SPAC shares outstanding, half of them held by the sponsor, and 5×106×$10=$50 million in the trust account. Under the merger agreement, target shareholders obtain 40 million shares. After the de-SPAC, the shares trade for $5 per share. Thus, this SPAC turns out to be a terrible deal for non-redeeming shareholders who bought their shares for $10 each in the IPO or later: They lose half their investment.

Losing money is nothing unusual in financial markets. But here’s the kicker: SPAC investors lose money even if the market perfectly anticipates the subsequent price decline. Imagine every sophisticated player knew from the get-go that the post-de-SPAC share would be worth $5. Nevertheless, the SPAC shares would have traded at $10 or more between the IPO and the de-SPAC. If not, sophisticated traders would immediately snap it up because they would earn a certain profit of $5 by buying for $5 and redeeming for $10. Put simply, the SPAC share includes a right to receive $10, so it trades at $10 (or more). The market is efficient – but it prices the cash flows that will accrue to sophisticated investors who know they can and should redeem.

Here’s another kicker: The sponsor and sophisticated investors in our SPAC make money – even if the SPAC created zero social value, i.e., even if the post-de-SPAC market capitalization is not more than the pre-de-SPAC cash in the SPAC plus the value of the target as a private company. After the de-SPAC, our sponsor has 5 million shares worth $5 each, or $25 million total. Thus our sponsor makes money assuming—realistically—that the cost of setting up the SPAC is less than $25 million. Redeeming shareholders at least break even (and may do better if they hold warrants). Our sponsor and redeeming investors can make money simply because the non-redeeming shareholders’ loss is their gain. Perhaps it is no wonder that SPACs have been amazingly popular with certain investment professionals.

ENDNOTES

[1] See generally Holger Spamann, Indirect Investor Protection: The Investment Ecosystem and Its Legal Underpinnings, 14 J. Leg. Analysis (forthcoming 2022).

[2] That redemption is the better choice in the vast majority of SPACs is probably not coincidental. As explained in our full SPAC Trap paper, promoters have incentives to set up a SPAC even though they do not expect the SPAC to find a valuable merger opportunity that would make SPAC shares worth more than their redemption value. We should thus expect many such SPACs to be formed.

This post comes to us from Professor Holger Spamann at Harvard Law School and Hao Guo, LLM ’22, Harvard Law School. It is based on their recent paper, “The SPAC Trap: How SPACs Disable Indirect Investor Protection,” available here.

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