Once heralded as the “hottest thing in finance,”[1] special purpose acquisition company (SPAC) IPOs accounted for more than 60 percent  of all IPO activity in 2021[2].  But the SPAC market cooled significantly in 2022, leveling off in the following years to what seems to be a steady state with a significant presence offering unique opportunities.[3]

Yet SPACs also face significant challenges, particularly from regulators calling for improved disclosures and shareholder lawsuits intent on reining in self-serving sponsors, who are compensated with large blocks of stock known as the sponsor “promote.” These challenges are encapsulated by a recent case involving Churchill Capital III and its intended target, Multiplan, where sponsors were able to benefit at the expense of non-redeeming shareholders.

In a recent paper, we construct a model to explore the dual nature of SPACs, addressing both their challenges and opportunities. Our model focuses on the rich strategic interactions surrounding a proposed business combination.  The SPAC sponsor identifies a target company and offers to enhance its value via cash, a public listing, and possibly industry or management expertise. The surplus created is then split via bargaining, with the sponsor and target negotiating deal terms that specify the sponsor’s compensation, the offer to the target, and any additional capital to be raised. Sponsors and targets must consider how their negotiated terms will affect the likelihood of deal completion, which in turn depends on the redemption rate chosen by SPAC shareholders. Sponsors and targets face a trade-off: Pushing for more favorable terms brings immediate gains at a heightened risk of deal failure due to elevated redemption levels, while more shareholder-friendly terms can mitigate this risk.

Lesser-informed SPAC shareholders must infer their expected returns based on public and private signals. The public signals include proposed deal terms and sponsor reputation. Shareholders decide whether to redeem their shares at face value or retain ownership beyond the de-SPAC. High redemption rates deplete the SPAC of cash, jeopardizing deal completion.

Our model features an equilibrium where decisions are jointly determined and rationally anticipated by all parties. When the sponsor and target negotiate deal terms, they account for anticipated redemptions from less informed shareholders. Similarly, shareholders base their redemption decisions on the deal terms they observe, which are set by the sponsor based on potentially misaligned incentives. As a result, the sponsor’s agency costs and shareholders’ information frictions play crucial roles in shaping how value is created and distributed in de-SPAC transactions. This equilibrium framework enables us to explore counterfactual scenarios where changes in these key frictions alter the interaction between deal terms design and shareholder inference, which, in turn, collectively influence the total value created in this market and how that value is shared among players.

To gauge the quantitative implications, we bring the model to the data through a structural estimation. We assemble a comprehensive dataset of U.S.-listed SPACs and the deal characteristics for SPACs that completed acquisitions between 2010 and March of 2022. A feature of our data that differentiates our work from previous studies is that the data contain details of sponsor compensation, external financing brought in by the sponsors, shares and cash offered to the target shareholders, and the aggregate redemptions of SPAC shareholders. Though most previous studies focus on SPAC returns, our data allow us to answer questions related to agency costs and information frictions embedded in SPAC contracts. To our knowledge, our paper is the first to construct and estimate a viable model of SPACs with these frictions.

In our model, redemptions are negatively correlated with later (post-deal) performance, suggesting that SPAC shareholders can partly infer deal quality based on the public and private information they observe. The estimated model reflects shareholders’ inference: Sponsors’ forfeiture of promote shares portends low shareholder returns; external capital raised certifies deal quality; and generous offers made to targets warn of potential over-payment. Sponsor reputation strongly correlates with deal quality but only weakly relates to agency costs.

We report several novel findings that call into question prevailing notions about the SPAC market. First, we find that SPACs, on average, create significant value for the economy by effectively screening and bringing high-potential targets to public markets. This value creation is substantial, amounting to approximately 24 percent of the targets’ standalone value, on average, in contrast to the popular belief that SPACs merely transfer wealth from uninformed investors to sponsors and targets. Moreover, this finding suggests that SPACs add substantial value by facilitating access to public markets: enlarging the set of firms that can access public markets and  expanding the ways firms gain a public listing.

Second, our analysis suggests a more balanced view of shareholder returns. While non-redeeming shareholders have experienced average losses of 9 percent, the overall picture changes when factoring in redemptions and the returns to redeeming shareholders. We estimate that, on average, SPACs generate shareholder gains of 2.4 percent when including both redeeming and non-redeeming shareholders. This discrepancy is driven by the redemption option, which allows shareholders to exit if they sense a poor deal is in the offing. We find that in deals that turn out to be less attractive, more shareholders redeem, leaving fewer to incur large losses and greatly diminishing value destruction. Conversely, in more promising deals, a larger number of shareholders remain invested and potentially earn substantial returns. This pattern underscores why focusing solely on non-redeeming shareholder returns gives a misleading picture of overall shareholder welfare.

To explore potential improvements to the SPAC structure, we use the estimated model to examine several policies debated by regulators and practitioners. The first is to tie sponsor promote shares to performance, known as earnouts, where shares subject to earnout provisions are canceled if the post-de-SPAC stock price fails to reach a predetermined price. The second policy involves limiting the number of dilutive warrants issued in a SPAC IPO, and the third focuses on increasing disclosure in deal prospectuses, with the aim of reducing information asymmetry among shareholders, sponsors, and targets.

We conduct these policy experiments by constructing counterfactual economies, altering the fraction of the sponsor’s promote that is tied to earnouts, limiting warrant issuance to varying degrees, and increasing the precision of shareholders’ private signals in differing amounts. Our findings reveal that tying the sponsor’s promote to performance via earnouts significantly improves shareholder returns: For every 10 percent increase in the fraction of sponsor promote tied to earnouts, non-redeeming shareholder returns increase by 1.8 percentage points. This improvement stems from both increased value creation and a reduced stake allocated to sponsors, helping to curb conflicts of interest between SPAC sponsors and shareholders. In contrast, curtailing warrant usage does little to mitigate agency costs, while increasing disclosure isn’t effective unless it increases the precision of shareholders’ private signals to an unrealistic extent.

Our findings provide a more comprehensive understanding of the SPAC market’s impact and efficiency, challenging the popular belief that SPACs destroy value on a massive scale. Instead, we offer a more nuanced view, showing that SPACs on average do create value despite the mixed returns to their investors. The critical issue is that the distribution of such value is uneven, with targets and sponsors capturing the lion’s share. In other words, bad deals for the investors are typically not caused by a lack of value creation, but by uneven value distribution that disfavors the investors.  Our policy experiments suggest a remedy: encouraging SPACs to tie more of the sponsor’s promote shares to performance.

ENDNOTES

[1] Wall Street Journal, January 23, 2021.

[2] In 2021 there were 613 SPAC IPOs in the U.S. raising close to $220 billion of new capital.

[3] As equity markets sold off broadly and the market for traditional IPOs cooled, SPACs remain active: In 2022 and 2023, more than one third of IPOs were SPACs. Moreover, in a more apt comparison, completed SPAC business combinations (so called de-SPACs) were nearly as common as traditional IPOs as a means of going public in 2022 and 2023: of the 414 private companies that went public in those years, 210 used a traditional fixed-price IPO, and 200 went public via a SPAC.

This post comes from Felix Feng at the University of Georgia, Tom Nohel at Loyola University of Chicago, Xuan Tian at Tsinghua University, Wenyu Wang at Indiana University, and Yufeng Wu at Ohio State University. It is based on their recent paper, “The Incentives of SPAC Sponsors,” forthcoming in the Journal of Financial Economics and available here.