SPAC Mania 2020: No Free Lunch at Wall Street

Being around since the 1990s, SPACs (Special Purpose Acquisition Companies) have become cool once again. SPACs are defined by some as a smart financial innovation that provides a cheaper and faster path to becoming a public company and as one of the hottest asset class in the markets. Others describe this model as a hazardous invention, designed to generate significant returns for canny financers while shifting risk to less conscious retail investors. Milos Vulanovic, a finance professor at EDHEC Business School who has studied the structure for years claims “overall, investing in a SPACs is like flipping a coin, where only half of them is shown to be value-creating”.

Overview of the SPAC Structure

SPACs are investment vehicles generally constituted by sponsors or investors with expertise in an industry or a business sector. These vehicles have no real operations, their only asset being the capital that is raised with the sole purpose of buying a significant stake in another (typically private) company.

The structure of SPACs allows investors to contribute money towards a fund without any specific knowledge of how their capital will be used. For this reason, they are also known as blank-check companies. Sponsors of the SPAC usually also invest in the transaction, contributing to the total capital raised. After the SPAC raises money through an IPO, the capital is placed in an interest-bearing account and cannot be distributed, except to complete an acquisition or to return the initial investment to investors if the SPAC is liquidated. Usually, a SPAC has 24 months to identify the target and complete the business combination, otherwise, it will face liquidation.

One of the main reasons why corporations look to go public via SPAC as an alternative to a traditional IPO, is efficiency. SPAC deals could be completed faster. SPAC transactions do not require a roadshow for potential investors, because the SPAC is already a public company. Furthermore, SPACs allow for a relatively simpler and less time-consuming regulatory process, having simpler financials. Finally, efficiency via SPACs is even negotiation-related. Instead of having to negotiate with a multitude of investors as in a traditional IPO, companies going public via SPAC negotiate only with the acquirer party, the SPAC itself, in a relatively more discrete way.

To better understand the economics of these vehicles, a key point to analyze is the structure of the shares issued by a SPAC, commonly noted as “units”. These units, usually priced at $10 each, are made of redeemable shares and warrants[1] (with a strike price at $11.5). The unit initially trades as a single security, but its component securities are usually allowed to trade separately 52 days after the IPO (meaning that an investor receiving a unit can gain from the sale in the aftermarket of both common shares and warrants). In other words, shareholders that do not approve the proposed merger can be refunded of their full initial investment (with interest), plus they have the right to keep the warrants included in the units (for free). 

Does this efficiency come at a cost?

These distinctive terms, designed to attract IPO investors and make them “park” their cash to the SPAC for two years, seem to have generated an average annualized return of 11.6% for redeeming investors, virtually as a no-risk trade. Recent research suggests that typically 75% of the shares initially issued by SPACs are redeemed. Looking in particular at SPACs that merged between January 2019 and June 2020, over a third had redemptions over 90%, this meaning that a consistent amount of cash invested by original investors is refunded with the mechanism previously described. Indeed, SPACs frequently raises additional financing through PIPE[2] deals, partially used to replenish some of the cash paid out to the shareholders who redeemed their shares.

A second element regarding SPACs’ return is commonly known as founders “promote”. Typically, SPAC sponsors compensate themselves with a generous amount of shares equivalent to 20% of the SPAC’s post-IPO equity, paying a nominal fee (usually $25,000). Sponsors received this lucrative reward in exchange for their expertise, time, and effort in finding an attractive target company. Finally, on top of that, while completing the initial IPO procedure, SPACs pay an underwriting fee to an investment bank. It is worth noting how this fee is based on the IPO proceeds, even though the majority of these shares will be redeemed from investors.

This peculiar route is usually taking place in the two years before the IPO inherently generates aggressive dilution in the SPAC shares and is the main factor of SPAC-related costs and poor post-merger performance. Indeed, through the mechanism of share redemption, founders promote allocation to sponsor and underwriting fee paid to the underwriter, SPACs pay cash and give shares, warrants, and rights to parties that do not contribute any form of cash to the eventual merger.

The median SPAC-related dilution founded by researchers[3] has amounted to an astonishing 50.4% of cash delivered in a merger. To rephrase it, for each share supposedly worth $10, there is $6.67 in cash backing these shares and $3.33 accounted for dilution. The value that must be generated for the SPAC and the target company shareholder finally break-even is 14.1% of the post-merger company. If this does not occur, the ultimate SPAC shareholders or the target shareholders (or both) will bear the dilution cost.

Following the median SPAC data above, while pricing the merger deal, a clever target shareholder should be well aware of this mechanism. To close an even deal and price its share in the post-merger company at least equal to its estimation of the pre-merger value, a target shareholder should agree to merge only if she pays no more than $6.67 per share. Consequently, shares in the combined entity would drop to $6.67 post-merger. If this happens, the target shareholder will have an even deal and SPAC founders will bear the dilution cost. Otherwise, the target shareholder will absorb the dilution cost, unless an adequate surplus is created from the SPAC in the future. In line with this reasoning, data from SPACs going from January 2019 and June 2020 suggest overall median negative 14.5% returns. However, among the overall universe of SPACs, there seems to be a subset that has consistently done well. These are SPACs having as sponsors established Private Equity Funds with more than $1 bn AuM or former CEOs or senior officers of Fortune 500 companies, generating higher returns and providing lower dilution.

Two sides of the coin

Unfortunately, in the SPAC history book, we have junky examples. One is Modern Media Acquisition Corp, a SPAC with $200 m in cash, which announced in 2019 its combination with Akazoo, a Greek music streaming service that already in the past had billed itself as the Spotify of emerging markets.  The deal was involved in massive accounting fraud. Akazoo’s 5.5m subscribers didn’t exist and the company was targeted as a short-selling trade, losing Modern Media’s backers their entire investment. 

Luckily, not all SPACs are born evil. For the sake of a more transparent financial word, we also have cases as Diamond Eagle Acquisition Corp, the SPAC which not only made public the sport betting giants DraftKings, but also merged it with gaming software company SBTech, creating the only vertically integrated U.S. sports betting and online gaming company. With a $49.25 stock price as of 04 December 2020 and a $19.3 bn market capitalization, this example of the elegance of a well-designed SPAC transaction is among the most highly valued companies to be listed through a SPAC merger.

Other positive signs from the SPAC world come from some notable investors, which publicly affirm of having finally introduced fairer SPAC deals. Among these, there’s activist investor Bill Ackman, whose SPAC Pershing Square Tontine Holdings is the biggest ever raised with $4 bn and is shopping for megadeals. He has promised much less dilution to its shareholders, eliminating the controversial founder promote. “The problem with the typical founder-shares arrangement is not just the outsized nature of the compensation or the inherent misalignment of incentives, but also the fact that the massively dilutive nature of founder stock makes it difficult to complete a deal on attractive terms,” says Ackman.

To wrap it up, SPACs are not a straightforward deal and 2020 is already defined by some as the SPAC bubble year. In the last eleven months, more than 178 SPACs went public, and a sizable $65 bn have been raised, being this one of the strongest waves ever registered (more of the last ten years’ worth of such deals combined). Innovative and efficient in appearance, from a closer look these vehicles resemble more a puzzling and far than certain investment tool, that should be handled with care.

Authors: Eugenio Molinatti, Seint Shin Ne Myo, Giuseppe Bucalo

Sources:

[1] Derivatives that give the right, but not the obligation, to shareholders to buy new shares of the SPAC at a pre-determined price, commonly referred to as strike price

[2] Private Investments in Public Equity, involving the selling of publicly traded common shares or some form of preferred stock or convertible security to private investors

[3] Michael Klausner (Stanford University), Michael Ohlrogge (NYU), and Emily Ruan (Stanford University): A Sober Look at SPACs, 19 November 2020

https://www.ft.com/content/6eb655a2-21f5-4313-b287-964a63dd88b3

https://corpgov.law.harvard.edu/2020/11/19/a-sober-look-at-spacs/

https://russellinvestments.com/us/blog/investing-spacs

https://www.winston.com/images/content/1/3/v2/135061/Winston-Strawn-SPAC-Basics-Presentation-2018.pdf

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