Special Purpose Acquisition Companies (SPACs) – which are listed investment vehicles for bringing private companies onto the stock exchange through mergers, as an alternative to traditional IPOs – have exploded in volume and popularity over the past two decades. last years. As of 2020, 248 PSPCs were listed on the stock exchange for an average listing size of $ 336 million and a total amount of capital raised of $ 83 billion. In contrast, in 2021, 613 SAVS listed at an average listing value of $ 265 million and gross proceeds of $ 162 billion. There are currently 575 listed SAVSs actively seeking target companies to merge with, and in 2021, 312 mergers were announced and 199 mergers were completed with a gross value of over $ 450 billion.
All of this activity catches the attention of investors, but too many of them fail to understand that SPACs are very complex investment vehicles that primarily benefit everyone involved in the merger transaction, except for those involved in the merger transaction. retail investors themselves. Therefore, it is imperative that investors understand the finances of SPACs before investing in them.
The life of a SPAC
PSPCs are publicly traded shell companies for the sole purpose of targeting and merging with a private operating company, with the target then listed. The raison d’être of PSPCs is that they provide private companies with a faster, easier, and more secure way to become public compared to a traditional IPO.
The life cycle of a PSPC is simple. PSPC is incorporated, publicly traded, searches for a target to merge with and negotiates a merger agreement, which is then voted on by PSPC shareholders; if approved, then PSPC merges with the target company. As soon as a PSPC closes its merger, the target company is listed, replacing the front company SPAC on the stock exchange. Note that once listed, the SPAC has two years to merge with a target or it must be liquidated.
At the beginning of its life, the PSPC proceeded to an IPO by selling shares at $ 10 each. A unit consists of one SPAC share and usually a fraction of a warrant, which gives the owner the right to purchase one SPAC share at $ 11.50 after the SPAC merger. with its target. After listing, PSPC simply keeps the money received from its IPO in a trust account. The trust can only be drawn down at the end of its merger with a target company, except under very specific conditions. After the approval of a merger agreement, if the shareholders of the SAVS do not believe that the merger will create value, they can buy back their shares of the SAVS for $ 10, if they wish, while retaining their shares. subscription warrants.
Problems with PSPCs
The intricate details of SPAC can put unwitting investors at risk. Naive investors lose out because of three main issues with PSPCs: misaligned incentives, dilution of shareholder value, and the cost of PSPC registration.
Each SAVS has a founder who manages the SAVS from its inception until the completion of the merger. The founder of PSPC receives 20% of the outstanding shares of listed PSPC at minimal cost as compensation for the establishment and management of PSPC. It is important to note that these Founder’s Shares are different from listed shares sold to investors, in that Founder’s Shares cannot be traded until a merger is consummated.
Because their actions do not pay off unless a merger is completed, there is a strong incentive for the founders of PSPC to merge with a Target even if it is a losing proposition, with the costs inherent in PSPC being passed on to the shareholders who do not buy back their shares. . We see it in the data, where a majority of shareholders will vote for a merger, but buy or sell their shares nonetheless. In a recent study, the median buyout rate of institutional investment managers was 73%, while an additional 25% sold their shares, for a total divestment rate of 98% before the merger.
Some have claimed that listing through a SPAC is cheaper than a traditional IPO. Another new study calculated that the median cost of a PSPC listing was 14.6% of target market capitalization after the merger, compared to the cost of a traditional IPO of 3.2%. The reason the founder and target company accept this is that they do not bear the costs of a PSPC listing; instead, the costs are borne by investors who do not redeem their shares.
Often, in order to complete a merger, it is necessary for the founder to raise additional capital by selling shares to new shareholders after the IPO. A study found that these new shareholders bought at a median 5.5% discount from the initial $ 10.00 value of a SPAC share, and in 37% of SPACs, at a 10% discount or more. Again, these costs are passed on to the non-redeeming shareholders.
Ultimately, due to misaligned incentives, founders often pay a premium for their merger goal by providing sweeteners for the target company and passing the costs onto non-redeemable shareholders. This premium covers the cost of the original PSPC registration and incentives to ensure that a merger is completed. But this is where unwitting investors can really feel the pinch: After a merger closes, when the founder’s shares start trading and warrants can be exercised, non-redeeming shareholders often see their positions. devalued. Research shows that this devaluation averages 25.2%, dropping from the PSPC stock price of $ 10 to an average of $ 7.48.
It is only if the founders buy a target for less than its true value that a surplus will be created for ignorant PSPC shareholders who do not buy back their shares. Typically, due to the incentives built into SPACs, the opposite is true, forcing founders to acquire the target at a higher price, thus reducing the value left to unwary investors.
Studies have shown that post-merger stock prices of listed targets ultimately drop over time, with post-merger returns for non-redeeming shareholders underperforming the market by a median of 49.3% for mergers taking place. in a 2019-20 sample through November 2021, when PSPC founders’ returns were positive by 198%, and average returns from new investors who helped fund the merger underperformed by 8%. For investors who redeemed their shares prior to the merger, returns averaged 11.6%, primarily due to the value of the warrants. Of course, a minority of PSPC make money, which turned out to be related to the quality of the founder of PSPC and the investment bank that signed up for the IPO.
PSPCs are actually more convoluted and complex than explained above, with structures that essentially mask their built-in costs and can trap unsuspecting investors. Overall, typical retail investors should avoid investing in SPACs unless they can spend the time necessary to understand the finances behind them; otherwise, the best advice is to avoid investing in after-sales service.