Special Purpose Acquisition Companies (SPACs) — which are listed investment vehicles for taking private companies public through mergers as an alternative to traditional IPOs — have exploded in volume and popularity over the past two years. in 2020, 248 SPAC listed on public exchanges has an average listing size of $336 million and total capital raised of $83 billion. In contrast, in 2021, 613 SPACs listed at an average listing price of $265 million and gross income of $162 billion. are currently 575 Listed SPACs that are actively looking for companies targeted for mergers and, in 2021, 312 mergers were announced and 199 mergers completed with a gross value of over $450 billion.
All this activity is catching the attention of investors, but what many of them fail to understand is that SPACs are very complex investment vehicles that mostly benefit everyone involved in a merger deal—except the retail investors themselves. Therefore, it is important that investors understand the finances behind it before investing in SPAC.
Life of a SPAC
SPACs are exchange-listed shell companies with the sole purpose of targeting and merging with a private operating company, making Target listed. The rationale for SPACs is that they provide private companies with a faster, easier, and more certain way of doing public business than a traditional IPO.
The lifecycle of SPAC is straightforward. SPAC is incorporated, listed on an exchange, seeks a target for merger, and negotiates a merger deal, which is then voted on by SPAC shareholders; If approved, the SPAC merges with the target company. Once a SPAC closes its merger, the target company is listed, replacing the SPAC shell company on the stock exchange. Note that, once listed, SPAC has two years to merge with Target or it should be liquidated.
Early in its life, SPAC conducts IPOs by selling units at $10 each. An entity holds a share of stock in SPAC and usually a fraction of warrants, which give the owner the right to purchase SPAC shares for $11.50 once the SPAC merges with its target. After its listing, SPAC only keeps the cash from its IPO in a trust account. Except in very specific circumstances, a trust cannot be attracted until it closes its merger with a target company. After the merger deal is approved, if SPAC shareholders do not think the merger will create value, they can redeem their shares from SPAC for $10, if they wish, while holding their warrants.
Issues with SPACs
The complex details of SPAC can put unintentional investors at risk. Naive investors lose out because of three main issues with SPAC: wrongful incentives, dilution of shareholder value, and the cost of SPAC listings.
Each SPAC has a founder who manages the SPAC from inception until the merger is complete. The founder of SPAC receives 20% of the outstanding shares of SPAC listed at minimum cost as compensation for the creation and management of SPAC. Importantly, these founding shares differ from listed shares sold to investors in that the founder shares cannot be traded until the merger ends.
Since their shares do not pay off until the merger closes, SPAC founders have a strong incentive to merge with Target, even if it is a losing proposition, with the underlying cost of SPAC being passed on to those shareholders. who do not redeem their shares. We see this in data, where the majority of shareholders will vote for a merger, but will still redeem or sell their shares. recently Study, the average redemption rate for institutional investment managers was 73%, while an additional 25% sold their shares, for a total pre-merger rate of 98%.
Some have claimed that getting listed through SPAC is cheaper than a traditional IPO. another new Study Calculated that the average cost of a SPAC listing was 14.6% of the post-merger target market capitalization, compared to the cost of a traditional IPO of 3.2%. The reason the founder and the target company accepted this is because they do not bear the cost of the SPAC listing; Rather the cost is borne by the investors who are unable to 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 It was found that these new shareholders bought SPAC shares at an average discount of 5.5% of the original $10.00 value, and 37% of SPAC at a 10% discount or more. Again, these costs are passed on to the non-redeeming shareholders.
The bottom line is that, because of the wrong incentives, founders often pay a premium to their merger goal by providing sweetness for the target company and inflating the cost to non-redeeming shareholders. This premium covers the cost of the original SPAC listing and the incentive to ensure the merger. But here’s where uninformed investors can really feel the pinch: After a merger closes, when the founder shares begin trading and warrants can be exercised, non-redeeming shareholders often have their positions devalued. it happens. Research This shows that the depreciation averaged 25.2%, with the SPAC share price averaging $10 to $7.48.
Only if the founders purchase a target at a discount to its actual value, will any surplus be created for uninsured SPAC shareholders who do not redeem their shares. Typically, the opposite is true, due to the incentives inherent in SPACs, which cause founders to achieve targets at a premium, thereby reducing the value left for unsuspecting investors.
Studies have shown that post-merger share prices of listed targets eventually fall over time, with below-average market-performing returns to non-redeeming shareholders after the merger. 49.3% For mergers taking place in the 2019-2020 sample as of November 2021, while the return to SPAC founders was a positive 198%, and new investors helping to finance the merger, the average return was lower at 8%. For investors who redeemed their shares before the merger, an average of 11.6% returns, mostly due to the value of the warrants. Of course, a minority of SPACs make money, which has been shown to be related to the quality of the investment bank that founded SPAC and underwrites the IPO.
SPACs are actually more complex and complex than those mentioned above, structures that essentially hide their inherent costs and can trap unintentional investors. Overall, typical retail investors should avoid investing in SPAC unless they can take the time needed to understand the finances behind them; If not, the best advice is to avoid investing in SPAC.