The SPAC Bubble May Burst—and Not a Day Too Soon
The hot new way to take companies public hurts most investors, and its track record is now clear.
There’s a growing fad on Wall Street: special-purpose acquisition companies, or SPACs. Touted as a better way to take companies public, SPACs have raised more equity in 2020 than over the entire preceding decade. But please, take a minute before jumping in—our research suggests that this trend will end poorly for a large majority of investors.
A SPAC is a shell company that a “sponsor” investor or group organizes and takes public in an initial public offering. Once public, the company has no operations. It simply holds cash—typically, $200 million to $400 million—and has two years to find a private company with which to merge and thereby bring public. The sponsor invests some of its own capital in the SPAC as well but takes an additional 20% interest in the SPAC at a nominal price.
Most investment in SPAC IPOs comes from hedge funds known in the market as the “SPAC Mafia.” The sponsor’s pitch to these funds is simple: Invest in “units” containing one share and one or two additional securities—a “right” and/or a warrant. The price is $10 per unit, but if you don’t want to participate in the merger, you can redeem your shares for $10 plus interest and keep the warrants and rights for free.
This is a tremendous deal for IPO investors who redeem their shares. A right gives a unit holder an additional one-tenth of a SPAC share when the merger is complete. A typical warrant gives the holder an option to buy between one-half and one share at an exercise price of $11.50 any time over five years following the SPAC’s merger. On average, if an investor buys units in a SPAC public offering, redeems its shares and keeps or sells its warrants and rights, the investor’s annualized return is more than 10% with no downside risk.
within six months following the merger, while the Nasdaq rose roughly 30%. Even with these drops in share price, the 20% that the sponsor gets essentially for free provides a nice return on its investment. The sponsors of these SPACs enjoyed a return on investment of more than 500% as of the end of 2020.
It is not a coincidence that sponsors and SPAC IPO investors who redeem their shares earn a high return, while shareholders who remain invested through the merger do poorly. The sponsors’ essentially free shares and the IPO investors’ free warrants and rights dilute the returns to investors. The shareholders who pay for their investments are, in effect, sharing the value of the merged company with others who did not. Our study of SPACs that merged between January 2019 and June 2020 found that, at the time of their merger, most SPACs had less than $6.75 a share in cash but ascribed a $10 value to those shares when they merged.
Two or three SPACs in the past few months have recognized this problem and offered structures with less dilution. But even with these improvements, the question remains: Are SPACs worth the cost?
Advocates claim that SPACs are a cheaper way to go public than an IPO. This may be true in some cases. But if it is, it is only because SPAC shareholders have borne the cost of the dilution built into the SPAC structure. Our research shows that, on average, when targets merge into SPACs they calibrate the fraction of their company that they give up to cash per share in the SPAC. If SPAC shareholders were to reject these losing deals, either the targets would incur costs far higher than what they would incur in an IPO, or the mergers would simply fail and the SPACs would liquidate and return their cash to the shareholders.
As an example, take Black Ridge Acquisition Corp. , which raised $138 million in its 2017 IPO but had only about $20 million in cash after redemptions. After accounting for the shares the sponsor received, the warrants given to redeeming investors (who contributed no cash to the post-merger company), and underwriting fees, we calculate that Black Ridge had only about $3.50 a share in cash at the time of its merger. And indeed, within a week of the merger its share price dropped to $3.52.
At some point—perhaps now—SPAC shareholders will better understand how the companies’ structure stacks the deck against them. When that happens, the SPAC bubble will burst.