- “A Sober Look at SPACS,” by Michael Klausner, Michael Ohlrogge, and Emily Ruan. SSRN Working Paper no. 3720919, January 2021.
Investors have complained for some time that the mechanism behind initial public offerings (IPOs) does not appear to achieve an optimal outcome. It usually begins with an investment bank canvassing big investors to get a rough sense of what they might pay for the new company’s stock, to establish a price range. The bank then attempts to steer the company to select an offer price at the lower end of that range.
The investment bank’s intent is to create a scenario in which the price “pops” as soon as it hits the market. The initial jump in price helps the investment bank’s reputation with investors and it also makes the bank some money, as the bank typically receives some of the stock as payment, and garners attention for the firm. However, the steep initial jump in price comes at a cost: if the original price had been set at the higher price, the company would have received more capital.
What’s more, the cost of doing an IPO is not cheap: underwriting fees can be as much as 7% of the value of the company.
Alternatives to the standard IPO process have been tried. Google famously did a reverse auction for its initial offering, but it was widely viewed as having been a disappointment because it raised less money than the company hoped. Some attributed the outcome to its investment banks, none of which wanted the status quo upended. Few reverse‐auction IPOs have been attempted since then.
More recently, the music app Spotify did a direct listing, whereby it simply listed its outstanding shares on the market without an underwritten offering. The perceived drawback of this is that existing shareholders are not required to hold onto their shares for a certain period — unlike in most IPOs — so the fear is that without that backstop the shares could tank. That, in turn, dampens demand and the new shares raise less money. While investors watched Spotify’s direct listing carefully, it failed to spur many imitators.
Another alternative to the IPO gained popularity in 2020: the Special Purpose Acquisition Company (SPAC).
A SPAC is a “blank check” shell company created specifically to obtain a private firm and take it public. Investors buy shares in the shell company at a price fixed at $10, and the principals park the money raised while they search for a promising firm to acquire. Once the principals have identified a target, they inform the shareholders, who vote on whether to approve the acquisition. Shareholders who don’t approve can get their original investment back with interest. If the process isn’t completed in two years, all shareholders get their investment returned.
The popularity of SPACs exploded in 2020, when companies executed 165 of them, compared to just 59 in 2019. And that popularity is growing: Bloomberg estimates that in January 2021, alone, investors initiated 90 SPACs.
The rise in their use has led some to declare that the SPAC is a superior tool for taking startups public and that it may someday achieve what the reverse auction and private listing couldn’t and supplant the IPO.
However, the popularity of SPACs may prove fleeting, the authors of this paper argue. The problem, they aver, is that SPACs may make a lot of money for the principals who found them, but the investors who buy stock in them often end up not doing very well.
While a SPAC may be simpler to execute than an IPO, it does not appear to be superior for investors. In their analysis of 47 SPACs that emerged between January 2019 and June 2020, the authors found that the average stock price was well below the starting price. The authors attribute this to dilution of the stock, which consists of the sponsor’s “promote,” or disproportionate share of profits, underwriting fees, and the post‐merger SPAC warrants. SPACS also have significant costs, but the authors say they are hidden, penalizing those who don’t redeem immediately.
And while stock prices for the SPACS in the data set tend to fall in the first year after the transaction is completed, the authors find that most of the initial investors exited the stock shortly after the acquisition was completed. Investors who bought into the SPAC after acquisition bore the brunt of the losses. Such an outcome is not a sustainable long‐run equilibrium, the authors suggest.
SPAC stock prices tend to fall in the first year after the transaction is completed, but most of the original investors exit the stock shortly after the acquisition.
They conclude that the benefits of SPACS appear to be overstated, for several reasons. There is little evidence that smaller investors are, in fact, participating in SPACS. The cost of executing a SPAC does not appear to be appreciably less than a regular IPO. And the post‐SPAC‐closure drop in price suggests to them that savvy investors may soon begin avoiding them.
In the two decades since the dot‐com bubble burst, we have seen Congress pass the Sarbanes‐Oxley Act of 2002 and the Dodd‐Frank Act of 2010 to give regulators more tools with which to govern financial markets. Many people have written about how these have increased the cost of doing an IPO. There have been economists predicting a continuing diminution of U.S. IPOs for two decades. In fact, in the last year a large number of companies have gone public, many of which have chosen to do so via SPACS.
The authors conclude that the SPAC does not offer a less expensive route to going public, although it may be easier to accomplish. As the market digests the fact that SPACS tend to lag the market post‐acquisition because of the higher costs, future SPAC transactions may be forced to become more efficient — although that hasn’t yet occurred in the IPO market.
But, the authors note, the higher cost of a SPAC is not endemic to the structure, and this could be addressed if the market forced it to.
This paper sheds light on a new phenomenon. It merits a rapid update that performs the same analysis for all SPACS that occurred in 2019 to see if the explosion of the phenomenon saw an increasing difference between the post‐SPAC stock performance and the broader market indices, and whether the dilution problem was lessened. — I.B.