SPACs in the middle: IPO shell vehicles are expensive but seem to fill a market niche

Special purpose acquisition vehicles are expensive, lightly regulated – and recently deeply trendy. Extensive international media coverage has painted them as poor bets at best for most investors, and irresponsibly risky at worst. And yet they are more popular than ever and taking on a growing role in the market.

The basic concept is a blank-check company that forms when a promoter gathers like-minded investors to form a pool of money that trades as a public company, then starts a two-year clock to merge with an existing privately held firm and thus take the new entity public. Terms and conditions vary. Usually, the promoter takes 20% ownership of the company off the top, usually the pre-merger investors get warrants alongside their equity stake, and usually the enterprise gets at least one more round of funding known as a private infusion of public equity (PIPE) around the time the merger takes place. Then the new merged company continues to trade publicly.

These types of companies aren't new, but they are newly fashionable given the surge in global stock markets and the enthusiasm of celebrity sponsors to join in the game. But are they comparable to, or in some cases better than, a traditional initial public offering (IPO)? Should global regulators take a closer look, as the U.S. Securities and Exchange Commission has said it plans to? More broadly, are they a decent investment, and for whom?

It might be telling us about the IPO process itself and its efficiency

"One of the reasons we care about this is, it might be telling us about the IPO process itself and its efficiency," said Tim Jenkinson, Oxford finance professor and European Corporate Governance Institute research member. As he explained: "In many countries, in particular in the US and UK, the number of listings has been going down pretty dramatically. This is reversing that trend and it might be quite important in the way that markets or the types of companies that markets get known for."

ECGI took a deep dive into the history and evolution of SPACs in an April workshop bringing together academics, lawyers and market players. The event kicked off with a review of the poor returns that awaited most of the shareholders in the SPACs that have been studied so far, before turning to focus on European considerations. Supporters of the format argued that the vehicles offer a middle ground to expensive private equity and traditional IPOs. In Europe especially, the lack of integrated capital markets, combined with demand for higher-yielding investments and longer-term financing, means that SPACs may fill a true gap.

A SPAC can be extremely useful in order to bring more patient minority equity capital to Europe

"Clearly this instrument is useful, and if it's useful it will be needed," said Jean-Paul Mustier, former Unicredit executive and now co-chief executive officer of Pegasus Europe. This SPAC raised €500 million in its April IPO and is looking to merge with a growth-oriented company in the financial services industry, according to its public profile. "A SPAC can be extremely useful in order to bring more patient minority equity capital to Europe."

The question is, how do the costs compare to other options and is there a way that regulation can make them safer and stronger. In what is becoming a familiar refrain, the research of New York University's Michael Ohlrogge and Stanford's Michael Klausner and Emily Ruan showed that the SPAC process tends to leech value out of the company, while enriching sponsors and some of the early shareholders. In a November study of 47 U.S. SPACs that completed mergers between January 2019 and June 2020, SPAC shares worth $10 at initial sale held only $6.67 of value at the median by the time the merger took place – and in an April update after further work, the median value fell to $6.40. The mean was $5.10, meaning that almost half the value of the initial share was diluted because of the distributions to the sponsor, the warrant holders and underwriting costs. Further, share prices usually fell after the merger.

"There are very high costs built into the structure," Klausner said, noting that many of these costs are hard to tease out and may not be visible until after the company has completed its merger. Any big gains go to the sponsor, and to investors who were able to redeem their shares pre-merger, often at full $10 value, while keeping the warrants that came with them.

The warrants part of the deal has been described by columnist Matt Levine as magic money, particularly when the warrants are allowed to be traded separately from the shares from the get-go. Klausner said this kind of trade has become markedly less lucrative in recent months, now that it has been widely publicized, and outside the U.S. it has often been less prevalent because warrants have not been able to be separated from the rest of the stake.

Ongoing control may explain why target companies continue to take part in these deals

Overall, SPACS seem to have higher costs than a traditional IPO, without giving shareholders of the merged companies much control over the firm they merge with. Klausner said on average, 70% of the merged company stayed with the target, leaving the combined SPAC holders with about 30% of the new entity. Ongoing control may explain why target companies continue to take part in these deals. Furthermore, SPACs really only make money if the merger happens within a two-year window, otherwise they typically have to liquidate.

This creates poor incentives for both SPAC sponsors and target companies, said Lora Dimitrova of the University of Exeter. "The targets knew that, it turns out, sponsors were overpaying for some deals, because they really wanted a deal, any kind of deal," in order to keep their 20% compensation stake, she said.

One current advantage that these blank-check vehicles hold over IPOs is a different set of disclosure obligations. In the U.S., for example, companies that are already public, including SPACs, can make forward-looking statements that are off limits to firms that are privately held. This means companies unsure about whether their IPOs will draw enough investors might turn to a SPAC to make a broader sales pitch for their prospects, particularly if they are working with new and as yet unproven technology. Another issue is that, in Europe especially, there simply aren't enough options for investors seeking returns, making any additions welcome.

"As long as you don't make money anywhere except in two asset classes, equity and emerging market bonds – and emerging market bonds is a rough sport not available to everyone – the only asset classes where you can get some form of yield is equity," said Stéphane Boujnah, CEO of Euronext. He argued a diversification of equity-risk vehicles is "what SPACS are made for," making them a logical part of market evolution and innovation.

Klausner and his co-authors found that there is a difference between "high-quality" sponsors, who are former senior executives at Fortune 500 companies or are themselves a fund with $1 billion under management, and other sponsors. Yet the better performance of the quality sponsors is driven primarily by "extreme winners," he said. "The median is still terrible." The sponsors themselves tend to do well regardless, he said, adding the target companies often can negotiate for more cash. This means that shareholders bear the brunt of the costs and the dilutive effects.

SPACs in the U.S. have taken on a celebrity-studded role that heightens the risks facing ordinary investors. To get a sense of how uneven the returns are, consider the case of billionaire SPAC investor Chamath Palihapitiya. According to Charles Duhigg's New Yorker profile, "if an everyday investor had bought one share of stock in each of his SPACs on the first day the stock traded, three of those investments would have lost money. The entire bundle would today be worth thirty-one per cent more than the investor had initially paid. A comparable investment in the S. & P. 500 over the same period would have returned similar profits, but would have involved much less volatility and risk."

SPACs in Europe may fill a less gaudy role. For one thing, the trend of the last decade has been generally subdued, as companies turn to markets in the U.S. and around the world. Luis Correia da Silva, a partner at the consulting firm Oxera, said that a 2006 study of EU primary markets found that EU exchanges had raised more new money from IPOs and attracted more international money than US exchanges. But EU listed companies have been getting larger and older, as the public corporation has declined in prominence. A 2020 study found the number of listings in the pre-Brexit EU 28 had declined substantially over the previous decade.

SPACs are sandwiched inside a matrix of market rules and national laws

The workshop highlighted that from a regulatory perspective, SPACs are sandwiched inside a matrix of market rules and national laws. There is no EU level SPAC regime. It's all done as a mixture of the local listing rules and the prospectus regulation and how the relevant member states seek to fit the SPAC regime into that.

The discussions observed that SPAC IPO listings in Europe have primarily been in the U.K., the Netherlands, Italy and Sweden. Factors in deciding where to list include regulation, company law flexibility, taxes, governance, the likely country of the SPAC's target, and the degree of investor familiarity with the process. Except for in the case of Italy, the companies are more likely to be incorporated in tax-friendly jurisdictions like the British Virgin Islands, Luxembourg or the Netherlands. Requirements for specifying a target industry sector vary, as do prospectus rules, although the general feeling is that SPACs are not subject to the Alternative Investment Fund Managers (AIFM) directive. It is seemingly possible to get "pretty close" to the U.S. structures, although the presence of negative yields on cash holdings means that either investors or sponsors need to provide extra capital to keep the funding pool stable.

Evidently, one bigger difference is how European investors can or cannot redeem their shares at the time of merger. There are limitations that have not been traditionally present in the U.S., and in some countries investors cannot redeem their shares unless they reject the proposed business combination. UK rules also have provided barriers, such as a requirement that share trading be suspended when mergers are announced, which limits how investors can sell or redeem their holdings. A review of the SPAC rules was included in the March 2021 UK Listings Review chaired by former EU financial services commissioner Jonathan Hill.

When sponsors have skin in the game, that's a big, big difference because they just can't afford to burn cash

Euronext, which has an exchange in the Netherlands, sees SPACs as filling a market niche and in the middle of a transformation. CEO Boujnah said Amsterdam is a popular venue for SPACS because it is a location where English is readily usable, corporate law is flexible and tax rulings are readily available. Tax and corporate law issues are the main drivers, rather than listing rules, he said. There are some EU-specific factors, he said: For example, retail investors make up only 5% to 6% of Euronext trading, which is twice what it was a year ago but still a small fraction of U.S. levels. Also, SPAC sponsors are more likely to succeed when they have a big personal investment in the company before and after its merger. "When sponsors have skin in the game, that's a big, big difference because they just can't afford to burn cash because this is their own money," Boujnah said. "This is also the one of the big differences between the European environment and the U.S. environment."

For Mustier, a SPAC sponsor who has indeed put his own money on the line, the vehicle offers a way to provide equity market access to business founders who don't have financial experience and cannot tap longer-term private capital. "The IPO process is very complex for an entrepreneur who might not be used to all the listing rules and might not have yet the governance to do that," Mustier said. SPACs "are actually a very complimentary product between the private market on one side and the IPO on the other, in order to help these entrepreneurs to come to the market." A pre-listing announcement for Pegasus said Mustier and his three co-sponsors would "invest a minimum of 10 per cent of the initial offering and commit to enter into a substantial forward purchase agreement."

Blank-check companies are not new investing vehicles, but until fairly recently they flew mostly under the radar. Klausner said that when he first began studying SPACs themselves, he thought it was the most obscure topic he had ever looked into. From here out, however, obscurity is a thing of the past.

"I started this paper when SPACs were very uncool," Klausner said. "This is not the product of great foresight. I thought they seemed odd and inefficient and I thought I would look more closely at them and here we are."

Rebecca Christie is a non-resident fellow at Bruegel, the Brussels-based think tank.

This article was written as part of the event on "New Listing Rules for SPACs and Dual Class?" on 14 -15 April 2021.

The following article was also published in response to the workshop: The Strongest 10%: How Dual-Class Shares Caught on and Why Investors Let Them

-------------------------------------

Event: New Listing Rules for SPACs and Dual Class? (14 - 15 April 2021)

Videos of the presentations are available on the ECGI website and YouTube channel.

Speakers:

• Marco Becht, Professor of Finance, Solvay Brussels School, ULB and ECGI
• Stephane Boujnah, CEO and Chairman of the Managing Board, Euronext
• Mike Burkart, Professor of Finance, London School of Economics (LSE) and ECGI
• Luis Correia da Silva, Managing Director, Oxera
• Lora Dimitrova, Senior Lecturer in Finance, University of Exeter
• Luca Enriques, Professor of Corporate Law, University of Oxford and ECGI
• Laura Field, Professor of Finance, University of Delaware and ECGI
• Tim Jenkinson, Professor of Finance, University of Oxford and ECGI
• Michael Klausner, Professor of Business and Professor of Law, Stanford Law School
• Michelle Lowry, Professor of Finance, LeBow School of Business, Drexel University and ECGI
• Roni Michaely, Professor of Finance, Hong Kong University and ECGI
• Jean-Pierre Mustier, Partner Partner, Pegasus Europe
• Anete Pajuste, Professor of Finance, Stockholm School of Economics (Riga) and ECGI
• Lucrezia Reichlin, Professor of Economics, London Business School and ECGI
• Roberto Tallarita, Associate Director and Research Fellow, Harvard Law SchooL