Should SPACs Be Back? - Part Three

Special Purpose Acquisition Companies (“SPACs”) are having their moment in the sun. This is the final component of our three-part series meant to provide a comprehensive overview of the current U.S. SPAC boom. This report delves into how SPACs have performed over time and provides insights on who may be gaining and losing money in the SPAC frenzy. As needed, view the first part of our series for a primer on SPACs and a detailed look at their structure and the second part of our series for a discussion on SPAC evolution and factors that drive SPAC activity.

The Players

In this report, we focus on four primary players in the SPAC space: 1) Investment Banks (“IBs”), 2) SPAC sponsors, 3) targeted private operating firms, and 4) SPAC investors. Below, we provide insights on how each group is faring in the SPAC market, identifying whether the player appears to be a net winner or loser in the SPAC space.

INVESTMENT BANKS (“IBS”)

Investment Banks are generally a key player in the initial public offering (“IPO”) process. As SPAC activity has rallied over the last two years, some of the world’s biggest banks have increased their presence in the SPAC space as well (See Exhibit 1). For example, in 2020 and 2021, Credit Suisse Group AG (“Credit Suisse”), Citigroup Inc. (“Citi”) and Goldman Sachs Group Inc. (“Goldman”) accounted for nearly 40% of SPAC underwriting. These firms raised $13.36 billion, $10.21 billion, and $7.67 billion, respectively, for U.S. SPACs in 2020 (See Exhibit 2).[1] These three IB’s pushed Cantor Fitzgerald & Co. out of the top SPAC underwriting spot, a position the firm had held in 2018 and 2019 (prior to the real SPAC craze run-up) and highlights the growing presence of the largest banks in the SPAC space.

On average, IBs often charge underwriting fees of approximately 5 – 7% of total proceeds raised when private operating firms conduct traditional IPOs. Although SPACs have no operating history, making the IPO process quicker, the entities still undergo a traditional IPO process. As a result, SPAC IPOs also require the use of IBs. For SPACs, IBs typically receive a fee of 2% of the proceeds raised in the SPAC IPO, with another 3.5% held in deference. The deferred feeds are only to be paid to the IBs if and when the SPAC completes an acquisition (i.e., completes the De-SPACing process). In addition to the underwriting fees, the IBs may also earn additional revenue through advisory roles to the SPACs or by helping raise additional capital for a SPACs acquisition of a private operating company.[2]

In 2020 alone, large IBs earned billions of dollars in fees associated with SPAC activity. One report noted that banks earned $3.4 billion from advising on 210 SPACs in 2020, up from approximately $0.65 billion the year prior.[3] In one example, Goldman’s total equity underwriting business brought in $3.41 billion in fees, more than double its 2019 figure, with its advisory unit bringing in another $3.07 billion. In both instances SPAC deals helped to boost these figures.[4] Additionally, Citi, generally known more for its debt than equity business, increased its equity-underwriting revenue by 64% in 2020, and moved from sixth to third place in total IPOs, also in largely due to its increased SPAC business.

In a time where most of banks were putting aside billions of dollars in reserves to cover future loan losses caused by the COVID-19 pandemic and the associated economic recession, SPAC-related revenue has provided a welcome boost to these IBs bottom lines. Michael Goldberg, head of U.S. equity capital markets at RBC Capital Markets, stated, “[this] has really been a very helpful shot in the arm for Wall Street.”[5] At present, it would appear the IBs are certainly winners in the SPAC game.

Looking forward, consensus on SPACs is mixed within the IB community. Many think an increased use of SPACs is here to stay. For example, Jeff Mortara, the head of equity capital markets origination at UBS Group AG, stated, “[SPACs are] a useful, flexible corporate finance tool… You’re going to see SPACs become a mainstay.”[6] However, others are wary of the exceedingly high levels of SPAC activity. David Solomon, Goldman’s Chief Executive, noted, “[you] have something here that is a good capital markets innovation, but like many innovations there’s a point in time as they start where they have a tendency maybe to go a little bit too far and then need to be pulled back or rebalanced in some way.”[7]

SPAC SPONSORS

SPAC sponsors are typically the founders and managers of a SPAC entity. Generally, the sponsors make a nominal investment of $25,000 in exchange for 20% of the SPACs equity (AKA founder shares). In addition, sponsors may be awarded warrants, which can be converted into additional share of equity later. Assuming the SPAC successfully merges with a private operating firm (i.e., completes the De-SPACing process), these shares convert into equity of the newly merged entity. This structure can lead to significant payouts for the SPAC sponsors, with billionaire Bill Ackman stating he believes the SPAC structure to be “one of the greatest gigs ever for the sponsor,” and noting that “[sponsors] get 20 percent of the company tax free until [they] sell the stock.”[8]

In one example, a group of sponsors received more than $60 million off their $25,000 SPAC investment in less than two years after taking Clarivate Analytics public (See Exhibit 3).  The Financial Times analyzed 10 SPAC deals and found an approximately $2 billion in combined value for the sponsors.[9] In another example, Opendoor’s $4.8 billion De-SPAC transaction also awarded the SPAC sponsors approximately $60 million in shares for their $25,000 investment (See Exhibit 4).[10] JPMorgan Chase found that, over the last two years, SPAC sponsors earn, on average, a 648% return on their investment.[11] J.P. Morgan Asset Management’s chairman of investment strategy commented that SPAC sponsor returns are “extremely high,” even when “accounting for forfeitures, concessions, and vesting provisions.”[12] The chairman went on to state that the only way for sponsors to lose money in the deal is if, 1) post De-SPACing, the merged entity’s share price falls below their upfront costs, or 2) the SPAC is liquidated with no merger. Given this, it appears SPAC sponsors are also winners in the SPAC game.

The SPAC sponsors compensation structure reduces the payouts to the other SPAC investors. The disparities in payouts have garnered increased attention in the media. Tom Farley, former president of the New York Stock Exchange, stated that it is critical for SPAC sponsors to be more tethered to projections they promote and release to the public, noting that he locked up his founder shares in his first SPAC deal for a period of three years and encouraged other sponsors to make similar agreements.[13] In order to help attract investors, there are signs that new incentive structures are in development. This can be seen in Perishing Square Tontine Holdings, the largest SPAC IPO to date (~$4 billion). This SPAC, launched by Bill Ackman, elected to tie the SPAC sponsors compensation to performance goals. The compensation was primarily made up of warrants as opposed to the standard 20% founder shares.[14]

In addition, there are other signs that the SPAC space is becoming less rewarding for SPAC sponsors. With the rising number of SPAC entities looking to De-SPAC (i.e., looking to acquire a private operating firm), there is a greater demand to acquire private operating firms. However, private operating firms have not increased at the dizzying rate of SPAC entities. As a result, there are now an increasing number of “SPAC-offs,” allowing the private companies to negotiate a better deal under the proposed acquisition. In a SPAC-off, a private operating firm pits multiple SPAC suitors against each other in the merger negotiation process. As part of this process, some SPAC sponsors are handing over parts of their compensation to sweeten the deal for the private firm. There are some developments in the SPAC arena that signal a reduced reward package for SPAC sponsors, it is unlikely that SPAC sponsors will become net losers in the space anytime soon.

TARGETED PRIVATE OPERATING FIRMS

Once a SPAC is formed, the sole purpose for the entity is to target and complete an acquisition of a private operating firm that will take the private firm public. As discussed in the earlier parts of our series, there are multiples reasons why a private operating firm may prefer to go public via a SPAC transaction as opposed to a traditional IPO. One growing reason relates to the surge in SPAC-offs. As of April 20 2021, there are approximately 430 SPACs seeking an acquisition target with approximately $139.4 billion in funds (See Exhibit 5). This highlights the significant imbalance between the demand for private firms and the supply of attractive private firms.[15] With an increasing number of SPACs looking to acquire, there is an increase in the negotiating power of the target private firms. Specifically, the private firms have more leverage in negotiating favorable deal terms for a SPAC merger. This leverage is further enhanced the closer SPACs get to their liquidation deadline, as the sponsor shares and warrants expire worthless if the De-SPAC process is not complete within the SPACs defined lifespan (See Exhibit 6).

In a blog post Bill Gurley, a venture capitalist, wrote that, in a SPAC deal “[everything] is negotiable,” going on to quote a SPAC board member who stated that each SPAC is a “choose your own adventure” experience.[16] With an abundance of SPACs looking to make a deal, there is increased competitive pressure on the sponsors to negotiate their compensations lower (e.g., percentage of ownership, warrants, etc.) in the favor of the private firm or other investors. Further, SPACs are changing how they issue warrants. In some cases, SPACs are reducing the number of warrants issued, which shifts the terms to be less dilutive and more favorable to the target private firm. In some industries, such as the life-sciences industry, the use of warrants has all but disappeared.[17]

In other cases, SPACs are changing deal terms to encourage investors to tie up their capital in the merged entity for longer horizons or tying their compensation with the merged entities’ performance. For example, the Clarviate acquisition did not allow the SPAC sponsors shares to fully vest until the merged entity’s stock price hit $17.50. Further, the company put additional lockups in place to keep investors from selling out of their stock right after the merger. In another example, the SPAC sponsors associated with the DraftKings deal gave up a portion of their compensation in the acquisition and added benchmarks before sponsor shares would fully vest. These concessions may help bolster the merged entities’ stock price, benefiting all shareholders.

SPAC INVESTORS

Excluding the shares held by SPAC sponsors, there are a large amount of SPAC shares that are held by other institutional or retail investors. Throughout this series, there has been an emphasis on the misaligned economic interests between the SPAC sponsors and other SPAC investors. The SEC has warned investors that the structure of SPACs increases the likelihood that sponsors make decisions that may not be in the best interest of shareholders at large. As discussed above, evidence shows that the SPAC sponsors are generally winners in the SPAC space. Now, the attention is turned to historical returns for the other SPAC investors.[18]

Due to the structure of SPACs, two groups of SPAC investors will be distinguished. As discussed in earlier parts of our series, once the SPAC conducts its IPO, its shares trade in the public markets (i.e., can be bought or sold). More importantly, when a SPAC merger is approved, the SPAC investors have the option to redeem their shares. In this case, the investor exits their investment position as opposed to converting their shares over to the merged entity. Investors who hold common stock in the original SPAC entity, prior to a merger with a private operating firm, are referred to as Pre-De-SPAC Investors. We then separately analyze those investors who hold investments in the common stock of the merged entity (i.e., following the De-SPAC transaction), denoted as De-SPAC Investors. Working academic studies emphasize the importance of this distinction as one study documents that at least 92% of Pre-De-SPAC investors (as identified in 13-F filings with the SEC) exit their investments prior to the completion of the De-SPAC process.[19]

PRE-DE-SPAC INVESTORS

YCharts recently analyzed 72 SPACs that conducted an IPO and completed the De-SPAC process between January 2012 and February 2021. The study split the performance of SPACs into several time frames, including from the time of the SPAC IPO to the definitive merger announcement and again from the definitive merger announcement to the closing of the merger (i.e., the completion of the De-SPAC process). As shown in Exhibit 7, approximately 70% of SPACs generate positive returns between the IPO date and the announcement of the definitive merger, however only 15% of these returns outperform the market (using the S&P 500 as a benchmark). The performance is even better when analyzing the performance between the announcement of the definitive merger and the completion of the merger. While approximately 70% of the SPAC’s experience positive returns during this time, more impressively nearly 50% outperform the market benchmark.

Further, an academic study by Klausner et al. analyzes 47 completed SPAC mergers that occurred in January 2019 and June 2020.[20] They report that investors who exit prior to the completed merger earn, on average, positive 11.6% per year. Moreover, in a more comprehensive study, Gahng et al. analyze a sample of 114 SPAC IPOs between January 2010 and May 2018 and find that, on average, SPAC IPO investors earn a positive 9.3% return per year (See Exhibit 8).[21] In fact, the authors find that even when the SPAC Is liquidated, Pre-De-SPAC investors earn a positive return of approximately 2% per year.

Given the nature of SPAC structure, a SPAC IPO investment is a risk-free investment. Gahng et al. state that a SPAC investment is equivalent to a default-free convertible bond with extra warrants. When this risk-free component is paired with an average 9.3% – 11.6% annual return it makes for an attractive investment opportunity. Overall, recent studies suggests that, on average, SPAC investors exiting prior to the completion of the De-SPAC process are winners in the SPAC space. But who exactly are these investors?

Klausner et al. note that SPAC shareholders are overwhelmingly large institutional investors (e.g., hedge funds) holding, on average, approximately 82% of SPAC shares prior to SPAC mergers. In fact, many of the largest holders of SPACs are hedge funds, whom Gahng et al. classify as “SPAC Mafia” members (See Exhibit 9). The authors note that many institutional investors (such as hedge funds) invest in SPAC IPOs with the strategy of selling or redeeming their shares prior to a completed merger, taking advantage of the risk structure of the investment. Klausner et al. support this notion in their analysis of SPAC divestment rates.[22] Specifically, the authors report an average divestment rate of 90% for shares held by large investors (measured as those who file 13-F forms), indicating very few pre-merger investors hold their shares after the De-SPAC process. This suggests that most De-SPAC investors may be retail investors – do they see the same favorable returns in the post-merger period as the Pre-De-SPAC investors?

DE-SPAC INVESTORS

Unfortunately for the De-SPAC investors, most studies indicate that, on average, the merged entities tend to have relatively poor stock performance. Often, this results in significant losses for those investors who held common stock at the time the merger was completed. Jenkinson and Sousa, analyzing a sample of 60 SPACs conducting an IPO between August 2003 and June 2006, indicate that more than 50% of approved SPAC transaction immediately destroyed shareholder value.[23] The authors state that investors experienced average cumulative returns of negative 24% and negative 55% in the six and twelve months following the completion of the De-SPAC process.

Looking at the recent YCharts study, YCharts also analyzed the performance of 72 SPACs from the time the merger was completed through February 2021. Unlike the relatively rosy outcome for the Pre-De-SPAC investors, the results are less bright for the De-SPAC investors. Specifically, 52% of SPACs have experienced a decrease in share price (i.e., a negative return) since the completion of the De-SPAC process. This aligns with the earlier findings of Jenkinson and Sousa, with more than half of SPAC transactions results in destroyed shareholder value.

Additionally, in the group of 47 completed mergers from 2019 to 2020, Klausner et al. report that the De-SPAC investors generate average returns of negative 2.9% in the three months following the merger. Like Jenkinson and Sousa, they find that the performance deteriorates over longer time frames, reporting that average returns for SPACs are negative 12.3% and negative 34.9% in the six- and twelve-months post-merger. Likewise, Gahng et al. document poor returns for investors who hold shares of the merged entity at the completion of the De-SPAC process. The authors find that investors earn between negative 4.0% and negative 15.6% on their shares in the twelve-months post-merger, with the negative returns persisting three-years post-merger (See Exhibit 10).[24]

The outcomes described above discuss SPAC performance in isolation. However, it is also important to look at how an investment performs relative to a benchmark. A study by Kolb and Tykvová, conducted on 130 SPAC acquisitions in the U.S. occurring between 2003 and 2015, found that the performance of merged SPAC entities “severely underperform[ed]” relative to market, industry, and matched peer benchmarks.[25] These results hold across a variety of time frames ranging from six months to five years (or 60 months). The authors conclude that long-term investors, who invest into the merged SPAC entity at the merger completion date, “systematically underperform the market, industry and similar non-SPAC firms.”

It is important to note that there is robust literature documenting that, on average, traditional IPO firms significantly underperform relative to a benchmark portfolio (e.g., the market or industry peers) in the first several years following issuance.[26] This does not necessarily mean that the IPOs do not earn positive returns but indicates that the IPOs underperform relative to a benchmark portfolio (e.g., compared to the returns of the S&P 500). As such, it could be expected that private firms who become public via a SPAC transaction may also underperform benchmarks.

However, the magnitude by which SPAC transactions underperform benchmarks is significantly larger than that of traditional IPOs. Kolb and Tykvová find that, on average, over a 24-month period SPAC firms underperform the benchmark portfolios by 59% (market) and 85% (industry) compared with only a 34% (market) and 45% (industry) underperformance by traditional IPOs. Further, when the authors look at the monthly alpha (i.e., abnormal return) of a portfolio of SPAC firms, they report that SPAC firms have a monthly alpha of negative 5.2%.[27] Related, the Gahng et al. study reports that 29% of the SPAC mergers in their sample exhibit returns below negative 90% in the first three years following the completion of the merger.[28] This is significantly higher than the 9% frequency found for traditional IPOs.

On average, it appears that the losers of the SPAC space are the investors who hold common shares in the merged entity at the completion of the De-SPACing process. In general, the merged entities exhibit negative returns over various time frames, spanning three months to five years. While there are SPAC transactions that generate positive shareholder returns (e.g., DraftKings, Utz Brands, and Virgin Galactic) and factors that are associated with better deal outcomes (e.g., SPACs sponsored by large private equity funds or by former CEOs and senior executives of Fortune 500 firms), it appears that the De-SPAC investors are left holding the bag on SPAC transactions, often taking substantial losses on their investment.

Summary

Throughout the series, we have routinely highlighted the SEC’s increasing concern with SPACs. The SEC has issued multiple statements advising investors, particularly retail investors, to be wary of SPACs. The structure of SPACs (discussed in Part 1 of our series) along with the research summarized above supports warnings of misaligned economic interests in the SPAC space. While the investment banks, SPAC sponsors, and pre-De-SPAC investors (largely comprised of institutional investors) seem to be making favorable returns from SPAC investments, this appears to come at the cost of the De-SPAC investors (largely comprised of retail investors).

While it is critical to conduct thorough due diligence on any financial investment, this is enhanced when evaluating whether to make a SPAC investment. If getting into the SPAC space excites you, it is vital that you understand the terms of your investment. According to the SEC, it is crucial to carefully read the SPAC’s IPO prospectus as well as the other reports filed with the SEC. [29] Additionally, the SEC notes that investors should:

• Understand the specific features of an individual SPAC, including the equity interests held by the sponsor, which may have been obtained for nominal consideration.
• Review the business background of SPAC management and its sponsors.
• Understand the terms of the trust account, including redemption rights and the circumstances in which cash may be released from the account.
• Consider whether attractive initial business combinations will become scarcer with an increased number of SPACs seeking to acquire private operating firms.
• Understand the terms of warrants when investing (e.g., how many shares the investor has the right to purchase, the price at which and period during which shares may be purchased, the circumstances under which the SPAC may be able to redeem the warrants, and when the warrants will expire).
• Decide whether to redeem shares or remain an investor in the combined company going forward in the event of an approved merger.
• Review a SPAC’s proxy, information or tender offer statement in the SEC’s EDGAR database.
• Be aware that although most of the SPAC’s capital has been provided by IPO investors, the sponsors and potentially other initial investors will benefit more than investors from the SPAC’s completion of an initial business combination.
• The sponsors may have an incentive to complete a transaction on terms that may be less favorable to other investors.
• If the SPAC requires additional financings to fund the initial business combination, sponsors often help provide financing. This may further dilute other investors’ interest in the combined company or may be provided in the form of a loan or security that has different rights from other investors.

Conclusion

While it remains to be seen how common SPAC transactions will be in the future, SPACs are most certainly experiencing their moment in the sun. Raising billions of dollars in the U.S. in the last year alone, the SPAC craze is quickly spreading worldwide. SPACs offer sizable returns to SPAC sponsors and SPAC IPO investors and have bolstered investment bank revenues during a time of economic uncertainty. Further, private operating firms are benefiting from SPAC transactions by finding a quicker, and possibly cheaper, alternative to the traditional IPO. Moreover, these firms are benefiting from more favorable deal terms due to the increasing number of SPAC-offs occurring in the crowded SPAC market.

However, not everyone is winning the SPAC game. An analysis of historical SPAC performance shows that investment returns in the merged entities are generally unfavorable, largely hurting retail investors at the expense of SPAC sponsors and large institutions (e.g., investment banks, hedge funds, and other large institutional shareholders). Despite evolving regulation, the relatively opaque nature of SPACs makes them a risky investment for most investors. The common structure of SPACs allows for a significant divergence in economic interests between SPAC sponsors and other investors. While some SPAC sponsors are working to correct this imbalance, it appears evident that the SEC will soon extend SPAC regulations to further protect retail investors.

Sources

[1] SPACs Rescued Wall Street From the Covid Doldrums - WSJ

[2] In Part 2 of the series, we briefly discussed that SPAC firms are not limited to purchasing a private operating firm solely with the proceeds from the SPAC IPO. Often, IBs will help assist the SPAC in raising additional forms of capital (e.g., debt) to help fund its ultimate acquisition target.

[3] Banks rake in record $3.4bn in fees as Spac frenzy lures Shaquille O’Neal, Playboy - Financial News (fnlondon.com)

[4] SPACs Rescued Wall Street From the Covid Doldrums - WSJ

[5] 2020 SPAC Boom Lifted Wall Street’s Biggest Banks - WSJ

[6] Investment bankers tracking SPACs see no slowdown in record-breaking year | S&P Global Market Intelligence

[7] SPACs Rescued Wall Street From the Covid Doldrums - WSJ

[8] The Spac sponsor bonanza | Financial Times (ft.com)

[9] The Spac sponsor bonanza | Financial Times (ft.com)

[10] SPAC IPO: Background and Policy Issues (congress.gov)

[11] Why SPACs Could Leave Investors in the Cold - The New York Times (nytimes.com)

[12] Op-ed: Here's what to evaluate before investing in the SPACs boom (cnbc.com)

[13] The SPAC boom has become a 'mania' and sponsors should be more tethered to growth projections, former NYSE President Tom Farley says | Markets Insider (businessinsider.com)

[14] SPAC IPO: Background and Policy Issues (congress.gov)

[15] Why SPACs Could Leave Investors in the Cold - The New York Times (nytimes.com)

[16] Going Public Circa 2020; Door #3: The SPAC | Above the Crowd | By Bill Gurley

[17] What’s Behind the SPAC Boom? - The New York Times (nytimes.com)

[18] It is important to note that, due to the relative scarcity of SPACs prior to 2019, there is limited published research investigating SPAC performance. In addition, to analyze long-term performance, time must pass by. As a result, it will be several years before research can analyze the long-term performance of the current SPAC IPOs and merger transactions.

[19] Large funds are required to file form 13-F with the SEC on a quarterly basis, in which they disclose their shareholdings. Klausner, Michael D. and Ohlrogge, Michael and Ruan, Emily, A Sober Look at SPACs (October 28, 2020). Yale Journal on Regulation, Forthcoming, Stanford Law and Economics Olin Working Paper No. 559, NYU Law and Economics Research Paper No. 20-48, European Corporate Governance Institute – Finance Working Paper No. 746/2021, Available at SSRN: https://ssrn.com/abstract=3720919 or http://dx.doi.org/10.2139/ssrn.3720919

[20] Klausner, Michael D. and Ohlrogge, Michael and Ruan, Emily, A Sober Look at SPACs (October 28, 2020). Yale Journal on Regulation, Forthcoming, Stanford Law and Economics Olin Working Paper No. 559, NYU Law and Economics Research Paper No. 20-48, European Corporate Governance Institute – Finance Working Paper No. 746/2021, Available at SSRN: https://ssrn.com/abstract=3720919 or http://dx.doi.org/10.2139/ssrn.3720919

[21] Gahng, Minmo and Ritter, Jay R. and Zhang, Donghang, SPACs (January 29, 2021). Available at SSRN: https://ssrn.com/abstract=3775847 or http://dx.doi.org/10.2139/ssrn.3775847

[22] The divestment rate represents the percent of shares held by investors who redeem or sell their SPAC shares to new investors after the prospective target private operating firm is announced (i.e., prior to the De-SPAC process).

[23] Jenkinson, T., & Sousa, M. (2011). Why SPAC investors should listen to the market. Journal of Applied Finance (Formerly Financial Practice and Education), 21(2).

[24] The authors also analyze the returns on the warrants held by De-SPAC investors and find that the average return for the warrants is between positive 15.6% and 44.3%.

[25] https://www.alexandria.unisg.ch/259427/1/1-s2.0-S0929119916300852-main.pdf

[26] Ritter, 1991; Loughran and Ritter, 1995

[27] The authors use a regression model that regresses the excess return of SPAC firms on the three Fama-French factors, a momentum factor, and liquidity factor.

[28] Gahng, Minmo and Ritter, Jay R. and Zhang, Donghang, SPACs (January 29, 2021). Available at SSRN: https://ssrn.com/abstract=3775847 or http://dx.doi.org/10.2139/ssrn.3775847

[29] SEC.gov | What You Need to Know About SPACs – Investor Bulletin

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