It’s Time to Rethink the SPAC

Special Purpose Acquisition Companies, SPACs, are white hot in 2020. These are companies that raise money from investors and sponsors at a traditional IPO (Initial Public Offering – when a private company sells shares to public investors to raise money) and sit on that cash for a defined, short period of time. Their whole raison d’être is to find a private company and use the raised capital to merge with it; the combined company takes the private company’s name, changes its stock market ticker to match the new company name and effectively brings the private company onto the public markets without the need for an IPO. Think of this as a backdoor to the public markets. Why do all the work to become public when you can just merge with a empty firm that’s already done it?

Investors are flocking to these investment vehicles in droves. According to data from Dealogic, the amount of money raised by these SPACs in 2020 was up c.370% from 2019. Most of this capital usually comes from large, institutional investors, hedge funds etc, however, worryingly the interest in SPACs has started to permeate into the realm of retail investors.

Many people tout the SPAC as a positive for the markets, reducing the difficulty of coming to market for a private company and thus encouraging more firms to do so. However, the point must be noted that with a traditional IPO comes scrutiny; a company’s finances are poured over and made clear to prospective investors. The regulatory burden imposed by an IPO is all to ensure that investors can have a properly informed view of the company they are planning to invest in. When a company merges with a SPAC, the requirements on them are much less stringent. In a note from the Financial Industry Regulatory Authority, they say that “in a traditional IPO, underwriters conduct significant and thorough due diligence on a company” and that “there may be no similar “gatekeeper” function by underwriters in connection with the acquisition target of a SPAC”. Investors should take note of this.

How do SPACs work?

None of this speaks to the true issue with SPACs, their inherent conflicts of interest. To explore this, we first need to go through the structure of a SPAC and how its IPO works .

All SPACs need a so called “sponsor”. This is a company who will provide some of the initial money needed for the SPACs operation and who will retain a holding in the final company after the merger happens. In order to assert this holding in the new company, the sponsor purchases “founder shares” of the SPAC before the IPO at a nominal fee of usually $25,000. The amount of founder shares they get is specifically designed so that when the IPO of the SPAC is complete, the sponsor will hold 20% of the total shares. During said IPO, shares go on sale to hedge funds etc who buy shares at a fixed price, typically $10 each. These shares come with something called a warrant, allowing the holder of the shares to buy more shares, usually at $11.50, in the future.

Say the SPAC wants to raise $40 million; they would sell 4 million shares at $10 each, but since the founder shares need to be 20% of the combined total, they would receive 1 million founder shares (20% of the total 5 million shares). All of this cash is then put in an investment account and can’t be touched until a merger is made. However, to give some working cash to the SPAC, the sponsor usually purchases more warrants. The cash from this purchase can then be used to cover costs of the IPO etc. When the company finds a private firm to merge with, the founder shares (and the shares given to the public) automatically transform into shares of the new combined firm, both typically on a one-for-one basis. 

The Conflict of Interest

The keen-eyed reader may have already spotted the problem. These ‘founder shares’ become unbelievably valuable given the price paid for them. Let us contextualise this with a recent example, that of the SPAC called Gores Metropoulos, Inc. and LIDAR company Luminar.

Upon IPO, the sponsor of Gores Metropoulos, Inc., unimaginatively named Gores Metropoulos Sponsors LLC (which itself is a mess of beneficial ownership that all comes together at the ownership of Mr. Gores and Mr. Metropoulos), paid $25,000 for 10,781,250 founder shares. After some forfeiting due to over-allotment reasons on the IPO, they ended up with 10,000,000. This means they paid approximately $0.002 per share. They also took up 6,666,666 warrants (exercisable for one share each at $11.50) for a total of $10,000,000.  According to their IPO documentation, Gores Metropoulos Sponsors LLC agreed to not sell these shares until 180 days after the merger; there are no restrictions on the use of the warrants. Now that the merger between Gores Metropoulos and Luminar has gone through, the founder shares owned by Gores Metropoulos Sponsors LLC have been converted on a one-for-one basis into shares of the new combined firm, Luminar.

This means that Gores Metropoulos Sponsors LLC paid $25,000 for 10,000,000 shares, which at close of trading on Tuesday the 22nd of December were valued at $36.76 (after hitting c.$45 after the merger was announced), valuing their holding at $367,600,000. The warrants (while not known if exercised) could yield huge profits. If the sponsors chose to exercise the warrants and purchase 6,666,666 shares at $11.50 and then immediately sell them back into the market, they could realise a further $168,399,983. The combined value of their realised holdings (minus the cost of buying the warrants) would be c$526,000,000. Even if the warrants expired worthless (i.e., the stock price fell below $11.50), the sponsor’s net gain would still be around $357,600,000. The stock price would have to essentially hit zero before they ran a risk of even making a loss. Not bad for a $25,000 upfront cost.

Knock-on Effects

This is exactly why SPACs need to be rethought. The current process rewards SPAC owners for simply making a deal, not even a good one. Hedge funds can make a profit too, by selling off their shares if the stock price rises after the deal is announced, or redeeming their shares if it falls, then holding onto the warrants for future use. This ‘redeeming’ is only available to do between the merger being announced and its completion and it allows shareholders to relinquish their shares and receive their initial investment back plus a little interest if they don’t approve of the merger.

So, everyone makes money, what’s the problem? The problem is that ordinary investors usually get burnt. According to the Financial Times, the majority of SPACs post-merger trade below the $10 issuance price and according to data collated by Bloomberg from Michael Klausner of Stanford Law School and Michael Ohlrogge of New York University School of Law, the average 3 month, 6 month and 12 month returns for post-merger SPACs are -2.9%, -12.3% and -34.9% respectively. This means that if you missed the boat to redeem your shares before the merger completed, you are stuck with shares that historically have mostly languished below what you initially paid for them. Combine this with the recent boom we are seeing in retail traders (i.e., the general public) coming into the markets due to zero-commission brokerages and this seems like a recipe for a lot of empty wallets.

Reform

What is to be done about it? Recently, hedge fund manager Bill Ackman has launched the largest SPAC in history, called Pershing Square Tontine Holdings, raising $4 billion. Importantly, Ackman has scrapped the concept of founder shares, instead choosing to sponsor the SPAC solely by the purchase of warrants. These warrants are only allowed to be used if the stock price goes up by 20% [9]. This structure must be the way forward as it incentivises the owner of the SPAC to find a good company, one that will continue to do well after the merger, putting the SPAC owner’s interests in line with investors interests.

Until this change is widely adopted amongst the financial community, SPACs will continue to be a brilliant pocket-liner for their founders and a risk not worth taking for retail investors.

Photo Credit: Midison IPO factory